Question

abc company's stock is currently selling at $100 per share. you have 12000 in your pocket but want to buy 200 shares. you can borrow the remainder of the purchase price from your broker at an annual rate of 5% the margin loan.

a. What happens to your net worth(i.e.return) in your brokerage account if the price of abc company increases to $100 after one year?

b.If the maintenance margin is 30%, how low can abc's price drop in one year before you get a margin call?

c.Explain why you may want to buy on margin.Is there any disadvantage of this strategy?

Answer 1

The current Price of the share = $100

For buying 200 shares, one would require = 200 x 100 = $20,000

However, the broker allows to buy $20000 worth of shares with $12000, which means

Initial Margin required = 12000/20000 = 60%

The balance amount = 20000 - 12000 = 8000 will carry a 5% return to be paid to broker

a. If the price of of ABC company = 100

Net return = (Ending Price - Purchase Price - Financing Charges) / Purchase price

= (100 - 100 - (5% x8000)) / 100

= - 400/ 100

= - 4%

B. If the maintenance margin is 30%

Investor has to maintain = 30% x 2000 = $6000 margin at any point of time

Margin Call Price = Initial Purchase Price x ((1- Initial margin) / (1- Maintenance margin)

= 100 x (1-60%)/(1-30%)

= 100 x 40% / 70%

= 400/7

= $ 57.14

Any drop below this price will invite margin call

The maintenance margin is the required percentage of the total investment Margin that is less than the initial margin, and which the investor must maintain in their trading account in order to avoid a margin call – a demand from their broker that they either deposit additional funds into their account or liquidate a sufficient amount of their holdings to meet the margin call

C Margin money gives the leverage to an investor. if one gets 50% margin, which means one can buy worth 2 times the value of stock.

The profits as well as losses multiply with the margins. This is the biggest risk with margin trading