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You are on page 1of 3

1. You put up $10,000 to take a long position in a stock with a price of $20.

(a) If the initial margin rate on the position is 80%, how many shares can you purchase? What

dollar amount are you borrowing from the brokerage firm?

Loan Amount = $10,000/0.80 – $10,000 = $2,500

Stock = $20 x 625 = $12,5000 Loan = $2,500

Equity = $12,500 - $2,500 = $10,000

[Sanity check: Equity = amount you put up]

(b) You will receive a margin call if the margin rate drops below 30%. Below what price will you

receive a margin call?

(Assume immediate price change, so you can ignore the dividend yield and interest on the loan)

= (Shares x P – Loan)/(Shares x P)

P = Loan/[Shares x (1 – Margin Rate)] = $2,500/[625 x (1 – 0.30)] = $5.71

Margin Rate = (Shares x P – Loan)/(Shares x P) = (625 x $5.71 - $2,500)/(625 x $5.71)

= $1068.75/$3,568.75 = 30%

(c) Calculate the return on the stock at the margin call price. Calculate the return on your equity

at the margin call price. Calculate the ratio of the return on the stock to the return on your

equity. How does this ratio compare to the initial margin rate?

Equity Return = $1068.75/$10,000 – 1 = -89.31%

Stock Return/Equity Return = (-71.45%)/(-89.28%) = 80%

[Sanity check: the ratio equals the initial margin rate]

(d) Assume the stock pays a single annual dividend of $1.00 one year from today. If, at the end of

the year, the stock’s price is $15, calculate the total return on the stock over the year.

Note that this is equal to the capital gain return plus the dividend yield:

Cap Gain Return = $15/$20 – 1 = -25%

Dividend Yield = $1.00/$20 = 5%

Overall Stock Return = -25% + 5% = -20%

1

(e) If your broker charges 8% on margin loans, calculate your return on equity (ROE) over the

year.

Assets Liabilities & Equity

Stock = $15 x 625 = $9,375 Loan = $2,500(1.08) = $2,700

Div Cash = $1.00 x 625 = $625 Equity = $10,000 - $2,700 = $7,300

Total Assets = $10,000

2. You invest $25,000 and take a SHORT position in a stock with a price of $100.

(a) If the initial margin rate is 50%, how many shares did you short?

Cash from Stock Sale = $100 x 500 = $50,000 Value of Stocks Owed = 500 x $100 = $50,000

Margin Cash = $25,000 Equity = $75,000 - $50,000 = $25,000

Total Assets = $75,000

Sanity check:

Margin Rate = Equity/Value of Stocks Owed = Equity/(Shares x P) = $25,000/(500 x $100) = 0.50

(b) Assume you will receive a margin call if the margin rate drops below 30%. ABOVE what price

will you receive a margin call?

(Assume immediate price changes, so you can ignore dividend yield and interest expense)

P = Total Assets/[Shares x (1 + MR)] = 75,000/[500*(1 + 0.30)] = $115.38

Margin Rate = Equity/Value of Stocks Owed = (Total Assets – Shares x P)/(Shares x P)

Margin Rate = ($75,000 – 500 x $115.38)/(500 x $115.38) = $17,310/$57,690 = 30%

(c) Calculate the return on the stock at the margin call price. Calculate you return on equity

(ROE) at the margin call price. Calculate the ratio on the return on the stock to the return on

your equity. How does this ratio compare to the margin rate?

Equity Return = $17,310/$25,000 – 1 = -30.76%

2

Stock Return/Equity Return = 15.38%/-30.76% = -50%

Note: the ratio equals the margin rate, with the opposite sign.

(d) Assume the stock pays a single annual dividend of $2.50 one year from today. If, at the end of

the year, the stock’s price is $90, calculate the total return on the stock over the year.

(e) The broker charges 8% on borrowed shares (calculated on the initial value of the position) and

you earn 2% on the cash in the account. Calculate the return on your equity over the year.

Cash from Stock Sale = $50,000*(1.02) = $51,000 Value of Stocks Owed = 500 x $90 = $45,000

Margin Cash = $25,000*(1.02) = $25,500 Interest on Borrowed Stocks = $50,000*(0.08) = $4,000

Total Assets = $76,500 Dividend Owed = 500 x $2.5 = $1,250

Equity = $76,500 - $45,000 - $4,000 - $1,250 = $26,250

(Note: interest and dividends are listed as “payable” liabilities. Once those are paid, the amount of cash

decreases so the equity does not change.)

The price dropped 10% and the investor was levered 2 to 1, but the cost of the short (including paying

dividends out) decreased the profit to 5.00%.

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