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B. Venkatesh

MARKET participants attribute margin calls as one of the reasons for the sharp fall in the market on Monday (May 17). What is margin call?

Suppose you offer a portfolio worth Rs 1 lakh as a collateral to borrow money from a bank. A bank will typically offer to lend Rs 50,000 against a collateral of Rs 1 lakh. In technical terms, you are said to have a limit of Rs 50,000.

Assume you borrow Rs 35,000. Now, suppose the market falls sharply as it did on May 14. The value of collateral falls from Rs 1 lakh to, say, Rs 60,000.

Since your bank has a policy of lending only 50 per cent of the collateral, you are eligible for a loan of only Rs 30,000 based on the market value of your portfolio. Yet, you have borrowed Rs 35,000.

The bank will ask you to pay Rs 5,000 or provide collateral worth Rs 10,000 so that you are eligible for a loan of Rs 35,000. This act by the bank asking you fund your borrowing limit is called margin call.

When traders face margin calls, they sell their holdings to generate money to pay the margin.

As supply of shares in the market increases, prices fall further.

In the derivatives market, futures can be bought by paying an initial margin. You can, for instance, buy Tata Steel futures by paying an initial margin of about 30 per cent. Then, there is the mark-to-market margin.

Suppose you buy Tata Steel futures at Rs 300 and the price declines to Rs 290 at the end of the day. You are required to pay Rs 10 per unit (Tata Steel futures has 900 units) as margin to your broker. Similarly, you will pay mark-to-market margin if you sell futures and the price moves up subsequently.

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