Trade is made with certain types of accounts in exchange which can be opened by the individual investor who is willing to buy or sell securities through brokerage firms. Every investor has single account number. There are further important subsidiary accounts associated with these the main accounts. Two important types of accounts in exchange are
Margin Account vs Cash Account
- Cash Account
- Margin Account
The investor that has a brokerage account automatically possesses a cash account. The investor should keep amount of money equal to the full value of particular security that he is willing to purchase. When the dividend & interest is earned these are accumulated in the cash account. The stock is not purchased by investor through borrowing and hence the total assets on the balance sheet are equal to total equity this means that there are no liabilities.
Margin accounts are also very beneficial in making trades in the exchange. When an investor has margin account then he can borrow some portion of amount from the brokerage firm in making certain investment. In fact the investor gets leverage from the brokerage firm while buying particular security. The investor should have certain amount in his margin account and therefore he will be able to borrow certain portion of money.
It is the measure to ascertain the additional purchasing capacity of the investor for securities without adding further cash in the account. Mostly investors ask their broker about their buying power. The broker has system on his desk that makes him able to quickly find the buying power figure of particular client investor. It is easy to compute the buying power figure. There is initial margin requirement of 50% indicated by the regulation T. So the point at which the debt balance equals the account equity is the extent to which an investor can borrow money from the broker. The margin loan becomes 50% of the portfolio total assets when debit balance & equity figures equalizes. The buying power is zero at that point. Following is the formula for calculation of buying power
B = [(1/m) – 1] E – D
Where B = Buying Power
D = Debt
E = Equity
m = Initial margin requirement
When the initial requirement is 50%, then it is very easy to find the buying power by subtracting the debt balance from the account equity.
(With 50% initial margin) Buying Power = Equity – Debt Balance
In order to withdraw cash from the account, buying power can be used. The total assets & account equity is reduced by withdrawing cash. By withdrawing cash, the marginal equity is doubly reduced. In order to ascertain the amount of cash that can be withdrawn, the margin balance is subtracted by the account equity and both these are divided by two.
In case the equity falls to much extent, more assets (generally cash and cash equivalents) are deposited by the investor into the account. Or the amount of margin debit is reduced by involuntarily shutting down some security position. Such a requirement is referred to as margin call. The minimum portfolio value is ascertained when the debit balance is divided by the quantity one minus the maintenance margin.
Minimum Portfolio Value = Debit Balance / 1 – maintenance margin
When a margin call is received by the investor then it is requirement of most brokerage firms that the investor should deposit additional funds in order to return the portfolio to 50% equity according to condition of full initial margin. The investor may receive a telephone call that indicates that the margin call is ready to come. Moreover a paper notice is also mailed to the investor in one day or more. The investor who lacks sufficient funds to deposit against the margin call must sell his stock in order to keep the balance sheet in order. By selling stock cash is generated which is used to adjust the margin loan. Sufficient shares are required to sell out in order to pay amount of margin call. If the securities in the portfolio do not generate income or appreciate, then a margin call is inevitable. With the passage of time, interest is accrued on the margin loan. So there is progressive decrease in the equity. If the investment is all dogs then the equity will eventually decline to 30%.
Variations in the Margin Account
There are certain products offered by some brokerage firms that are similar to traditional margin account but it provides additional flexibility to the customer. For example Personal Security Loan Account is offered by the PaineWebber that permits the customers to borrow against the securities in their accounts. There is independent setup of this account from the regular investment account and the loan proceeds of this separate account is used for home improvement, car payments, education and other similar uses. Because the additional securities are not purchased by this loan, the loan is considered as less risky by the Federal Board and allows the borrowing of such loan to a large percentage of the portfolio value.
Margin & Speculation
The level of margin debt is considered as precursor of elements to come with the market averages by certain market observers. The movement of margin buying occurred together with the famous averages like S&P 500 and DJIA in past. When there was increase in the margin debt resultantly the level of stock prices also increased and vice versa.
Other Types of Accounts in Exchange
Two important types of accounts in exchange are cash and margin accounts. There are other accounts also that are possessed many investors. Income account is separate account that deals with the bonds & income producing securities. There is also segregate account for convertible bonds in similar way as government bonds has.