Question

Scott has $40,000 of his own money to invest. He approached his bank for a margin loan to add to his money. He intends on purchasing Australian shares. The bank’s loan-to-value ratio (LVR) is 70%. Scott borrows $110,000. After six months, Scott’s portfolio value has dropped from $150,000 to $100,000.

a. Calculate the LVR using the reduced portfolio value.

110,000/100,000

b. Assume the bank issues a margin call. Suggest at least two different ways that he could return his portfolio to a 70% LVR.

c. What are some of the risks involved with this type of gearing?

Answer 1

a) LTV ratio= MA/ APV

where,

MA - Mortgage Amount

APV - Appraised Property Value

in this case mortgage amount is $110,000 and APV is $100,000

Therefore, LTV ratio is 110,000/100,000 = 1.1

b) If the bank issues a margin call then Scott can return to his portfolio to an LVR of 70% in the following ways -

1. He should reduce his borrowed amount to = $70,000 (i.e., 70% × $100,000).

This can be done by putting $40,000 cash on the loan ($110,000-70,000)

2. Scott can also sell off some of his shares and can use those proceeds to repay the loan.

c) Portfolio should be managed carefully and properly. to ensure it performs well.

- Full personal insurance can add to costs like brokerage, lender fees and charges.

- A person should have additional security (cash or additional shares) to cover a situation where they do not have enough equity in their gearing package.

- Borrowed money should be invested in growth assets for a successful package. A portfolio with only growth assets would be above their risk tolerance.

- Arrangements should be made to pay off the investment debt and is majorly done through sale of sufficient investment assets. However, this might lead to capital gains tax payments.