Call Loan Rate
Wouldn't it be great if you saw a great deal on a stock that was selling low, you could borrow the money, buy the stock and then quickly sell it at a profit to pay back the loan? After all, it does take money to make money. Investors do this all the time by setting up a margin account at a brokerage firm. They can borrow money to buy up to 50% of the value of a stock and pay it back (usually within 30 days).
But where does the brokerage firm get the money to loan out? From a bank of course, with a special call loan rate.
Let's say Johnny Hotshot wants to purchase 5,000 shares of a stock that has hit what he thinks is a temporary low price of $15 per share on his margin account. He promises to pay the money back within 30 days after he has bought and sold the stock, preferably at a profit. The brokerage firm Get Rich Quick does not have that much cash available, so they go hat in hand to a bank who loans them the money at a call loan rate of 4%.
This sounds like a great deal except the call loan rate is recalculated every day and also compounds daily until the loan is repaid or is called in by the bank. Calling in means the bank decided they want their money pronto, so if they do, Get Rich Quick has to pay back the loan immediately. If they do not have the funds, they will need to force Johnny Hotshot to use the cash in his margin account or sell his securities in order to raise enough money to repay the call loan.
Related or Semi-related Video
Finance: What is Convertible Debt?43 Views
finance a la shmoop. what is convertible debt? okay so we presume you
know what debt is. if not go uh you know watch that video. we'll wait actually no [man smiles at camera]
we won't wait. so convertible debt is just normal debt
but with one potentially highly valuable added feature. its convertible into
something else. well we were Marvel superheroes that would be our superpower.
you know finance man or something like that.
anyway example time. drone Ranger Inc needs money to upgrade a factory so that
it can produce drones that don't just fly, they swim too. like Aquaman. Alright well
prevailing interest rates for its level of risk and credit worthiness are 7%. the
company needs to raise a hundred million bucks, and the idea of paying seven [graph shown]
million dollars a year for that debt is just too high a price, so the CEO boss
says no .no new factory for you but if the company could get the debt cheaper
well then she might run bulk. unfortunately the company's stock trades
today at a very low multiple of earnings. only 15 times the dollar share they'll
earn this year. so I don't want to raise the hundred million dollars by selling
equity. it would be dilutive to do so, meaning that they would have to print
too many shares to raise that hundred million dollars, specifically a hundred [Dilution defined]
million divided by 15 or six and a half-ish million shares. well some of the
company's investors or rather all of them believe that the company's stock is
and or will be worth more per share than it is today at some point in the future.
otherwise they wouldn't own the stock today, right?
so the wily CFO of the company wonders if there's a Miley Cyrus style best of
both worlds solution here where you could sell equity at a higher price in
the future in part for a price decline on the cost of renting the debt. and in [Cyrus shown swinging across screen]
fact there is and yeah you guessed that it's called a convertible bond, or
convertible debt. yeah different kind of conversion there.
all right well the drone rangers stock is 15 bucks a share today but through
careful negotiated back-and-forth with capital markets people at an investment
bank, the company learns that there actually is demand for its debt price to
pay only 3% interest. if that debt is convertible into equity at 30 bucks a
share. so what does that mean? well if the stock stays under 30 bucks so pretty [definitions on screen]
much forever, then the buyers of the debt or the lenders of the money to the
company got taken. that is they only got three percent interest on their money
when they should have gotten seven percent for loaning money as debt to the
company. but if the stock takes off and the over water underwater drones really
you know fly off the shelves, then the convertibility feature of the
debt will be exercised or used which would be a good thing. so the debt is
convertible at 30 bucks a share which means that a hundred million dollars
raised would cause the company to be diluted a hundred billion divided by 30
bucks, or you know 3.3 ish million shares, I eat it's half the dilution it would [equations]
have been at the company just sold shares at 15 bucks each.
it essentially wrote a call option to the buyers of the debt to be able to
call or buy its stock for 30 bucks a share or 30 times the current year's
earnings at some point you know whenever in the future. like being diluted at 30
times earnings is way less painful than being diluted at 15 times.
so yeah that's convertible debt in a nutshell. not what you find yourself in
during your midlife crisis when you desperately feel the urge to buy a [woman races by in sports car]
silver Beamer that cost three times our annual salary yeah. been there it was a
nice Beamer
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