Question

Kenix Brokerage House (KBH) provides brokerage services, including margin trading. Initial margin requirement is set at 50% with maintenance margin of 30%. Margret plans to short 1,000 shares of Tasty Meat at $50 per share.
a) Without considering interest cost of borrowing stock, how high the Tasty Meat price is when Margret gets a margin call? (rounded your answer to 4 decimal places) How much cash should she deposit in order to maintain the percentage margin back to 40%?

b) Compute effective annual return if Margret closes the position at $46 five months later. (Ignoring the interest cost of borrowing stock)
c) Compare the level of risk by using inverse ETFs and short sales to make profit in expected bear market.

Answer 1

a) given

Maintenance margin rate is 30% or 0.3

Initial margin is 50% or 0.5

we know,

margin call price = Shorting Price X (1+initial margin)    / (1+Maintenance margin)

                          =    50    X    ( 1+0.50) /   (1 + 0.30)

                          = 50      X 1.5   /   1.3

                          = $57.69

so margin call will be initiated when the price goes above 57.69

Additional margin required to maintain the margin at 40%

selling price =50000 as seen above

Current market value of Tasty meats when margin call made at 57.69 per share = 1000 X 57.69 = $57,690

we know,  

margin % =    Selling price + margin required - current Value      / Current Value

40%          = (50000+margin required - 57690 )/57690

23076      = margin required - 7690

margin required =   23076+7690

                                   = 30,766

Total margin required for 40% margin is 30766

Additional margin required   =total margin    -   initial margin

                                                 =30766      -25000

                                                = $ 5,766

b)  

the effective annual return is 38.4%

     the total profit made from shorting is 4000. it was made on an investment of 25000-being the initial margin.( Note : the additional margin call requirement of question a is not considered here)

so the return of 4000 for 25000 investment gives a return of 16%

but this return is a period of 5 months, so annual rate will be

   =    38.4% ( 16/5 X12)                   

c) Inverse ETFs and short selling of stocks are both methods to make profits during a   bear market.   an Inverse ETF- is a fund that is managed by the fund managers in such a way that the Returns generated by the fund is INVERSELY PROPORTIONAL to the underlying Index's return.

Thus if S&P500 falls by 1% - the inverse ETF raises by 1 %

and if S&P500 rises by 1% - the inverse ETF falls by 1 %.

so in a bear market -when prices are expected to fall- it makes sense to buy Inverse ETFs.

Short selling- on the other hand requires us to short sell a stock which is not owned by us. the stock is borrowed from a lender and sold at the current price and the position is squared off subsequently by buying in the market.

Both Inverse ETFs and Short selling have inherent risks. Theoretically the loss on short selling is unlimited, whereas it is only to the extent of investment made in ETF.   Supposing a stock is short sold at a price-and the short seller fails to cover it when the price rises- he holds on to it.........his loses will rise by each passing day- requiring him to deposit margin money to maintain the position. The value of loses can be huge-and can wipe out the entire capital ( or sometimes requiring huge margin call) when there is a sudden spike.

whereas in case of an ETF- the value of ETFs cant be less than 0. so the max loss in case of the ETF is the amount invested in ETF.

also , in case of short selling- if dividends are declared on those stocks, and we still continue to hold them-past the dates notified-we may be liable for those dividends too.   Whereas there is no case of a dividend in a an Inverse ETF .