Institute of Chartered Financial Analysts of India (ICFAI) University 2006 Certification Finance Security Analysis-II - Question Paper

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part E: Caselets

Caselet 1

7.
To buy securities, an investor must have funds in his account and to sell securities he must have the share in his demat account. But sometimes investors may not have sufficient money to buy particular securities. In such a situation, he can take a loan from his broker up to a certain percentage as prescribed by the norms. In addition, if there is a fall in the share price to a certain level he has to pay the deficit amount. In other words, the investor has to maintain a margin throughout the period. If the margin falls by a level (normally prescribed by SEBI) the broker can liquidate the client’s holdings. The “margin” here is the money truly borrowed from the broker, who uses the investor’s stocks thus purchased as collateral for the funds advanced. It helps to leverage to funds several times. Margins are quoted as a percentage of the value of the transaction. Let us understand the process by an example.

Suppose an investor wants to buy 100 Reliance industries shares, whose market price is Rs.500. This transaction requires Rs.50,000 but the investor has only Rs.30,000 as bank balance. He can approach a broker who will invest money on his behalf, taking interest for the identical. Now he invests 50% of the amount (i.e., Reliance) and the broker puts in the other half on his behalf and buys 100 Reliance shares in his name. suppose maintenance margin is 40%, and if it falls beneath 30%, the broker has the right to sell the stock. Now the stock may fall to 410, then the loss is Rs.90 per share. In this case the loan from the broker is still 25,000 but the investor’s own account equity will fall to Rs.16,000. Now his maintenance margin equals 39.20% (Equity Account/market Value of Holding ´ 100 i.e., 16,000/41,000 ´ 100). In this case the broker can ask him for the balance to take the margin to the 40% mark. He has to deposit (41,000 ´ 40% – 16,000) or 400 to maintain the level of 40%.
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8.
For doing trading, the clients generally depend on the brokers for funds and securities. In this market, the interests of the lender are well protected. Clauses relating to the initial margin requirements, the need to maintain such margin, and the right to sell the securities go in favor of the lender. So, the lender is needed to implement prudent risk management practices for the recovery of principal and interest. Further, the lender also needs to take quick decisions and act swiftly for making margin calls and for selling the securities in time. The risks of loss to the lender are three-fold: The transaction cost for selling the securities, the liquidity risk arising out of a failure to sell the securities and the loss of interest on the loan.

Earning:   Approval pending.