Question

2.A. The current market price for XYZ is $48 per share. Initial margin is 50%, maintenance margin is 35% and margin interest is 1.50% per year. XYZ pays annual cash dividends of $2.25 per share.

2.A.1) You believe the stock price will increase over the next year and wish to trade exactly one round lot. What trade should you make (2 points)? How much margin would you have to post to your account (4 points)? At what price would you receive a margin call (7 points)?

2.A.2) Suppose you are correct and the stock rises to $55 per share at the end of the year. What is your percentage return on equity for this trade (4 points)?

2.B. The current market price for ABC is $75 per share. Initial margin is 50%, maintenance margin is 35% and there is no margin interest. ABC pays annual cash dividends of $3.50 per share.

2.B.1) You believe the stock price will decrease over the next year and wish to trade exactly one round lot. What trade should you make (2 points)? How much margin would you have to post to your account (4 points)? At what price would you receive a margin call (7 points)?

2.B.2) Suppose you are correct and the stock falls to $68 per share at the end of the year. What is your percentage return on equity for this trade (4 points)?

Please provide steps/problem solving to reach each answer.

Answer 1

(2)   One round lot of trading usually (but not always) refers to 100 shares and the same has been taken as the traded volume for this question.  

(2.1) Current Market Price = $ 48

         Value of Stock Purchased = 48 x 100 = $ 4800

Initial Margin Requirement = 50 % and Initial Margin Posted (Investor's Equity) = 4800 x 0.5    =              $ 2400 (Margin to be posted to the account)

Further, the trading period is one year and the stock price is expected to rise. Hence, a sensible thing to profit from this price rise would be to buy (go long on) the stocks.

Margin Interest = 1.5 % and Initial Borrowing = Total Purchase Value - Investor's Equity = 4800 - 2400 = $ 2400

Total Borrowing Liability after 1 year = 2400 + 2400 x 0.015 = $ 2436

Let the price at which margin call will be received be $ K. Maintenance Margin = 35 % which implies that any given point of time the equity value of the account should not be less than 35 % of the total account value,

Equity Value of the Account = Total Account Value - Debt Liability (Initial borrowing + interest)

0.35 x K x 100 = K x 100 - 2436

K = $ 37.48 approximately.

(2.2) Stock Price after 1 year = $ 55 and Dividend = $ 2.25 per share

Appreciation in Share Value (capital gains) = (55 - 48) x 100 = $ 700 and Dividend Gains = 2.25 x 100 = $ 225

Total Returns = Capital Gains + Dividend Gains = 700 + 225 = $ 925

Equity Contribution = $ 2400

Net Total Return = 925 - Margin Interest = 925 - 36 = $ 889

Return on (Initial) Equity = 889 / 2400 = 0.37042 or 37.042 % approximately.