Investors can borrow cash to buy securities and use the securities them- selves as collateral. A transaction in which an investor borrows to buy shares using the shares themselves as collateral is called buying on mar- gin. By borrowing funds, an investor creates financial leverage. The funds borrowed to buy the additional stock will be provided by the broker, and the broker gets the money from a bank. The interest rate that banks charge brokers for these funds is the call money rate (also labeled the broker loan rate). The broker charges the borrowing investor the call money rate plus a service charge.
The brokerage firm is not free to lend as much as it wishes to the investor to buy securities. The Securities Exchange Act of 1934 prohibits brokers from lending more than a specified percentage of the market value of the securities. The initial margin requirement is the proportion of the total market value of the securities that the investor must pay as an equity share, and the remainder is borrowed from the broker. The 1934 act gives the Board of Governors of the Federal Reserve (the Fed) the responsibility to set initial margin requirements. The initial margin requirement has been below 40% and is 50% as of this writing.
The Fed also establishes a maintenance margin requirement. This is the minimum proportion of (1) the equity in the investor’s margin account to (2) the total market value. If the investor’s margin account falls below the minimum maintenance margin (which would happen if the share price fell), the investor is required to put up additional cash. The investor receives a margin call from the broker specifying the additional cash to be put into the investor’s margin account. If the investor fails to put up the additional cash, the broker has the authority to sell the securities in the investor’s account.