Mar
22
2023
Explaining the Different Types of Asset Classes
If you’re new to investing, you might ask, “What is an asset class?” Here’s an explainer—plus learn how this can help you diversify your portfolio.
Read more
SoFi
Student Loan Consolidation and Refinancing
Mar
21
2023
What Is a Swaption? Guide to Understanding Swap Options
A swaption, also known as a swap option, is an option contract that grants the owner the right but not the obligation to enter into a swap contract with specified terms. The swap contracts tend to be interest rate swaps, but can be other types of swaps as well.
With swaptions, one party can exchange a currency of the same value, an interest rate, or the liability of repaying a loan. Read on for how they work, the different types, pros and cons, and more.
How Swaptions Work
As mentioned above, a swaption is an option on a swap rate. Like other types of options contracts, the buyer pays a premium to enter into the swaption, and beyond that they are not obligated to act on the contract.
Although Swaptions are a type of option, they are more similar to a swap than to an option. Similarities to swaps include:
• They are traded over-the-counter instead of on centralized exchanges.
• They are customizable and offer a lot of flexibility since they are not standardized exchange products.
When two parties want to enter into a swap option agreement, they decide on the terms of the contract, such as the the premium, the expiration date, the notional amount, the swap’s legs (fixed vs. float), the benchmark for the floating leg, and the frequency of adjustment for the variable leg.
Recommended: Options Trading 101 Guide
Who Often Uses Swaptions
Swaptions are typically used by institutional investors instead of retail investors, although some private banks offer them to their clients. Large corporations, investment banks, commercial banks, and hedge funds use them for various purposes. It takes a lot of work and experience to create a portfolio of swaptions, so they generally aren’t used by individuals or small firms.
They are often used to hedge against macroeconomic risks such as interest rate risk or securities risks. If an institution thinks interest rates might change, they can enter into an agreement to protect against that. Financial institutions can also use them to change their interest payoff terms.
They tend to be used to hedge specific financings, but they can also be used to hedge a broader change in future interest rates. This can be useful if an institution holds a lot of debt maturities for the year and doesn’t want to risk losses.
The way swaptions are generally set up, their strikes are a strike above the current 10 year swap rate. Therefore the borrower takes on risk between the current rate and the higher rate, but not more than that.
Swaptions can be purchased in most major currencies, such as the U.S. Dollar, Euro, and British Pound.
Recommended: Popular Options Trading Terminology to Know
What Are the Different Types of Swaptions?
There are different types of swap options that each have different types of ‘legs’ in the predetermined swap contract they represent. The two types of options are payer and receiver.
Payer Swaption
If a buyer enters into a payer swaption, they are purchasing the right but not the obligation to enter into a future swap contract. When exercised, the buyer would become the fixed-rate (non-changing) payer and receive the floating rate (variable) payments.
Fixed interest rates don’t change with the market, they stay the same through the duration of a loan. Floating rates change based on a reference rate, the most common one being LIBOR. LIBOR is an average of interest rates that are collected from some of the top banks in London.
Receiver Swaption
In a receiver swaption contract, the swap holder has the option to pay the floating rate and receive the fixed rate.
When Can a Swaption Be Exercised?
There are also swaptions that have different terms of execution. The three most common are:
American
American swaptions can be exercised on any date prior to and including the expiration date.
European
European options can only be exercised on the expiration date, making them less flexible.
Bermudan
Bermudan swaptions have several specific dates when they can be exercised prior to the expiration date.
Finally, user-friendly options trading is here.*
Trade options with SoFi Invest on an easy-to-use, intuitively designed online platform.
*Check out the OCC Options Disclosure Document.
Swaption Example
A borrower wants to purchase rate protection on their current floating rate debt maturities totalling $50 million. They decide that they would like to purchase the right, but not the obligation, to pay a fixed rate on their debts for ten years.
For this right, they are willing to take on the risk of 10 year interest rates up to 3.8%, but no higher than that.
The borrower enters into an agreement with a settlement date in the current year, for a notional amount of $50 million, with a 10 year term and a strike of 3.8%. The premium they must pay to enter in this contract is $400,000.
Including the premium, the rate is actually hedged higher than 3.8%, but for the sake of this example we will call the strike 3.8%.
If the strike is lower or the settlement date is farther in the future, this increases the value of the swaption and therefore increases the cost of the premium.
The borrower enters into this agreement to hedge against a large increase in swap rates but without choosing a specific rate they want when the contract expires.
It’s important to note that the swaption isn’t tied to the 10 year Treasury, it’s tied to 10 year swap rates, although their movements tend to be related. Also, swaptions are derivatives, so they aren’t the underlying assets themselves, but contracts derived from rates or assets.
When the settlement date occurs, there are two ways the swaption could turn out.
- If 10 year swap rates are below 3.8%, the option contract expires, the lender keeps the premium and the borrower uses the current swap rate.
- If 10 year swap rates are higher than 3.8%, the borrower exercises the option. In this case the provider of the swaption pays the borrower the difference between the swap rate and 3.8%. The borrower locks in the current swap rate for a swap agreement, and uses the payment they received to buy down the rate on this new swap.
Pros and Cons of Swaptions
There are a few reasons why financial institutions use swaptions, but there can be downsides to them as well. Some of the pros and cons of swap options are:
| Pros | Cons |
|---|---|
| Can be used to hedge against risk when there is a possibility that an interest rate will go up. | Swaptions can have longer durations than other types of options. |
| If the swaption is not exercised, the buyer loses the premium amount they put in. | There is a risk of the other party defaulting on the agreement. |
The Takeaway
Entering into swaption agreements is one type of options trading strategy commonly used by institutional investors. They are usually used to help with restructuring a current financial position, alter a portfolio, hedge options positions on bonds, or adjust payoff profiles.
There are other types of options on the market that retail investors often trade.
If you’re ready to try your hand at options trading, You can set up an online options trading account and trade from the SoFi mobile app or through the web platform.
And if you have any questions, SoFi offers educational resources about options to learn more. SoFi doesn’t charge commissions, and members have access to complimentary financial advice from a professional.
SoFi Invest® INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
SOIN0821366
Mar
21
2023
What Are Asian Options and How Are They Priced?
Asian options (also known as average strike options or average options) are a type of exotic option that is priced according to the average price of the underlying commodity, as opposed to the spot price.
Read on for how they’re priced, how they work, pros and cons, and more.
What Is an Asian Option?
Asian options are a type of exotic option that trade differently than standard American or European options.
American and European options allow the holder to exercise an option at a strike price known on the purchase date. They differ in when the option can be exercised.
American options can be exercised at any time up to and including the expiration date. European options can only be exercised on the expiration date.
Asian options, on the other hand, are priced based on the average price of the asset over a period of time and like European options they are exercised on the expiration date.
The various parameters of an Asian option are negotiable, but there are two different types of Asian options, average strike options and average price options.
Average strike options are sold with an unknown strike price. The strike price will be determined based on the average price of the underlying asset at selected time intervals.
Average price options are sold at a known strike price. The exercise price will be determined based on the average price of the underlying asset at selected time intervals.
In addition, both types of Asian options may be priced according to arithmetic or geometric averages.
Who Buys Asian Options?
Asian options are usually purchased to solve a particular business problem:
- A buyer wants to lock in an average price or exchange rate over a period of time.
- A buyer wants to protect against price manipulation in the market.
- A buyer wants to protect against volatility in the price movement of the underlying asset.
- A buyer wants to mitigate against inefficient pricing due to an asset being thinly traded.
How Asian Options Work
Like standard options, the price of a call or put in Asian options depends on the price of the underlying asset when the option expires. But unlike standard options, the price of an Asian option will depend on the average price of the underlying over a specified period of time.
Different kinds of Asian options will define average in different ways, so make sure that you check the details of the contract before investing. It’s common for Asian options to define average either as an arithmetic or geometric mean over a period of time.
One example might be for an Asian option to be priced as the arithmetic mean of the underlying stock’s price as measured every 30 days.
Maximum Payoff
Like standard options, the maximum payoff for an Asian option will depend on whether it is a call or put option. Even though the prices in an Asian option are determined by the average price instead of the spot price, the maximum payoff for Asian options works in the same way.
For a call option, the maximum payoff is unlimited, since there is no limit on how high the stock’s price can go.
For the purchase of a put option, the maximum payoff will be if the stock’s price goes to zero.
Maximum Loss
Losses on Asian options are limited to the premiums paid at initiation of the trade. Because of average pricing and lowering the volatility of large price swings, the purchase premiums are also typically lower than available with regular options.
Breakeven
The breakeven price of an Asian option depends on the strike price of the option and the amount of premium that you paid for the option originally. If you paid $1.50 for a call option with a strike price of $50. Your breakeven price in this scenario will be $51.50 (the strike price of 50 plus the $1.50 in premium paid originally).
If the stock’s average price when the option expires is above $51.50, you will earn a profit on the option investment.
It’s more complicated to know in advance what the breakeven will be on an Average strike option but the calculation is the same.
Finally, user-friendly options trading is here.*
Trade options with SoFi Invest on an easy-to-use, intuitively designed online platform.
*Check out the OCC Options Disclosure Document.
Pros and Cons of Asian Options
Here are some of the pros and cons of trading with Asian options:
| Pros | Cons |
|---|---|
| Less volatility than standard options due to the averaging of the price | Not supported by all brokers |
| Generally less expensive than standard options due to lower volatility | Lower liquidity than standard options |
| Useful for traders who have exposure to the underlying asset over time, like suppliers of commodities | More complicated to price than standard options |
Asian Option Pricing
Because Asian options are priced based on an average price instead of the closing price on the date of expiration, they experience lower volatility. This makes intuitive sense, since averaging several price values over time will tend to dampen out extreme values. Because volatility is a key measure of the price of an option, the lower volatility of Asian options generally means lower prices for options.
How Asian Option Pricing Works
The pricing of Asian options is calculated using an average value. Different types of Asian options calculate the average in different ways, and it’s important to understand how the average will be calculated before you purchase the contract. The two most common ways that an average is calculated with Asian options are the arithmetic mean and the geometric mean.
Asian Options Pricing Example – Average Price Option
On March 1, you buy a 90-day call option for stock XYZ with a strike price of $50. This option costs you $1.25 and the average price is defined as the arithmetic mean of the underlying asset price taken every 30 days.
XYZ has a price of $51.00, $48.50 and $52.00 at the 30, 60 and 90 day mark. The arithmetic mean of those 3 prices is ($51 + $48.50 + $52) / 3, or $50.50. Since the option has a strike price of $50, the option closes with a value of $0.50 (calculated price at expiration less spot price, $50.50 – $50).
Because you purchased the option for $1.25 originally, in this scenario you would take a loss on the position.
As with standard options, if the average price of the underlying asset is below the strike price (for a call option), the option expires worthless.
Asian Options Pricing Example – Average Strike Price Option
On March 1, you buy a 90-day call option for stock XYZ. This option costs you $1.25 and the average strike price is defined as the arithmetic mean of the underlying asset price taken every 30 days.
XYZ has a price of $51.00, $48.50 and $52.00 at the 30, 60 and 90 day mark. The arithmetic mean of those 3 prices is ($51 + $48.50 + $52) / 3, or $50.50. Therefore, at expiration the strike price will be $50.50. The option closes with a value of $1.50 (price at expiration less calculated spot price, $52 – $50.50).
Because you purchased the option for $1.25 originally, in this scenario you would have a gain on the position.
The Takeaway
Unlike standard options that are valued based on the spot price of the underlying asset when the option expires, Asian options are valued based on an average price taken in discrete time periods before expiration.
Because the value of an Asian option is based on an average of prices, there is less volatility in the prices. Lower volatility leads to generally cheaper prices than standard options.
If you’re ready to try your hand at online stock options trading, You can set up an Active Invest account and trade options from the SoFi mobile app or through the web platform.
And if you have any questions, SoFi offers educational resources about options to learn more. SoFi doesn’t charge commissions, and members have access to complimentary financial advice from a professional.
FAQ
Are Asian options cheaper?
Asian options are usually (but not always) cheaper than standard American or European options. This is because Asian options are priced using an average price rather than the spot price of the underlying commodity on the date of expiration. Because an average price is used, this makes Asian options less volatile, and consequently, generally cheaper.
How are Asian options priced?
Rather than using the spot price of the underlying stock or commodity on the date of the option’s expiration, Asian options are priced using an average price over the preceding period of time. While there are different methods for calculating the average price, it’s usually calculated as either the arithmetic or geometric mean of the underlying stock or commodity.
Why can’t Black-Scholes models value Asian options?
The Black-Scholes pricing model is one of the most common ways to price standard American or European options. To price options, the Black-Scholes method makes a variety of assumptions about the price of the underlying stock. One assumption required by Black-Scholes is that the stock’s price will move following something called Brownian motion. Because arithmetically-priced Asian options do not follow Brownian Motion, the standard Black-Scholes pricing model does not apply.
Photo credit: iStock/Boris Jovanovic
SoFi Invest® INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
SOIN0422028
Mar
17
2023
Bull Markets, Explained
A bull market occurs when a broad market index rises at least 20% over two months or more. Bull markets signal higher levels of investor confidence and optimism about the future of the market. They are generally a sign of a strong, healthy economy.
The opposite scenario, in which stock prices fall by 20% over an extended period, is known as a bear market.
If you’re investing in the stock market, it’s important to know the nature of bull markets and their potential impact on your returns.
What Is a Bull Market?
When asset prices generally rise over time, the upward trend is known as a bull market. The traditional benchmark for identifying a bull market is an increase of 20% or more in a market index over a two-month period. For example, stock experts might look closely at the Dow Jones Industrial Average (DJIA) or the S&P 500 to determine whether a bull market exists.
Bull markets can imply that the economy is in good shape, with unemployment low and new jobs being created. Investors tend to view a bull market favorably because it suggests that stock prices may continue to rise over the long term. People who buy stocks early in a bull market may benefit later from the investments’ significant price appreciation.
Why Is It Called a Bull Market?
Although there’s no single explanation for how bull and bear markets got their names, people often suggest that the descriptive names are meant to reflect the nature of each animal.
Bulls, for instance, have a reputation for charging or attacking. In a bull market, eager investors may rush in to buy stocks in the hope of capitalizing on future price increases.
Bears, on the other hand, are often seen as being defensive animals that only attack when threatened. In a bear market, it’s common to see investors pull back out of caution and sell off stocks they own or avoid buying new ones. Those behaviors are often driven by fear and uncertainty about the market trending down.
Characteristics of a Bull Market
Identifying when a bull market begins or ends is sometimes challenging, given the nature of stock prices and how rapidly they can move up or down. Generally, there are three indicators that stock experts use to determine whether a bull market exists.
• Stock prices, or prices for a broad market index, have increased by 20% or more over a set period of time, typically two months or longer.
• Investor confidence is high and those buying into the market have an optimistic outlook toward the future.
• Overall economic conditions are largely positive, with low unemployment rates and, ideally, low inflation rates as well.
These three signs usually indicate that the market is on a sustained upswing. Other indications of a bull market can include strong earnings reports and marked increases in investors’ dividends.
What Causes a Bull Market?
Bull markets are usually driven by changing undercurrents in the economy. They tend to reflect the business cycle.
The business cycle experiences periods of expansion, followed by periods of contraction. Real gross domestic product is a commonly used metric for determining which of four phases the economy is in.
• Expansion. During the expansion period, the economy is growing and domestic production is up. There may be a bull market for stocks during this period.
• Peak. A peak occurs when the economy exhausts its ability to grow. At this stage, the bull market typically hits its highest levels before entering the next phase.
• Contraction. During the contraction period, the economy shrinks. Companies may cut back on spending or hiring to save money and stocks may enter bear market territory.
• Trough. The trough is the lowest point in the business cycle. It’s followed by the beginning of the next expansion phase, which can open the door to a new bull market.
The business cycle also influences when bear markets occur. In addition, there are times when a bull or bear market is triggered by something other than the business cycle. For example, in early 2020 there was a short-lived bear market caused by uncertainty over the emerging COVID-19 pandemic.
Example of a Bull Market
The bull market that began in 2009 following the shock of the financial crisis is the longest on record, lasting until the bear market that occurred in early 2020.
Several factors contributed to the sustained length of the bull market, including strategic moves to manage monetary policy on the part of the Federal Reserve, and tax breaks delivered by the 2017 Tax Cuts and Jobs Act.
Many stockholders benefited from steady dividend payouts, and the real estate market also delivered a strong performance during that time.
Bull Market vs Bear Market
Bull markets and bear markets are opposites in terms of how participants behave and what the outcomes can mean for investors. Bull markets typically involve upward movement of stock prices while bear markets indicate a downturn.
In a bull market, investors tend to take a positive view of the market. Bear markets, on the other hand, can trigger pessimism, fear, or other negative feelings among investors.
Bull markets are usually marked by thriving economies and high levels of corporate growth. Bear markets point toward a slowing economy and limited growth. In extreme cases, a bear market could suggest that a recession may be on the horizon (although a recession can offer certain opportunities as well).
Investing Tips During a Bull Market
Investing in a bull market isn’t one-size-fits-all, so your personal approach may be different from other investors’. There are, however, a few overall strategies that could help you to maximize gains while taking on a level of risk you’re comfortable with.
Keep Your Goals In Sight
It’s easy to be tempted to follow the crowd when investing in a bull market or a bear market, but it’s important to stay focused on your individual goals, especially if you’re a beginning investor. If you already have a financial plan in place, that plan can act as a guide for how to choose the right asset allocation during a bull market.
Diversify Your Portfolio
Diversification is an important tool for managing risk in a portfolio. When you’re diversified across different asset classes or industries, it helps to limit your exposure to certain kinds of investment risk. If one investment begins to decline in value, your other investments can help to bolster your portfolio.
A higher allocation to stocks may be optimal if stock prices are rising, but you may want to balance those out with less risky investments, like bonds.
If you’re investing in mutual funds or exchange-traded funds (ETFs), consider what assets each one holds to avoid becoming overweighted in one particular industry or sector.
Go Long in Your Positions
Going long simply means adopting a buy-and-hold approach when investing in a bull market. The end goal is to buy stocks at a low price, then sell them later for a higher price to maximize returns. The key is knowing how to identify the impending end of a bull market so that you can sell before prices drop.
The Takeaway
Bull markets, in which asset prices rise and investors feel optimistic, are a natural part of the market cycle. A bull market begins when a market index rises 20% or more over a two-month period, and it can last months or years. Generally, during a bull market, maintaining a diverse portfolio and a clear idea of your goals can help you manage your investments prudently.
If you’re not investing yet, it’s never been easier to get started. With SoFi, you can open an online investment account and start building a portfolio. You can choose between self-directed trading or automated trading as you begin your journey to growing wealth. SoFi doesn’t charge management fees, and investors can choose between stocks, ETFs, and more.
FAQ
Is a bull market a good market?
A bull market usually signifies that the market is strong. A market where stock prices are generally increasing can offer an opportunity to buy and hold stocks — if you can purchase them before prices rise too high.
How long can a bull market last?
Bull markets have no set duration; they can last months or even years. When a bull market occurs, it typically sticks around for a longer period of time than bear markets do.
Should you sell stocks in a bull market?
Selling stocks in a bull market could make sense if you’re able to sell them for substantially more than you paid for them. Essentially, it all comes down to timing and what makes sense for your individual goals and tolerance for risk.
Photo credit: iStock/GOCMEN
SoFi Invest® INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
SOIN0322046
Mar
17
2023
What Is Broker Call, or Call Money Rate?
The broker’s call — also called “call money rate” or “call loan rate” — refers to the interest rate that brokerage firms pay to banks when they borrow money.
Brokerage firms borrow money from banks in the form of call loans in order to offer loans to traders and investors with margin accounts. As such, the interest rate that brokerages pay banks is what’s referred to as the broker’s call, or call money rate.
Banks can call those loans back from brokerages at any time (hence the name “call loans”), which may cause brokerages to call the money they lent to traders or investors (in the form of margin). That’s one example of what’s referred to as a “margin call.”
Broker Call Rate Definition
The broker call rate is the interest rate that brokerage firms pay banks for borrowing money that they, in turn, loan to traders and investors to pursue margin trades. Since many brokerage firms allow investors to trade “on margin,” the brokerages need to have access to a pool of money that they can borrow from.
In effect, banks lend money to brokerages, and the brokerages lend money to investors — each loan carries a different rate. The broker call rate, again, is the interest rate that the brokerages pay to the banks.
Investors and traders that are using margin to trade will be on the hook for interest payments to the brokerages, and the applicable interest rate for those traders are called margin rates.
But, in terms of a broker call rate, that is only referring to the interest rates that brokerages pay to banks, not the margin rates traders pay to brokerages for their margin accounts.
In addition, although the broker call rate is quoted as an annual rate, these loans are typically for much shorter periods of time. As such, the fees are assessed daily. If the annual rate is 5%, the overnight rate is 5% divided by 365 days or roughly 0.014% per day.
Margin rates, or the rates charged to traders, would be higher.
Recommended: What is Margin Trading and How Does it Work?
Explaining Call Money Rate
Although the terms sound quite different, the broker call rate and the call money rate are essentially the same thing: it’s the interest rate that brokers pay to banks for borrowing money. That typically comprises short-term loans that the brokers then turn around and lend to traders or investors for use in margin accounts.
Brokerages will typically include a service charge, expressed as a percentage, on top of the call money rate to get their margin rates. So, in effect, traders or investors using margin accounts pay a premium, plus interest, to trade with margin loans.
As an investor is deemed capable of borrowing more money, the gap between the broker call rate and the margin rate narrows.
Brokerages drive extra revenue by exploiting the difference in interest rates, just as investors do the same via interest rate options.
The Use of the Term ‘Call’
A quick side note: You may have noticed that the term “call” is a common financial term with various meanings, including:
1. A brokerage issuing a “margin call” requiring a borrower to increase the cash in their account or sell assets to raise cash for their account.
2. A lender “calling a loan” on a borrower, requiring them to repay their debt.
3. Yield to call is another example of the word that in this phrase refers to bonds.
What Is a Call in Options Trading?
A “call” is also a common type of option (the two main types of options are puts and calls), but the sense of the word here is quite different. A call option is a derivative contract that gives investors the right, but not the obligation, to buy a certain number of shares of an underlying asset.
While options trading and margin trading are similar in that they use leverage, margin trading specifically involves borrowed funds. A margin account is not required for options trading.
How Is the Broker Call Rate Calculated?
The broker call rate in the U.S. fluctuates continuously, but generally increases along with interest rates across the board due to the Federal Reserve lifting benchmark rates. Conversely, as the Federal Reserve cuts rates, the broker call rate falls as well.
The broker call rate and the Federal Reserve funds rates are tightly linked, but they are not required to be the same.
It’s also important to know that the broker call rate fluctuates on a daily basis, much like other interest rates. With that in mind, the broker call rate’s calculation is less of a calculation, and more based on a benchmark, such as the London InterBank Offered Rate, or LIBOR rate.
LIBOR serves as a benchmark interest rate that lenders around the world use when they lend to another financial institution on a short-term basis. As such, it makes sense that it would serve as the benchmark for the broker call rate.
But LIBOR is being phased out as of the beginning of 2022, and is being replaced in most instances by the Secured Overnight Financing Rate (SOFR). The transition won’t fully replace LIBOR until 2023, however.
How Does It Affect Margin Traders?
Margin traders utilize leverage to attempt to supercharge their returns. That is, they’re borrowing more money than they actually have in order to make bigger trades. This increases their investing risk, but can also increase their gains.
And, as discussed, it’s pretty obvious how the broker call rate can affect margin traders. Since brokerages need to borrow money from banks, and pay the associated costs for doing so (in the form of interest), they need to turn a profit through their own lending activities. Lending to margin traders, by charging interest plus a service fee or other related cost, helps them cover those costs.
So, the higher the broker call rate, the more interest brokerages need to pay banks in interest charges. That gets passed down to margin traders, who, in turn, end up paying more in interest charges to brokerages when they use margin. This is one of the drawbacks when using a cash account versus a margin account — there are additional costs to consider for using margin, which can eat into returns.
Broker Call Rate Example
Here’s an example of how the broker’s call rate may come into play in the real world:
Brokerage X needs to offer margin funds for its clients with margin accounts, but doesn’t have the money to cover its needs. So, it borrows the money from Bank Y at a predetermined broker call rate. Bank Y decides that the rate will be the current LIBOR rate, plus 0.1%. So, if the LIBOR rate is 3%, for example, the broker call rate is 3.1%.
Brokerage X then uses the borrowed funds to offer margin funds to its clients, for which it charges a margin rate of 4%, plus a $10 service fee. By doing so, Brokerage X drives a little extra revenue through its lending activities, and when the traders pay the margin funds back, it can return them to Bank Y, paying the 3.1% broker call rate for the privilege of borrowing.
Current Call Money Rate
The current call money rate is published daily by the Wall Street Journal, and others. As it fluctuates often, margin traders, or others who may be subject to those fluctuations, can or should make a habit of looking at the current rate in the event that it changes their strategy.
Due to the Federal Reserve raising benchmark rates in an effort to blunt high inflation, the call money rate has seen rapid increases throughout 2022. As recently as June 2021, for instance, the call money rate was only 2%.
Margin Trading With SoFi
The broker call rate is the interest rate that brokerage firms pay banks for borrowing money that they, in turn, loan to traders. Since many brokerage firms allow investors to trade “on margin,” the brokerages need to have access to a pool of money that they can borrow from.
Brokerages typically charge a fee, expressed as a percentage, on top of the call money rate to get their margin rates. So, in effect, investors using margin accounts pay interest to trade stocks with margin loans — plus a little extra.
Leveraged trades are complicated and can be risky. While using borrowed money lets traders place bigger bets, and possibly see bigger gains, they also risk steep losses.
If you’re interested in opening a margin account, you can start by opening a new investing account with SoFi. From there you can apply for a margin loan and start trading. SoFi doesn’t charge commission, and SoFi members have access to complimentary financial advice from professionals.
FAQ
Who decides the call rate for margin trading?
A brokerage ultimately decides the costs associated with margin trading for investors. But as far as what determines the broker call rate, it goes back to the rate as determined by the prevailing benchmark interest rate, such as LIBOR, or the Secured Overnight Financing Rate (SOFR), which is taking precedence as LIBOR is phased out.
What is the overnight call rate?
The overnight call rate refers to the interest rate that banks use when lending or borrowing overnight. Again, since the call money rate is constantly fluctuating, the overnight call rate may or may not be different from the call money rate during normal trading hours.
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*Borrow at 11%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
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