Question

an equity fund has a beta of 1.4, interpret its beta value

You have €40,000 to invest in a stock currently priced at €80 a share. The initial margin requirement is 60 percent. Ignoring taxes and commissions show the impact on your rate of return if the stock rises to €100 a share and if it falls to €40 a share assuming (a) you pay cash for the stock, and (b) you buy it using maximum leverage.

Answer 1

Solution:-

Part-1: Interpreting beta value of equity fund:

If a fund has a beta value of 1.4, this means that the risk of the fund is 1.4 times that of the risk of the overall market. Therefore, the risk premium expected from the fund (i.e. the expected return over and above risk free rate) would also be 1.4 times that of the risk premium of the overall market.

Part-2

(a)

If we pay cash for the stock it means that the entire purchase price of the stock is paid in cash as an equity investment with no leverage. Thus, the rate of return is calculated as follows:

No. of shares bought= 40,000/80= 500 shares

Selling value of shares (if it goes up to 100)= 500 shares*100= 50,000

ROC (If the stock price goes up)= (50,000-40,000)/40,000= 25%

Selling value of shares (if it goes down to 40)= 500 shares*40= 20,000

ROC (If the stock price goes down)= (20,000-40,000)/40,000= -50%

(b)

If maximum leverage is taken, it means that 60% of the purchase value is paid using 40,000 and the remaining 40% is paid through leverage.

Gross purchase value of shares= 40,000/60%= EUR 66,666.7

No. of shares bought= 66,666.7/80= 833.33 shares

Selling value of shares (if it goes up to 100)= 833.33 shares*100= 83,333.3

ROC (If the stock price goes up)= (83,333.3-66,666.7)/40,000= 41.7%

Selling value of shares (if it goes down to 40)= 833.33 shares*40= 33,333.2

ROC (If the stock price goes down)= (33,333.3-66,666.7)/40,000= -83.3%