Question

Discuss the effect of leverage and margin requirements on the arbitrage strategy.

The Federal Reserve’s Regulation T. requires that investors post minimum initial capital of 50% for any long position and short positions. Both the NYSE and NASD require maintenance margin of 25% for long positions and 30% for short positions.

Answer 1

I assume here the margin and leverage are in context of equity and not derivatives. Arbitrage strategy thus simply means buying equity that you consider to be undervalued by the market given it’s fundamentals and prospects or selling ( or short selling ) equity that you consider overvalued using the same principles.

In this context margin refers to the fact that a loan has been made to the investor. As per the given information, the maximum loan or “margin” is 50%. That is, a maximum of 50% of the investment amount can be borrowed and the rest is investor’s own equity. However, once the investment is made, the equity portion can be less than the initial margin of 50% but can’t be less than the maintenance margin ( 25% or 30% as the case may be ).

Thus, borrowing the money creates a leverage. When the investment value goes up, gain is amplified and when it goes down, the losses are also amplified. The borrowed money has to be repaid eventually along with the interest. Thus, the basic arbitrage strategy becomes riskier with the use of margin and leverage and can significantly enhance gains and losses both.