FIN 435 (Faculty: SfR)

CHAPTER 3 HOW SECURITIES ARE TRADED

Problem 4: (a) In principle, potential losses are unbounded, growing directly with increases in the price of IBM. (b) If the stop-buy order can be filled at $ 128, the maximum possible loss per share is $8. If IBMs shares go above $128, the stop-buy order is executed, limiting the losses from the short sale. Problem 17: On January 1, you sold short 100 shares of Zenith stock at $14 per share. On March 1, a dividend of $2 per share was paid. On April 1, you covered the short sale by buying the stock at a price of $9 per share. You paid $0.50 per share in commissions for each transaction. What is the value of your account on April 1st? The proceeds from the short sale (net of commission) were: ($14 x 100) ($0.50 x 100) = $1,350 You must repay the dividend to the original owner of the borrowed shares. As a result, the dividend payment of $200 is withdrawn from your account. Covering the short sale at $9 per share cost you (including commission): ($9 x 100) + ($0.50 x 100) = $950 Therefore, the value of your account is equal to the net profit on the transaction: $1350 $200 $950 = $200 Note that your profit ($200) equals (100 shares x profit per share of $2). Your net proceeds per share were: $14 selling price of stock $ 9 repurchase price of stock $ 2 dividend per share $ 1 2 trades x $0.50 commission per share -------------------------------------------------$2 Extra Problem (Similar to 9): You are bullish on Telecom stock. The current market price is $50 per share and you have $5,000 of your own to invest. You borrow an additional $5,000 from your broker at an annual interest rate of 8% and invest $10,000 in the stock. (a) What will be the return on your margin position if the price of Telecom increases to

FIN 435 (Faculty: SfR)

$55 during the next year? (b) Suppose the price drops immediately after you take this position. At what price would you receive a margin call from your broker? (c) Suppose instead that the large price drop occurs one year after you take the position. At what price would you receive a margin call from your broker? a. You buy 200 shares of Telecom ($10,000/$50 per share). These shares increase in value by 10%, or $1,000. You pay interest of: 0.08 x 5,000 = $400 The rate of return will be: ($1,000 $400)/5000 = 0.12 = 12% b. The value of the 200 shares is 200P. The equity in the account is (200P $5,000). You will receive a margin call when: (200P $5,000)/200P = 0.30 when P = $35.71 or lower c. The value of the 200 shares is 200P. After one year, the equity in the account is (200P $5,000(1.08)). You will receive a margin call when: 200P $5,000(1.08)/200P = 0.30 when P = $38.57 or lower Extra Problem (Similar to 11): Suppose that Intel currently is selling at $80 per share. You buy 250 shares, using $15,000 of your own money and borrowing the remainder of the purchase price from your broker. The rate on the margin loan is 8%. a. What is the percentage increase in the net worth of your brokerage account if the price of Intel immediately changes to (i) $88; (ii) $80; (iii) $72? What is the relationship between your percentage return and the percentage change in the price of Intel? b. If the maintenance margin is 30%, how low can Intels price fall before you get a margin call? c. How would your answer to (b) change if you had financed the initial purchase with only $10,000 of your own money? d. What is the rate of return on your margined position (assuming again that you invest $15,000 of your own money) if Intel is selling after one year at (i) $88; (ii) $80; (iii) $72 What is the relationship between your percentage return and the percentage change in the price of Intel? Assume that Intel pays no dividends. e. Continue to assume that a year has passed. How low can Intels price fall before you get a margin call?
Solution: Cost of purchase is $80 x 250 = $20,000. You borrow $5,000 from your broker, and invest $15,000 of your own funds. Your margin account starts out with a net worth of $15,000.

FIN 435 (Faculty: SfR)

a. (i)

Net worth rises by $2,000 from $15,000 to $88 x 250 $5,000 = $17,000. Percentage gain = $2,000/$15,000 = .1333 = 13.33%

(ii)

With unchanged price, net worth remains unchanged. Percentage gain = zero

(iii)

Net worth falls to $72 x 250 $5,000 = $13,000. Percentage gain = $2,000 = .1333 = 13.33% $15,000

The relationship between the percentage change in the price of the stock and the investors percentage gain is given by: % gain = % change in price x Total investment = % change in price x 1.333 investor's initial equity

For example, when the stock price rises from 80 to 88, the percentage change in price is 10%, while the percentage gain for the investor is 1.333 times as large, 13.33%: % gain = 10% x $20,000 = 13.33% $15,000

b. The value of the 250 shares is 250P. Equity is 250P 5000. You will receive a margin call when:

250P 5,000 = .3 or when P = $28.57 250P

c. The value of the 250 shares is 250P. But now you have borrowed $10,000 instead of $5,000. Therefore, equity is only 250P $10,000. You will receive a margin call when

250 P 10,000 .3 or when P = $57.14 250 P

(250 $88 $5,400) $15,000 = .1067, or 10.67%. $15,000

(ii)

(250 $80 $5,400) $15,000 = .0267, or 2.67%. $15,000

FIN 435 (Faculty: SfR)

(iii)

(250 $72 $5,400) $15,000 = .160, or 16.0%. 15,000

The relationship between the percentage change in the price of Intel and investors percentage return is given by:

Total investment % change Funds borrowed % gain = in price x 8% x investor's initial equity investor's initial equity

For example, when the stock price rises from 80 to 884, the percentage change in price is 10%, while the percentage gain for the investor is

10% x

20,000 5000 8% x = 10.67% 15,000 15,000

e. The value of the 250 shares is 250P. Equity is 250P 5,400. You will receive a margin call when

250P 5,400 = .3 or when P = $30.86 250P