Question

New Economy Traders opened an account to short sell 2,500 shares of Internet Hopes plc. The initial margin requirement was 50%. (The margin account pays no interest.) A year later, the price of Internet Hopes plc. has risen from £70 to £80, and the stock has paid a dividend of £3.5 per share.

i) What is the remaining margin in the account?

ii) If the maintenance margin requirement is 30%, will New Economy receive a margin call?

iii) What is the rate of return on the investment?

Answer 1

i) What is the remaining margin in the account?

Remaining Margin in the account is £53,750

This is a short sale transaction which involves selling now with the hope that price of the shares will fall in future. In the given question price of the shares increased (from 70 to 80) and also dividend declared (3.5) as well. The increase in share price along with the dividend is a loss to the trader (total of 10+3.5 = 13.5 per share). From the initial margin of 50% of £87,500, the loss of £33,750 (£13.5 * 2,500) is reduced and the remaining margin is £53,750

ii) If the maintenance margin requirement is 30%, will New Economy receive a margin call?

If the maintenance margin requirement is 30%, New Economy will receive a margin call.

The margin maintained is 26.9% (£53,750/£200,000) which is less than the margin requirement of 30%. Hence the trader will receive the margin call.

iii) What is the rate of return on the investment?

The rate of return on the investment is -38.57%

Loss incurred as above is £33,750 which is -38.57% of margin provided of £87,500.