Initial margin refers to the percentage of equity a margin account holder must contribute to the purchase of securities. In other words, initial margin refers to the proportion of the total market value of the securities purchased that must be paid in cash by the investor.
Understanding Initial Margin
An investor that is looking to open a margin account, which is an account that allows investors to purchase securities with borrowed funds, must contribute a certain amount of cash or unmargined securities. The amount is known as the initial margin. Essentially, it is the collateral amount that enables the investor to borrow additional money to purchase securities.
For example, with an initial margin of 50%, a cash contribution of $100,000 in a margin account would allow the investor to borrow up to $100,000 from a broker and have $200,000 in purchasing power. The image below illustrates the example:
Initial Margin in the United States
Regulation T governs the amount of credit that brokers and dealers can provide to investors for the purchase of securities in the United States. In the US, the initial margin is set at 50% of the purchase price of a security. With that said, brokers and dealers may require a higher margin if they deem the investor to be riskier.
Purchasing Power and the Initial Margin
The following formula can be used to determine the purchasing power multiplier given the initial margin percentage:
An initial margin of 50% would have a purchasing power multiplier of 2x (1 / 50%). Therefore, an investor who contributes $100,000 in cash would have a total purchasing power of $200,000 ($100,000 x 2) – $100,000 in the investor’s cash and $100,000 in borrowed funds;
An initial margin of 40% would have a purchasing power multiplier of 2.5x (1 / 40%). Therefore, an investor that contributes $100,000 in cash would have a total purchasing power of $250,000 ($100,000 x 2.5) – $100,000 in the investor’s cash and $150,000 in borrowed funds; and
An initial margin of 20% would have a purchasing power multiplier of 5x (1 / 20%). Therefore, an investor that contributes $100,000 in cash would have a total purchasing power of $500,000 ($100,000 x 5) – $100,000 in the investor’s cash and $400,000 in borrowed funds.
John is an investor based in the United States who is looking to open a margin account and purchase 100 shares of ABC Company at $50 per share. According to Regulation T, the initial margin requirement is 50%. To purchase 100 shares of ABC Company at $50 per share, how much equity (cash) must John contribute?
To purchase 100 shares of ABC Company at $50 per share, a total market value of $5,000, John must contribute a 50% initial) margin. Therefore, the amount of equity (cash) that John must contribute is $5,000 x 50% =$2,500.