Question

If you are a trader making use of leverage to trade, it is very important that you risk manage your trade very carefully as you are trading with borrowed funds. You need to ensure that you hold sufficient cash in case your broker informs you of their intention to recall the loan, i.e. to return all borrowed funds.

Assume that you are given one trading day to raise the cash for the loan amount.

If you are unable to pay the full loan amount in cash, the broker will unwind your trade and use the proceedings to pay for the loan. If the proceeding is not enough to pay off the loan, you are required to top up the difference with cash. Therefore, you need to hold a minimum amount of readily available cash to top up this difference, if you do not want to be served with a bankruptcy order by your broker. Your broker has offered you a $1,000,000 interest-free loan and you used the loan to execute trades in $300,000 of Microsoft (MSFT), $200,000 of Goldman Sachs (GS) and $500,000 of Lending Club (LC) stocks on 29-Nov-2019 at the following prices,

	MSFT	GS	LC
Prices on 29-Nov-2019	$151.38	$221.35	$13.81

1) Calculate and appraise the amount of cash that you need to fork out from your pocket, in Cases A and B, if your dealer decides to recall the loan when the hypothetical stock prices of the three stocks are given as follows respectively:

	MSFT	GS	LC
Case A	$152.00	$225.00	$14.00
Case B	$150.00	$220.00	$13.60

2) Hence, making use of the historical stock prices, suggest how you would appraise the amount of cash you should hold to manage this cash shortfall for 99% of the cases. Explain your methodology and the resulting amount of cash clearly. Document and explain any assumptions you have made in your evaluation.

Answer 1

1) Calculate and appraise the amount of cash that you need to fork out from your pocket, in Cases A and B, if your dealer decides to recall the loan when the hypothetical stock prices of the three stocks are given as follows respectively:

$300,000 of Microsoft (MSFT), - 1981 Shares if price is 151.35

$200,000 of Goldman Sachs (GS) - 903 Shares if price is 221.35

$500,000 of Lending Club (LC) - 36205 Shares if price is 13.81

Case A

$300,000 of Microsoft (MSFT), - If price is 152 then total = 301112

$200,000 of Goldman Sachs (GS) - if price is 220 then total = 203175

$500,000 of Lending Club (LC) - if price is 14 then total = 506870

Total cost = 1011157

Out of pocket cost = 11157

Case B

$300,000 of Microsoft (MSFT), - If price is 150 then total = 297150

$200,000 of Goldman Sachs (GS) - if price is 220 then total = 198660

$500,000 of Lending Club (LC) - if price is 13.60 then total = 492388

Total cost = 988198

Out of pocket cost = Nil

2) Hence, making use of the historical stock prices, suggest how you would appraise the amount of cash you should hold to manage this cash shortfall for 99% of the cases. Explain your methodology and the resulting amount of cash clearly. Document and explain any assumptions you have made in your evaluation.

To manage your stock effectively, you need to find the balance between the cost and benefits of holding the stock. The cost of holding a stock includes the money you have used to buy stock and stock and insurance. The benefits include having enough stock to meet your customers' needs.

Keep in mind that:

having more stock equals additional costs to you as it can lead to a decrease in your cash flow and result in excessive maintenance costs
having very little stock equals lost revenue in the form of lost sales, while also undermining the customer's confidence in your ability to provide the products you are selling
having a bad stock means lost revenue through lost sales, underwriting and poor customer service.
Having the right stock and being able to sell it can lead to:

rising sales
new customers
boosting customer confidence
improved cash flow
new investors
Finding the right suppliers for your business can reduce your stock management costs. Your supplier can handle your stock, or send directly to your customers on your behalf. Your providers can offer payment terms that can help lower your stock management costs. For example, you can negotiate a 30-day payment terms with your customers and with a 45-day terms with your suppliers. This would mean that you would not need a cash flow tied to your stock.