Question

An investor opens a margin account with a discount broker. The initial margin requirement is 50%. The maintenance margin is 30%. The investor intends to buy 1000 shares of XYZ at $40. An interest rate on the margin loan is 4% per year. The stock does not pay any dividends.

How much money must the investor deposit?

Assuming the investor deposits $30,000 (NOT the amount you calculated in part (a) and buys the shares. How far could the stock price fall before the investor would get a margin call?

Assuming the stock price reaches the price you calculated in part (b) and the investor receives a margin call. How much money must the investor deposit to avoid the liquidation actions by the broker?

Assume that the investor receives a margin call in one year after purchasing the stock, but instead of depositing the amount calculated in part (c) he or she sells the shares. What is the rate of return realized by the investor?

Answer 1

1. As the investor plans to purchase 1000 shares at $40, the total investment would $40,000. The initial margin requirement entails that the investor would be required to deposit 50% of $40000 as margin. Therefore, initial margin is $20,000. Maintenance margin is 30% of investment, which is $12,000. Therefore, initial margin may go down to $12,000 without any need to make a call. With 1000 shares, the price per share may dip by $8 per share, before the investor is asked to replenish the margin.
2. If the price of stock falls down to $32 per share ($40 - $8), the investor would be required to add $8,000 to their margin account to get it back to initial margin requirement amount.
3. The stock price is down to $32 per share and the margin is down to $12,000, which means that the investor is allowed to retain only $24,000 worth of initial investment which translates to 600 shares. Revenue from the sale of 400 shares at $32 per share will be $12,800 and loss per share will be $3,200 (400 * $8). Rate of loss is $8/$40 x 100 = 20%.