Analysis of Positions and Design for Swaps

Posted: August 26th, 2021

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Analysis of Positions and Design for Swaps

Question 1: Margin Call

Margin call covers buying and shorting securities, which can either be long or short calls. Margin refers to the equity ratio of a marginal account divided by the value of security price. The account equity is the aggregate value after the debit balance is fully settled or once the short financial instruments have been purchased back and reimbursed to the lender (Jylhä, 1290). The borrowed funds should be paid back; thus, the borrowed amount and the accrued interest on margin is treated as a debit to the margin account. Additionally, when the stock is sold short, the value from the short stock is debit as the short stock should be repurchased. Thus, the margin is given as the division of equity and securities value.Financial institutions interested in margin trading are required to open a margin account through a contract. The contract aims at prescribing fundamental margin requirements and maintenance stake expressed as a percentage of the aggregate returns (Jylhä, 1290). The securities purchased in a margin account remains with the broker as theagreement offers the broker a right to advance the securities out on a short sale.

            Usually, the administration of margin call trading is implemented through self-regulated organizations like FINRA New York Stock Exchange and also by the Federal Reserve.It is a requirement to make a minimum deposit of $2,000, with the initial percentage on margin being at least fifty percent. Thus, 25% of deposits are often considered as the minimum costs for maintaining a margin account.However, depending on exchanges or brokerages involved, there could be stricter requirements that are set above the Federal Reserve,probably higher than 30%. Besides, the conditions should be based on the margin ratio which must be above the cost of maintaining the margin call (Jylhä, 1290).For instance, in case the ratio drops below the 50% markalthough still higher than the maintenance costs, the margin account could be restricted. Therefore, there will be no purchase or selling of additional securities until the account is deposited with additional cash to remain above the 50% mark.

            Further, the securities price determines the available amount for a margin call. Where the margin is used in purchasing securities, the margin amount increases the security’s market value. On the contrary, when the margins are used in short financial securities, the margin value is inversely related to the financial instrument or securities. More so, in the cases where the margin applied toshort financial securities, then the margin amount adopts an inverse relationship with the shorted securities (Chan et al., 110). When the equity drops lower than the required maintenance margin, the agent issues a margin call, requesting additional funds to be deposited to increase the margin ratios above 50%. However, in case the investor does not respond, the broker will dispose of enough securities acquired under the margin agreement or repurchase the short financial securities in the market to stabilize the initial margin requirements to 50%.

Benefits of Margin Call

There are several benefits of trading in margin call as an investor. When an investor uses margin, he can leverage the investments thereby increasing the returns from the call when prices move up.  Additionally, margins have competitive interest rates since they offer the lowest rates from brokerage fees. Margin account also helps to eliminate cash account violations from unsettled funds as there is no physical cash involved in its trading(Chan et al., 110).  Equally, trading of margin calls is flexible as an investor can invest more with inadequate cash in hand. The process involvesopening a margin account where the trader will be trading and take advantage of market opportunities with limited funds; thus maximizing profits.

Margin trading provides a diversified investment avenue for investors to improve the performance of their portfolio given that they hold concentrated stock positions. More so, an investor can finance their investment needs without incurring additional fees once they open the margin account(Chan et al., 110). In this case, one is only required to top up their maintenance margin when it drops below the agreed level after initial margin investment. Hence, margin trading is a source of current income to investors from cash dividends received. Besides, the interest on margin loans is tax-deductible against the investor’s net investment income. Figure 1 below shows that margin call can be short or long call as depicted by the charts below.

Figure 1: Short/Long Margin Calls

Figure 2: 75% Margin Requirement

Question 2

Swaps refer to financial derivative contacts where two parties agree to exchange liabilities and cash flows from two financial instruments. Swaps usually entail cash flows from notional principal amounts like bonds and loans (Ramlall et al., 67). However, they can be based on any financial instrument and the principal amount remains with the initial owner. Every cash flow generated involves one leg of a swap. Besides, swaps are traded with having one fixed cash flow while the other left to vary depending on the current price indices or according to the floating exchange rates. Interest rate swaps are the most common types. They are often traded by financial institutions (Ramlall et al., 67). Thus, swaps are neither traded on exchanges nor by retail investors but they are over counter contracts between financial institutions, companies, and businesses. They are customized to the needs of both parties. In the scenario below, companies A and B enter into a swap agreement through a bank to counter their interest rates and they give different indices.

10 Basis Points Swap

The company quotes are as follows;

Firm	Sterling	U.S dollars
A	11%	7%
B	10.6%	6.2%

The loan sterling currency;

The total gain to all parties is as follows;

Difference between the interest rate spread and sterling loan currency

%

 Basis point

Therefore, the swap will earn10 basis points to the bank. Every company A and B gaining annual 15 basis points, which is possible by going to the financial markets directly. One of the possible swaps is as below;

From the swap agreement, company A borrows at an effective annual rate of 6.85% and borrows in US dollars. On the other hand, company B borrows in sterling currency with an effective annual rate of 10.45%. From the swap, the financial institution earnsa spread of 0.1% or 10 basis points. The principal amounts in dollar and sterling are chosen,which are almost equivalent. As indicated in the swap chart, the amounts flow in the opposite direction to the arrows on swap inception. The interest payments move in the opposite directionin the swap life. On centrally, the principle amount flows in a similar direction of the swap life.However, the bank is exposed to risk onthe exchange rate from this swap. The bank gains 0.65% in US dollars and pays 0.55%in sterling. Thus, it should exercise currency arbitrage to cushion itself. Figure 3 below indicates the 10 basis points swap between company A and B

Figure 3: 10 Basis Point Swap for Company A and B

20 Basis Points Swap

 The company quotes are as follows;

Firm	Sterling	U.S dollars
A	11%	7%
B	10.6%	6.2%

The loan sterling currency;

The total gain to all parties is as follows;

Difference between the interest rate spread and sterling loan currency

%

 Basis point

Therefore, the swap will earn 20 basis points to the financial institution. Every company A and B gaining annual 10 basis points, which is possible by going to the financial markets directly. One of the possible swaps is as below;

From the above swap agreement, company A borrows in US dollars at an effective rate of 20%, while Company B borrows at an effective annual rate of 10% in sterling. From the swap, the bank earns 20 basis points. The amounts and interest paymentsmove on opposite directions while the principle amount flows in a similar direction to the arrows. Though, the bank faces the exchange rate risk from the swap. Below is the graphical representation of 20 basis points on company A and B.

Works Cited

Chan, Konan, et al. “Share pledges and margin call pressure.” Journal of Corporate Finance 52     (2018): 96-117.

Jylhä, Petri. “Margin requirements and the security market line.” The journal of finance 73.3          (2018): 1281-1321.

Ramlall, Indranarain, and Indranarain Ramlall. Derivatives and Financial Stability’, Economic       Areas Under Financial Stability (The Theory and Practice of Financial Stability, Volume             4). Emerald Publishing Limited, 2018.