Question

XYZ Ltd is selling at K45 a share. You would like to buy 200 shares for your preferred price of K42 a share using 60% margin. XYZ pays no dividends and the interest rate on a margin loan is 6%. You have two types of orders at your disposal:

 Limit buy order

 Stop loss order

A. Which of the two types of orders would you place to buy XYZ at your preferred price?

B. Assuming your order in part A gets executed, how much money will you have to place in your margin account?

C. Which of the two types of orders would you place after buying XYZ in order to ensure that the shares are sold if they drop to K35?

D. With the price drop to K35 calculate the return on your investment following a sale at this price.

E. Describe two (2) characteristics of a good market

Answer 1

A]

Limit buy order would be placed to buy XYZ at your preferred price. This is because a limit buy order purchases the stock at the price specified. A stop loss order would sell the stock if the price falls below a specified level.

B]

Money to place in margin account = number of shares purchased * purchase price * margin %

Money to place in margin account = 200 * 42 * 60%

Money to place in margin account = K5,040

C]

Stop loss order would be placed to ensure that the shares are sold if they drop to K35. This is because a stop loss order would sell the stock if the price falls below a specified level.

D]

Return on investment = (((sale price - purchase price) * number of shares purchased) - interest paid) / margin deposited

interest paid = margin borrowed * interest rate

margin borrowed = number of shares purchased * purchase price * (1 - margin %)

margin borrowed = 200 * 42 * (1 - 60%) = K3,360

interest paid = 3,360 * 6% = 201.60

Return on investment = (((35 - 42) * 200) - 201.60) / 5,040

Return on investment = -31.78%

E]

Two characteristics of a good market are :

• Liquidity - A highly liquid market ensures that bid-ask spreads are low, and orders are executed quickly at the best price
• Settlement - In a good market, there is very low counterparty risk, and trades are settled fairly and with certainty