|Topics||Forums||Articles||Glossary||Margin Loan Simulator||Other||Today's Posts|
Margin Loan Simulator Documentation
About the simulator
The margin loan simulator is designed to act as a learning tool for investors who are looking at gearing into shares or managed funds. The simulator uses real historical data for unit or share prices to demonstrate the impact that various choices about gearing levels and loan management have on the overall returns of the investments.
There are a few key assumptions made in this version of the simulator, such as:
There are a set of parameters that can be adjusted for the simulation to show how choices made affect the end result. Each time you change one of these parameters, the page will be reloaded and the simulation chart rebuilt. If you want to adjust multiple parameters, you need to make the changes one at a time and wait for the page to reload after each change.
If you want to save a set of parameters for future reference - simply bookmark the URL of the page as it shows with the parameters adjusted. Each parameter which has been changed from the default is reflected in the URL of the page, thus a bookmark of that URL will automatically set the parameters for you when you revisit the page.
Margin Loan Basics
A margin loan is a type of asset-loan which allows an investor to borrow against the value of an existing portfolio of shares and/or managed funds, or to invest in a portfolio of shares and/or managed funds using borrowed money. Margin loans are generally secured by the investments themselves, and as such, the lender must take steps to minimise the risk that they will not get their money back. Unlike loans for real estate which are generally considered to be low risk to the lender, margin loans have an inherent level of risk due to the volatility of the share markets.
The worst thing that can happen to a margin lender is that the value of the investment they have loaned money against, drops to the point where if they forced the sale of the investment, they would not recover all of their money. The lender manages this risk by setting maximum gearing levels for each different share or managed fund - and by limiting the range of shares and funds that they will lend against to only those they consider to be safe enough to reduce the risk.
Further more, margin loans include a safety mechanism for the lender - a margin call. If the value of the investment portfolio drops below a certain pre-defined threshold, the lender literally "calls" the investor and demands that they restore the loan to a safer level. The investor can do this by either paying cash into the loan to reduce the outstanding balance, or by adding additional unleveraged assets to increase the overall value of the portfolio. A third option is to sell down some of the geared investment and apply the proceeds to the loan. If the investor is unable or unwilling to meet the margin call - the lender will typically force the third option and sell down the investments themselves to restore the safety margin. Margin calls are generally required to be met withing 24 hours - so time is of the essense.
Margin calls are generally bad news for investors, since they either require quick access to additional capital, or they result in the realisation of losses in a falling market. Investors manage the risk of a margin call in a number of ways, including keeping a buffer of cash available to meet margin calls, but also by limiting the amount they borrow in the first place to make the chances of a margin call less likely.
The key measure used to track the value of a margin loan is the loan-to-value ratio (LVR). This is simply calculated by dividing outstanding loan amount by the current total value of the portfolio to give a percentage figure. Each individual asset within the portfolio has a maximum allowed LVR assigned to it by the lender, and a maximum LVR for the overall portfolio is also calculated. Typically this might be something like 70% - meaning that if the portfolio is worth $10,000, then the loan is allowed to be no greater than $7,000 (which is 70% of the value). The LVR changes on a daily basis, as the value of the portfolio changes (and also if there are changes to the loan balance, which typically occur less often).
A buffer is allowed above the maximum LVR to cater for day-to-day market fluctuations, this is typically 5% or 10%, depending on the lender. If this buffer is exceeded, then the portfolio is "in margin call" and the lender will generally demand that the LVR be restored back to the maximum allowed (ie out of the buffer zone).
Income distributions from a margined investment will be dealt with in a number of ways - some lenders allow the investor to take the distributions as cash, but some others insist that they be paid back into the loan account to reduce the outstanding loan balance. You may also be able to reinvest the distributions as additional shares or units in the investment that paid the distribution. Note that the unit price (and hence value) of a managed fund investment will drop by approximately the amount of the distribution, and similarly the share price will typically drop when it goes ex-dividend, thus taking the distribution as cash will cause the LVR to increase. Revinvesting the distribution will maintain the LVR at the current level, while having the distribution paid into the loan account will decrease the LVR - but not by much, since the value of the investment also drops.
Some lenders offer the ability to capitalise the loan interest. This means that rather than paying the interest yourself using cash from your bank account, the lender instead adds the outstanding interest for the month to the loan balance - increasing the loan (and also the LVR). This is done to reduce the cashflow requirements of the investment - but without careful maintenance can lead to an increased risk of margin call, since the loan amount is growing at a compound rate over time with interest being paid on interest.
Margin Loan Scenarios
The simulator covers a number of different scenarios that investors may find themselves in. This is not an exhaustive list of possibilities - but it does allow a degree of customisation in how the simulation is started. Note that the scenarios only impact on the starting situation based on the parameters chosen, and have no further impact in calculating the daily results.
Cash invested and geared
You have cash to invest and want to gear the investment to a specific LVR. This is typical for a new investor with no existing portfolio, making their first geared investment. You have an amount of cash available to invest and you want to increase the amount invested using borrowed money. For example, you might have $10,000 and you are prepared to start with an LVR of 50%, thus you might borrow an additional $10,000 for a total investment of $20,000. If your preferred starting LVR was 60%, you could borrow $15,000 to make your total initial investment worth $25,000.
If you preferred to calculate it using a specific loan amount rather than a starting LVR, you could just work backwards and say: I have $10,000 in cash and I want to borrow no more than $5,000, then I would start with an LVR of 33%.
Existing investment geared up
You have an existing non-geared investment gear it up to a specific LVR. This is typical for an investor who has an existing portfolio of investments and they want to increase the value of their investment using borrowed money. The term "geared up" means to increase the leverage. For example, you might have a portfolio worth $10,000, and you want to gear this to 60% LVR and invest the borrowed money, then your portfolio is increased to $25,000 with a $15,000 loan.
Additional cash investment
You have an existing geared investment and you want to make an additional geared investment, maintaining the LVR. This is typical for an investor who has an existing geared portfolio and wants to make an additional investment. They have an amount of cash available to invest and want to increase their loan, but maintain the current LVR, thus not increasing the overall risk of a margin call. For example, you might have a portfolio worth $10,000 which is currently geared at 60% LVR, which means you have a loan of $6,000. You have another $10,000 of cash and you want to invest this, keeping the overall LVR at 60%. Thus you can borrow an additional $15,000 taking the total loan to $21,000 which increases the value of the investment by $25,000 ($10,000 in cash plus $15,000 borrowed) to give a total investment of $35,000.
Equity draw down
You have an existing non-geared investment, you want to borrow against it at a specific LVR and use the borrowed money elsewhere. This is typical for an investor with an existing ungeared portfolio who wants to extract some equity from the portfolio without selling down the assets. This means that they get to use some of the value of their portfolio for some other purpose, but still get the benefit of ongoing growth and income from the investment. For example: you have an investment portfolio worth $10,000 and you want to borrow against this with an LVR of up to 40%, which means that you get $4,000 to spend on something without needing to sell the portfolio. Naturally you will now need to start paying interest on this borrowed money.
The simulator allows you to adjust the following parameters:
There are sometimes yellow circles appearing on the value chart - these represent distribution payments, hover over them with the mouse cursor to see details.
Similarly, there are sometimes red circles appearing on the chart - these represent margin calls, hover over them with the mouse cursor to see details.