Academic journal article Atlantic Economic Journal

Trigger Prices for Margin Calls

Academic journal article Atlantic Economic Journal

Trigger Prices for Margin Calls

Article excerpt

Trigger Prices for Margin Calls

The 984-point decline in the DJIA between August and December 1987 revived an unhappy reality of the market--margin calls.

Plummeting prices can reduce the equity of an investor who buys on margin from an initial minimum of 50 percent of market value to a level in need of repair--normally below 25 percent of market value. The failure to restore equity to an acceptable percentage leads to a liquidation of the investor's position and, when repeated often enough, can fuel a market tailspin not unlike the "Crash of '29".

If such disasters cannot be forecast, at least the price at which margin calls are possible can be. (Possible is used since brokerage firms exercise discretion in deciding when and for whom calls are issued.) Equation (1) solves for the trigger price of a margin call: PM = [(1 - IM) (1 - MM)-1]PP - 0.125 (1) where: PM = margin-call price; IM = initial margin rate; MM = maintenance margin rate; and PP = purchase price.

Where an investor's broker uses a safety margin in lieu of the industry's maintenance margin, the former should substitute for MM in Equation (1). …

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