Abstract

Equity margin loan deals are loans to counterparties secured by collateral in the form of equities. Credit exposure arises when the equity collateral falls below the value of loan. During the life of the deal, the counterparty has to give more shares (or cash) to banks or brokerage houses in case of a fall in the share price, so that the level of the collateral amount stays approximately the same and does not deteriorate. The objective of this paper is to attempt to review the risks associated to margin loan deals and propose some suggestions to factor in certain margin call delays or liquidation uncertainties under the stressed COVID-19 situation. Moreover, we also showed a sample practical approach to measure the tail risk of margin loan which included the counterparty’s likely behavior under stress and used a callable bond pricing logic to assess the likely time and moral hazard problem of the counterparty to walk away from margin loans.

Highlights

  • Equity margin loan deals are loans to counterparties secured by collateral in the form of equities

  • The objective of this paper is to attempt to review the risks associated to margin loan deals and propose some suggestions to factor in certain margin call delays or liquidation uncertainties under the stressed COVID-19 situation

  • We have studied a recent case from India capital markets that might be useful as a good reference for margin loan business risk measurement under COVID-19

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Summary

Introduction

Equity margin loan deals are loans to counterparties secured by collateral in the form of equities. During the life of the deal, the counterparty has to give more shares (or cash) to banks or brokerage houses in case of a fall in the share price, so that the level of the collateral amount stays approximately the same and does not deteriorate. Pricing: Xia and Zhou (2007) are pioneers in solving the margin loan problem They valued margin (stock) loans using the classical GBM model and a purely probabilistic approach. We would like to highlight these legal uncertainties under COVID-19 when we assess the risk of margin loans and try to quantify the potential impact to FIs. We feel the COVID-19 pandemic event is an opportunity for all the stakeholders in FI sector to revisit their contractual obligations and the related models used. We showed a sample practical approach to measure the tail risk of margin loan which included the counterparty’s likely behavior under stress (moral hazard risk) and used a callable bond pricing logic to assess the likely time of the counterparty to walk away from margin loans

Deal Definition in Brief
Margin Calls and Rebalancing
Stopping Rules
Case Study from Indian Stock Market
Practical Model
Behavioral Assumptions
Possible Assumption Review of Block Sales and Its Discount
Stock Price Process to Be Chosen
A Practical Approach to Measure the Tail Risk
Numerical Example
Findings
Conclusion
Full Text
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