Beta And The Problem With Leverage
Another potential problem of using margin to create leverage in an account to boost returns by boosting Beta is the problem of market drawdowns. The maximum margin debt to account value is 50%. This would give a beta of 2. The account equity is the account asset value minus the margin debt. There is a minimum margin maintenance requirement of 30% account equity to account value. Periodically the market as defined by the S&P 500 has lost 40% or even up to 50% of its value. If an account using the maximum amount of margin experienced a 50% drop in account value the account equity would be zero. Wiping out your equity.
Brokerages have a minimum margin maintenance requirement of around 30% account equity to account value. When the ratio of account equity to account value falls below 30% the account holder is expected to make up the difference between the account equity and the required equity.
In the case where the account value fell 50%, there would be a margin maintenance call for additional capital worth 30% of the existing account value. If the funds were not provided, the margin clerk would sell assets in the account, locking in big losses, to get to the required account equity.
At maximum margin, a 50% loss locks in a loss of 15%, while a 40% loss locks in a loss of 5.3% when equity in the account is sold to satisfy the margin maintenance call. Since 12/31/71, there have been two instances of 40% losses and one instance of a 50% loss. This would result in a total loss of around 23.82%. This represents an annual loss of 0.6%.
The Capital Asset Pricing Model can be modified to include the effect of margin maintenance.
The information presented here is the opinion of the author and may quickly become outdated and is subject to change without notice.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.