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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
Purchase
Or, One- period rate of return
=
=
1 or, 100%
When investor bought on margin, the one period rate of return is defined
as:
(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.
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%
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 =
Actual margin =
0.726 or 72.6%
= 1000shares Rs. 50
= Rs.50000
Loan
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
Solution,
Here given:
Stock price
=Rs.50
6
Initial margin
=60%
Maintenance margin=30%
a.
rate of return = ?
We have,
Rate of return
(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
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
Rs.37500 Rs.20000
Rs.37500
=0.4667 or 46.67%
Working notes:
Market value
Loan
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
purchase price
Rs. 80
=Rs.61.54
If the price falls below Rs. 61.54, a margin call will be made.