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An investor purchase aRs.100 stock on 55% margin and then its price

doubled to Rs.200. the brokerage firm charged 10% interest for the loan on

the margin investment. No cash dividend was received while the investor

held the stock. What was the investors one period rate of return on this

transaction with and without margin, net of all costs? Show your calculations

and discuss why the returns are not same with and without margins.

Solution

Here given:

Purchasing or starting price (Pt)

Initial Margin

Ending price (P t+1)

Interest for the loan

One period rate of return

=Rs.100

=55%

=Rs.200

=10%

=?

We know,

When an investor purchases without using the margin, the one period

return will be as:

One- period rate of return =

cash dividend

Margin money paid for

Purchase

Or, One- period rate of return

=

=

im x P t

Rs.100

1 or, 100%

When investor bought on margin, the one period rate of return is defined

as:

dividend interest expense

Margin money paid for

Purchase

Or, One- period rate of return =

interest fraction

(Pt+1 - Pt) +D

t+1

- Pt (1-im) x

im x

Pt

0.10

Rs.100 0.55

=

1.736 or 173.6%

Hence, an Investor made a 173.6 % return when the price of the stock he

bought doubled. Stated differently, margin transformed a 100% price rise

into a 173.6% gain.

Note: Investors brokerage firm charged him a 10% interest rate for

the Rs. 45 per share (Rs. 100 Rs.55) it loaned to him.

The rates of return without margin and with margin are not equal due to the

difference in their investment. The amount of investment is lower with

margin so, the rate of return is higher though it pays some interest as well.

Buck Ewing opens a margin account at the local brokerage firm. Bucks initial

investment was to purchase 200 share of Woodbury Corporation on margin

at Rs.40 per share. Buck borrowed Rs.3000 from a broker to complete the

purchase.

a) At the time of the purchase, what was the collateral in bucks account, and

what was the actual margin in bucks account?

the collateral in bucks account and what is the actual margin in the buck s

account?

c) If wood bury stock subsequently falls in price to Rs. 35 per share, what is

the collateral in bucks account and what is the actual margin in bucks

account?

Solution

Here given:

Numbers of shares

= 200shares

Purchase price of share

=Rs.40

Borrowed amount

= Rs.3000

a.

The total market value of assets or 200 shares costing Rs.40 each was

the collateral in Bucks account at the time of purchase. It means,

collateral = Rs.40 200 shares = Rs.8000

Market value of assets loan

Actual margin =

Market value of assets

= Rs.40 200shares Rs. 3000

Rs. 40200shares

= 0.625 or 62.5%

b.

Market value of assets= (collateral) = Rs. 60 200 shares = - Rs.

12000

RS.60 200shares Rs.3000

Actual margin =

Rs.60 200shares

c.

= 0.75 or 75%

Rs.35 200 shares Rs.3000

Actual margin=

Rs.35 200 shares

= 0.57143 or 57.143%

Through a margin account candy Cumming short sells 200 shares of Madison

inc. stock for Rs.50 per share. The initial margin requirement is 45%.

a) If Madison stock subsequently rises to Rs.58per share, what is the equity

in candys account and what is the actual margin in candys account?

b) If Madison stock subsequently falls to Rs.42 per share, what is the equity

in candys account and what is the actual margin in candys account?

Solution

Here given:

Market price of stock

Numbers of shares

Initial margin requirement

=Rs.50

=200 shares

=45%

Here,

a. Equity, if price of stock rises to Rs.58

We have,

Equity = No. of shares Beginning price (1+initial margin) No. of

shares Ending price

Or, Equity = 200 shares Rs.50 (1+0.45) 200 shares Rs.58 =

Rs.2900

Now,

Actual Margin =

loan

Rs.58

Rs.58 200 shares

= 0.25 or 25%

Equity = 200shares [Rs .50 (1+ 0.45)] - 200 shares Rs.42 =

Rs.6100

4

Actual margin =

Rs.42 200 shares

0.726 or 72.6%

Snooker arnovich buys on margin 1000shares of Rockford systems at Rs.60

per share. The initial margin requirement is 50% and the maintenance

margin requirement is 30%. If the Rockford stock falls to Rs.50, will snooker

receive a margin call?

Solution

Here given:

Number of shares purchase

= 1000 shares

Stock price

=Rs.60 per share

Initial margin requirement

=50%

Maintenance margin requirement

=30%

Decline in stock price

=Rs.50

First calculate the actual margin and this margin compare with

initial margin.

Market value loan

Actual margin

=

market value

= Rs. 50000 Rs.30000

Rs.50000

= 0.40 or 40%

Working notes:

Market value

= 1000shares Rs. 50

= Rs.50000

Loan

=Rs.30000

The snooker will not receive a margin call because maintenance margin is

less than actual margin i.e.30% < 40%.

Alternatively,

Calculation of the margin call price and compare this price with Rs.50.

1 Initial margin

Price of stock

=

1 maintenance margin

purchase price

= 1 -0.50

1-0.30

Rs. 60

= Rs.42.857

The snooker will not receive a margin call because price Rs.50is still above

the price Rs.42.857 i.e. Rs.50> Rs.42.857. to receive margin call the price

should fall below Rs. 42.857.

Note: you can do any one method; all method gives you same results

Consider the following information:

Stock price per share

Rs.50

Margin requirement

60%

Maintenance margin

30%

Ignoring transaction cost and taxes:

a) Assumes that an investor takes a short position with a cash deposit equals

to 100% of the requirement (It means without using the margin).

Calculate the rate of return if the investor covers (purchases) the stock at

Rs 40 after one year.

b) Assumes that an investor takes a short position with a cash deposit equals

to 60% (i.e. initial margin) of the Sales value. (1) Calculate the stock price

that will trigger a margin call.

(2) Calculate the rate of return if

the investor covers (purchase) the stock at Rs.40 after one year.

c) Explain why the rates of return in parts (a) and (b) are different.

Solution,

Here given:

Stock price

=Rs.50

6

Initial margin

=60%

Maintenance margin=30%

a.

rate of return = ?

We have,

Rate of return

Starting price

=

(Rs.50 Rs.40)

Rs.50

= 0.20 or 20%

b. (1) stock price that will trigger a margin call.

We have,

Trigger Price of stock

1+ initial margin

1+maintenance margin

selling price

(Pt)

=

=

1+ 0.60

1+ 0.30

Rs.50

Rs.61.538

made.

b. (2) rate of return

Rate of return

Equity deposit

= (Rs.50 Rs. 40)

Rs.30

= 0.3333 or 33.33%

c. the HPR on 60% margin position margin is larger than the return on 100%

margin. This occurs because the investor is allowed to deposit 60% of stock

price and can invest the remaining money at 20%.

7

You have borrowed Rs. 20000 on margin to buy shares to Disney, which is

now selling at Rs.80 per share. Your account start at the initial margin

requirement of 50%the maintenance margin is 35%. Two days later, the

stock price falls to Rs.75 per share.

a) Will you receive a margin call?

b) How long price of Disney shares fall before you receive a margin call?

Solution

Here given:

Position

= long position

Purchase price or starting price (p1)

=Rs.80

Initial margin

=50%

Maintenance margin

35%

a. receive a margin call or not?

We have,

Actual margin =

=

Market value of Assets

Rs.37500 Rs.20000

Rs.37500

=0.4667 or 46.67%

Working notes:

Market value

Loan

=Rs.20000

Since the actual margin is 46.67%, which is greater than the maintenance

margin therefore, you will not receive a margin call.

b. Triggering price of the stock

Here given:

8

= 50%

Maintenance margin required by brokerage firm

=35

Purchase price on margin

=Rs.80per share

Price of stock that will trigger a maintenance call:

Triggering Price of stock =

1 initial margin

1 Maintenance margin

= 1 0.50

1 0.35

purchase price

Rs. 80

=Rs.61.54

If the price falls below Rs. 61.54, a margin call will be made.

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