a. There can be two types of accounts of an investor with a broker, the cash account and the margin account.
b. In the cash account, the amount of purchase of assets is restricted to the level of cash available for investment in the account. The investor can only go long in such an account.
c. In a margin account, however, the investor can have a levered position. Here, the investor can borrow funds, in the form of a margin loan, from the broker to buy securities. Trading in derivatives especially requires a margin account. The interest rate on the borrowed money in the margin account requires a call money rate.
d. For the margin accounts, there are requirements of minimum margin, which may be set by the regulation, exchange, or clearinghouse. There are basically two kinds of margins required, i.e. initial margin and maintenance margin.
e. The initial margin is the amount (in terms of cash or asset) of deposit to be made by a customer to confirm his acceptance of contractual obligation while trading with futures and options.
f. The maintenance margin, on the other hand, is the minimum amount of money (cash or cash equivalent) that must have to be maintained by the client of the option or future market with the broker or the clearinghouse. If the margin falls below the level due to mark-to-market, the broker has to make the margin call to increase the level of initial margin.
g. If the investors are unable to maintain the maintenance margin, then they are forced into liquidation, by selling the investments.
h. A margin call is a request issued by a broker to a client or by a clearinghouse to a clearing member for additional funds. The request is made when the fund position falls below the amount of maintenance margin.
1.1. Leverage Ratio
The leverage ratio is the value of position per dollar of equity investment. We can write this in the form of a formula as follows:
And the maximum leverage ratio can be calculated as follows: