Question

On January 2010, Mr. Ronald Spahr won a prize of a $300,000. For the last few years, Ron has been educating himself about the stock market. Because of the financial crisis, Ron, among others, believes this is a great entry point for investors and that there are so many undervalued stocks and great investment opportunities.

It is now May 2010; Ron is still sitting on his money waiting to learn more about the stock market. Ron heard a lot of investment professionals talking about making money by investing in new stocks offered to the public at initial public offerings (IPOs). So, Ron is waiting for a good IPO to jump in the market.

Ron started to learn about an upcoming IPO of an automobile company that so many people believe will change the future of the industry in the US and globally, that’s Tesla Motors (TSLA). Ron likes this new company so much and is ready to start his investment journey once the stock goes public on June 29^th of 2010.

• Ron was not able to purchase the stock at the IPO price of $17. However, he purchased the shares in the secondary market at a price of $25 per share on July 1^st, 2010. Ron’s account manager is also so positive about TSLA, so she advised Ron to use the maximum allowed margin to maximize his returns from this great investment opportunity. Ron’s broker initial margin requirement is 60% and charges interest rate of 5%.

1. How much money will Ron borrow from his broker in order to use the entire margin in this transaction?

1. $750,000
2. $300,000
3. $333,333.3
4. $200,000

2. How many shares did he purchase if he will use the entire allowed margin?

1. 13,330 shares
2. 20,000 shares
3. 30,000 shares
4. 12,000 shares

3) What is the minimum initial margin requirement as specified by the Federal Reserve   system?

a) 70%

b) 50%

c) 60%

d) 40%

  

4) If Ron’s broker has a maintenance margin of 40%, how far could TSLA stock decline before

Ron receives a margin call?

a) $15.8

b) $16.67

c) $17.50

d) $26.25

Answer 1

1)   D -   $ 200,000

since Ron has decided to use the maximum margin allowed,   he would invest his entire 300000 at a margin of 60%

so his entire investment of 300000 willl be his initial margin amount

initial margin %   =   60 %   or   0.60

his maximum elligible limit will be   =      Initial margin amount    /   Initial Margin %

                                       =        300000 /   0.60

                                       =       $ 500,000

Amount borrowed from broker =    maximum limit - initial margin

                                            = 500000     -   300000

                                            = $200,000

2)    b- 20,000 shares

if he uses his entire margin- his maximum limit will be 500,000 as seen above

so   for 500,000 he can get   20,000 shares of TSLA   (    500000 / 25   ) ( total elligible amount / market price of TSLA)

3)   b -    50%

The minimum initial margin requirement as specified by the Federal Reserve is 50%

4)    b) $ 16.67

Given                   

Maintenance Margin       (MMR) = 40% or 0.40

Initial Margin    %     =    60%             or 0.60             

Original purchase price of TSLA=   $ 25   

Price at which margin call will occur                                                                         

                           =         original price X ( 1   - initial margin%)    /      (1 -   Maintenance margin %)                                                     

                            =                         25             X   (   1     -     0.60    )    /       (   1     -     0.40    )                                                 

                             =                         25              X        0.40        /              0.60                                                              

                               =                     $ 16.67                                                         

                               

A fall below $ 16.67 in TSLA will initiate a margin call