Question

The current market price for ABC is $79 per share. Initial margin is 50%, maintenance margin is 35% and there is no margin interest. ABC pays annual cash dividends of $3.95 per share. You believe the stock price will decrease over the next year and wish to sell short using margin. Suppose you are correct and the stock falls to $62 per share at the end of the year. What is your percentage return on equity for this trade?

Answer 1

The current market price is $79 and if we short the stock at this price that means our selling price turns out to be $79.

As it is clearly mentioned that there is no margin interest charged by the broker so there is no additional cost. Only the initial margin is invested as equity.

Let say we short 'X' shares which means we have to pay 50%*X*79 as margin amount to the broker for the trade to happen.

In a short sale, the dividend is not received as the dividend is only given to the owners i.e. stock buyers, so the only gain is the capital gain which is obtained by buying at low and selling at a higher price of the stock. And the dividend has to be paid by the seller to the buyer in this trade as a substitute payment in lieu of dividends.

The buying price is $62 as mentioned in the question. So we buy 'X' shares at $62 and sell it at $79 in this trade.

The capital gain would be = X(79-62) = 17*X

Dividend Paid = 3.95*X

The net capital gain = 17X-3.95X = 13.05X

Equity Invetsed is = 79*X*50% = 39.5X

ROE of the trade = 13.05X/39.5X = 33.037%