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Special Memorandum Account (SMA) Calculations on the Series 7 Exam

The Series 7 will expect you to know the skinny on SMA’s. A special memorandum account (SMA) is a line of credit that a customer can borrow from his margin account or use to purchase more securities on margin.

If all is right in the universe and the market goes in the right direction, the customer actually has more equity in the margin account than he needs, which generates an SMA. If a customer removes the SMA, he is borrowing money from the margin account; therefore,

  • The equity is reduced for both long and short margin accounts.

  • The debit balance (the amount owed to the brokerage firm) is increased for long margin accounts.

  • The credit balance is decreased for short margin accounts.

After SMA is generated in a long or short account, it doesn’t go away until a customer uses it, even if the account becomes restricted. You can think of developing an SMA as establishing credit; after you establish credit (on a credit card, for example), it remains there until you use it.

SMAs for long margin accounts

When an investor purchases on margin, that customer has a leveraged position, so he has an interest in a larger amount of securities than he would’ve had if he had paid in full. When a customer has a long margin account, excess equity is created when the value of the securities in the account increases and the equity in the account increases above the margin requirement.

The following question tests your ability to answer a question on excess equity.

Mrs. Glorious purchased 1,000 shares of DUD Corp. on margin at $50 per share. If DUD is currently trading at $70 per share, what is Mrs. Glorious’ excess equity?

(A)    $5,000
(B)    $7,500
(C)    $10,000
(D)    $20,000

The answer you’re looking for is Choice (C). This question throws you a little curveball because you have to set up a new equation when the market price changes. You first need to find the debit balance. Mrs. Glorious purchased $50,000 worth of securities (1,000 shares × $50 per share), so enter $50,000 under the LMV (long market value).

Then Mrs. Glorious had to deposit the Regulation T amount (50 percent) of the purchase, so enter $25,000 (50% × $50,000) under the EQ (the investor’s portion of the account). This means she borrowed $25,000 (the DR) from the broker-dealer:

LMV – DR = EQ
$50,000 – DR = $25,000
DR = $25,000

Now the curveball: The LMV changes to $70,000 ($70 × 1,000 shares). Because the DR (the amount borrowed from the broker-dealer) doesn’t change, you bring the $25,000 to your new equation. You find that the EQ has increased to $45,000:

LMV – DR = EQ
$70,000 – $25,000 = EQ
$45,000 = EQ

Now multiply the LMV by Regulation T to get the margin requirement, the amount that Mrs. Glorious should have in EQ to be at 50 percent. Take the $35,000 ($70,000 × 50%) and compare it to the EQ. Because Mrs. Glorious has $45,000 in equity, she has $10,000 in excess equity ($10,000 more than she needs):

Margin requirement = Reg T × LMV
Margin requirement = 50% × $70,000
SMA = EQ – margin replacement
SMA = $45,000 – $35,000 = $10,000

The R in DR should help you remember that the debit balance remains the same as the market price changes.

SMAs for short margin accounts

Unlike in a long account, an investor with a short margin account earns excess equity when the price of the securities in the margin account decreases. An SMA is a credit line that investors can withdraw as cash or use to help purchase or sell short more securities on margin.

Excess equity is the amount of equity that a customer has in a margin account that’s above the Regulation T requirement.

The following question tests your knowledge on determining excess equity for a short account.

Mrs. Rice sold short 1,000 shares of HIJ Corp. on margin at $60 per share. If HIJ is currently trading at $50 per share, what is Mrs. Rice’s excess equity?

(A)    $5,000
(B)    $7,500
(C)    $10,000
(D)    $15,000

The correct answer is Choice (D). This question has a twist because you have to use a new equation when the market price changes.

Start by setting up the equation to find the credit balance. Mrs. Rice sold short $60,000 worth of securities (1,000 shares × $60 per share), so enter $60,000 under the SMV (short market value). Then Mrs. Rice had to deposit the Regulation T amount (50 percent) of the purchase, so enter $30,000 (50% × $60,000) under the EQ (the investor’s portion of the account). The credit balance (CR) is $90,000:

SMV + EQ = CR
$60,000 + $30,000 = CR
$90,000 = CR

Next, the SMV changes to $50,000 ($50 × 1,000 shares), so you need to calculate the investor’s current equity. Put that value under the SMV. In a short account, the CR remains the same as the market price changes, so you need to bring the $90,000 straight down from the previous equation. This means that the EQ has increased to $40,000 (the difference between $50,000 and $90,000):

SMV + EQ = CR
$50,000 + EQ = $90,000
EQ = $40,000

Now multiply the SMV by Regulation T to get the amount that Mrs. Rice should have in equity to be at 50 percent. Compare the margin requirement of $25,000 ($50,000 × 50%) to the current equity. Because Mrs. Rice has $40,000 in equity, she has $15,000 in excess equity ($15,000 more than she needs):

Margin requirement = Reg T × SMV
Margin requirement = 50% × $50,000 = $25,000
SMA = EQ – margin requirement
SMA = $40,000 – $25,000 = $15,000

The R in CR should help you remember that the credit balance remains the same as the market price changes.

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