Question

Ivanka maintains an aggressive investment posture including margin trading. She currently holds a $100,000 diversified stock portfolio in her margin account. The account has a debit balance of $40,000. She believes T. Enterprises, which is selling at $20 per share, is about to soar to at least $50 per share in the next year. The company pays no dividends. The initial margin requirement is 50% and margin loans charge 10%.

1. Suppose Ivanka decides to buy 1000 shares of T. Enterprises. Bear in mind this is a $20,000 transaction.
   1. What is her current (before the purchase or T. Enterprises) margin?
2. 2. Suppose she pays cash, what is the new margin in her account?
3. 3. What is her new margin position after the transaction if she uses $5,000 of her own money and obtains a $15,000 margin loan for the balance?
4. 4. Explain why in part c Ivanka can purchase the stock while putting up only 25% of the transaction ($5,000/20,000) and borrows the rest when the initial requirement is 50%
5. 5. Suppose she finances the new stock completely on the margin that is, she puts up no money and borrows the full purchase price. What is her account’s new margin?
6. 6. Explain why both d and e involve pyramiding.

Answer 1

In this case the normal margin requirement is not mentioned. The minimum requirement as per NYSE is 25% but there is no restriction that it cant be more. so assuming the initial margin requirement is also the normal margin requirement.

a Currently the margin requirement is 50% of 100000 i.e. $50,000. As there is shortfall of $10,000, Ivanka has to pay the difference amount or opt for margin loan which will bear interest of 10% on 10000 additionally.

b If she buys new shares in cash her investments will be of 120000 with margin money of 60000 (40000+20000 new) which is 50% of 120000 and hence there will be no need for any loan or payment for margin further.

c If she uses $5,000 of her own money then the margin balance will be $45,000 whereas the required margin is 60000. i.e. a short fall of $15,000 for which he has taken a margin loan.

d.As after purchase the margin requirement is of 60000 and she has paid only $5,000 in cash there will be a shortfall of $15,000. The concept of pyramiding allows client to initiate trades with lower margins if there are unrealized profits in the stocks. The brokers allows such types of trades if there are possibilities of profit are certain in the future.

e. Again this is the effect of Pyramiding, where the unrealized gains in the portfolio allows the client to book more trades even below initial margin requirements.

e