Beta And The Cost Of Margin

What is the cost of using margin in an account to boost returns by boosting beta? In a margin account you can borrow up to 50% of the purchase price of marginable assets.

This allows investors to potentially double the amount of assets they could buy.

The risk free rate of return is currently very close to zero (around 0.75%). In theory you could use margin to boost beta to nearly 2.0 and thereby boost your expected return. The biggest problem with this plan is that the cost of margin is not zero or even the risk free rate. The current base rate for margin at the largest discount brokers is 6.75%, which is 6% above the risk free rate.

The risk free rate (90-day T-bill) from 12/31/71 through 1/31/17 averaged 4.91%. If you assume in the past that the margin rate was 6% above the risk free rate you would have needed a return greater than 10.91% to improve your return by increasing beta. Unfortunately, the market return (S&P 500) during this period of time was 10.39%. You would effectively lower your return by using margin to buy the S&P 500 with today's cost of margin at 6% above the risk free rate.

The Capital Asset Pricing Model can be replotted with the margin rate at 6% above the risk free rate.

Disclosure:

The information presented here is the opinion of the author and may quickly become outdated and is subject to change without notice. All material presented in this article are compiled from sources believed to be reliable, however accuracy cannot be guaranteed. No person should make an investment decision in reliance on the information presented here.

The information presented here is distributed for education purposes only and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or participate in any particular trading strategy.

Performance data showing past performance results is no guarantee of future returns.