Question.1. You bought 400 shares of Metallica Heavy Metal, Inc.

, at $30 per
share. Over the year, you received $ .75 per share in dividends. If the stock sold
for $33 at the end of the year, what was your dollar return? Your percentage
return?

Solution.1. Total dollar return = Dividend income + Capital gain (or loss)
Dollar return is just your gain or loss in dollars. Here, we receive $ .75 in
dividends on each of our 400 shares, for a total of $300. In addition, each share
rose from $30 to $33, so we make $3*400 shares = $1200. Total dollar return is
thus $300 + $1200 = $1500.

Total percentage return = Dividend yield + Capital gains yield

= [D t+1/Pt ] + [(Pt +1 - Pt)/Pt]
= [D t+1 + (Pt +1 - Pt)]/Pt
Percentage return (or just “return” for short) is equal to the $1500 we made
divided by our initial outlay of $30* 400 shares = $12000; so $1500/12000 = .
125 or 12.5%. Equivalently, we could have just noted that each share paid a
$.75 dividend and each share gained $3, so the total dollar gain per share was
$3.75. As a percentage of the cost of one share ($30), we get $3.75/30 = .125
or 12.5%.

Question.2. You bought 200 shares of Lowe’s Companies, Inc. (LOW) at a price
of $48 per share. In three months, you sell your stock for $51. You didn’t
receive any dividends. What is your return for the three months? What is your
annualized return?

Solution.2. In this case, we say that your holding period, which is the length of
time you own the stock, is three months. With a zero dividend, the percentage
return can be calculated as:

1
Percentage return = (Pt +1 - Pt)/Pt = ($51 - $48)/$48 = .0625 or 6.25%

This 6.25 percent is your return for the three-month holding period, but what
does this return amount to on a per-year basis? To find out, we need to
convert this to an annualized return, meaning a return expressed on a per-year
basis. Such a return is often called an effective annual return, or EAR for short.
The general formula is this:
1 + EAR = (1 + holding period percentage return) m
where m is the number of holding periods in a year.
In this example, the holding period percentage return is 6.25 percent, or .0625.
The holding period is three months, so there are four (12 months/3 months)
periods in a year. We calculate the annualized return, or EAR, as follows:
1 + EAR = (1 + holding period percentage return) m
= (1 + .0625)4
= 1.2744
So, your annualized return is 27.44 percent.

Question.3. You buy some stock in Qwest at a price of $8 per share. Four
months later, you sell it for $8.40. No dividend is paid. What is your annualized
return on this investment?
Solution.3. For the four-month holding period, your return is:
Percentage return = (Pt +1 - Pt)/Pt = ($8.40 - $8) / $8 = .05 = 5%
There are three four-month periods in a year, so the annualized return is:
1 + EAR = (1 + holding period percentage return) m
= (1 + .05)3 = 1.1576
Subtracting the one, we get an annualized return of .1576, or 15.76 percent.

2
Question.4. You buy some stock in Johnson & Johnson (JNJ) at a price of $50
per share. Three years later, you sell it for $62.50. No dividends were paid.
What is your annualized return on this investment?

Solution.4. The situation here is a bit different because your holding period is
now longer than a year. For the three-year holding period, your return is:
Percentage return = (Pt +1 - Pt)/Pt = ($62.50 - $50) / $50 = .25 = 25%
How many three-year holding periods are there in a single year? The answer is
one - third, so m in this case is 1/3. The annualized return is:
1 + EAR = (1 + holding period percentage return) m
= (1 + .25)1/3
= 1.0772
Subtracting the one, we get an annualized return of .0772, or 7.72 percent.

Question.5. Using the following returns, calculate the arithmetic average

returns, the variances, the standard deviations, and the geometric returns for
the following stocks:

Year Michele, Inc. Janicek Co.

1 12% 5%
2 -4 -15
3 0 10
4 20 38
5 2 17

Solution.5. First, calculate arithmetic averages as follows:

Year Michele, Inc. Janicek Co.
1 12% 5%
2 -4 -15
3 0 10
4 20 38
5 2 17
30% 55%
Average return: 30/5 = 6% 55/5 = 11%

3
Using the arithmetic averages above, calculate the squared deviations from the
arithmetic average returns and sum the squared deviations as follows:

Year Michele, Inc. Janicek Co.

1 (12- 6)2 = 36 (5 -11)2 = 36
2 (-4 -6)2 = 100 (-15 -11)2 = 676
3 (0 - 6)2 = 36 (10 -11)2 = 1
4 (20 - 6)2 = 196 (38 - 11)2 = 729
5 (2 - 6)2 =16 (17- 11)2 = 3 6
384 1478

Calculate return variances by dividing the sums of squared deviations by four,

which is the number of returns less one.
Michele: 384/4 = 96 Janicek: 1478/4 = 369.5
Standard deviations are then calculated as the square root of the variance.
Michele: √96 = 9.8% Janicek: √369.5 = 19.22%
Geometric returns are then calculated as:
Geometric average return = [(1 + R1) * (1 + R2) * . . .* (1 + RN)]1/N - 1
Michele: [(1 + .12)(1 - .04)(1 + .00)(1 + .20)(1 + .02)] 1/5 - 1 = 5.65%
Janicek: [(1 + .05)(1 - .15)(1 + .10)(1 + .38)(1 + .17)] 1/5 - 1 = 9.65%

Question.6. Over a 30-year period an asset had an arithmetic return of 12.8

percent and a geometric return of 10.7 percent. Using Blume’s formula, what is
your best estimate of the future annual returns over the next 5 years? 10
years? 20 years?
Solution.6.
To find the best forecast, we apply Blume’s formula as follows:
R (T) = (T - 1 /N – 1) *Geometric average + (N - T /N – 1)*Arithmetic average
R(5) = [(5 – 1)/29]*10.7% + [(30 – 5) /29]*12.8% = 12.51%
R(10) = [(10 – 1)/29]*10.7% + [(30 – 10) /29]*12.8% = 12.15%
R(20) = [(20 – 1)/29]*10.7% + [(30 – 20) /29]*12.8% = 11.41%

4
 Questions for practice
1. You bought 100 shares of stock at an initial price of $73 per share. The stock
paid a dividend of $0.88 per share during the following year, and the share
price at the end of the year was $82. Compute your total dollar return on this
investment. Does your answer change if you keep the stock instead of selling
it? Why or why not?

2. Calculating Yields in the previous problem, what is the capital gains yield?
The dividend yield? What is the total rate of return on the investment?

3. Calculating Returns Rework Problems 1 and 2 assuming that you buy 750
shares of the stock and the ending share price is $68.40.

4. You bought 200 shares of Lowe’s Companies, Inc. (LOW) at a price of $52 per
share. In six months, you sell your stock for $58. You didn’t receive any
dividends. What is your return for the six months? What is your annualized
return?

5. You buy some stock of a company at a price of SR10 per share. Five months
later, you sell it for SR12. No dividend is paid. What is your annualized return
on this investment?
6. You buy some stock of a company at a price of SR60 per share. Four years
later, you sell it for SR75. No dividends were paid. What is your annualized
return on this investment?

7. The rate of return on Cherry Jalopies, Inc., stock over the last five years was
17 percent, 21 percent, -8 percent, -5 percent, and 31 percent. Over the same
period, the return on Straw Construction Company’s stock was 12 percent, 34
percent, -11 percent, -7 percent, and 41 percent. What was the arithmetic
average return on each stock over this period?

5
8. Using the following returns, calculate the arithmetic average returns, the
variances, and the standard deviations for stocks A and B.
Year A B
1 17% 21%
2 9 7
3 -14 -10
4 24 26
5 13 15

9. A stock has had returns of 16 percent, -19 percent, 4 percent, 34 percent,

and 22 percent over the last five years. What is the geometric return for the
stock?

10. A stock has had returns of 31 percent, 9 percent, 17 percent, -3 percent,

-21 percent, and 37 percent over the last six years. What are the arithmetic
and geometric returns for the stock?

11. Over the 81-year period 1926–2006, the geometric average return for the
large company stocks was 10.4 percent and the arithmetic average return was
12.3 percent. Calculate average return forecasts for 1, 5, 10, and 25 years into
the future.
Questions on Margin Account

1. Suppose you want to buy 10000 shares of Intel Corporation at a price of

SR30 per share. You put up SR200000 and borrow the rest. What does your
account balance sheet look like? What is your margin?
Solution:
The 10000 shares of Intel cost SR300000. You supply SR200000, so you
must borrow SR100000.
The account balance sheet looks like this:

6
 Assets Liabilities and Account Equity
10,000 shares of Intel SR300000 Margin loan SR100000
________ Account equity 200000
Total _ Total SR300000
SR300000
Your margin is the account equity divided by the value of the stock
owned:
Margin = SR200000/SR300000
= .666 . . .
= 67%
2. You purchased 500 shares of stock at a price of SR56 per share on 50
percent margin. If the maintenance margin is 30 percent, what is the critical
stock price?
Solution:
The lowest price the stock can drop before you receive a margin call is:
Amount borrowed/Number of shares
P =--------------------------------------------------------------
1 - Maintenance margin
You borrowed 500 * SR56 * .50 = SR14000. Therefore:
14000/500
P = ----------------------
1 - .30
= SR40.00
You will receive a margin call if the stock drops below SR40.00.
3. Suppose you have SR 3000 in cash in a trading account with a 50 percent
initial margin requirement. What is the largest order you can place (ignoring
commissions)? If the initial margin were 60 percent, how would your answer
change?
Solution:
When the initial margin is 50 percent, you must supply half of the total (and
you borrow the other half). So, SR 6000 is the largest order you could place.

7
When the initial margin is 60 percent, your SR 3000 must equal 60 percent of
the total. In other words, it must be the case that

SR 3000 = 0.60 * Total order

Total order = SR3000/.60
= SR 5000
As the higher the initial margin required, the less you can borrow.

4. Suppose your account has a 50 percent initial margin requirement and a

30 percent maintenance margin. Suppose stock in Vandelay Industries is selling
for SR50 per share. You have SR20,000, and you want to buy as much of this
stock as you possibly can. What does your account balance sheet look like?
What is your margin?
Unfortunately, right after your purchase, Vandelay Industries share prices
plummet to SR35 per share. What does the account balance sheet look like
when this happens? Are you subject to a margin call?
Solution:
With a 50 percent initial margin, you can buy up to SR40,000 worth, or 800
shares. The account balance sheet looks like this:
Assets Liabilities and Account Equity
800shares@SR50/shar SR40000 Margin loan SR20000
e ________ Account equity 20000
SR40000 Total SR40000
Total
To create the new account balance sheet, recalculate the total value of the
stock. The margin loan stays the same, so the account equity is adjusted as
needed:
Assets Liabilities and Account Equity
800shares@SR35/shar SR28000 Margin loan SR20000
e ________ Account equity 8000
SR28000 Total SR28000

8
Total

As shown, the total value of your “position” (i.e., the stock you hold) falls to
SR28,000, a SR12,000 loss. You still owe SR20,000 to your broker, so your
account equity is SR28,000 - SR20,000 = SR8,000. Your margin is therefore
SR8,000 / SR28,000 = .286, or 28.6 percent. You are below the 30 percent
minimum, so you are subject to a margin call.

5. A year ago, you bought 300 shares of Pepsico, Inc. (PEP) at SR 55 per share.
You put up the 60 percent initial margin. The call money rate plus the spread
you paid was 8 percent. What is your return if the price today is SR 50?
Compare this to the return you would have earned if you had not invested on
margin.
Solution:
Your total investment was 300 shares at SR 55 per share, or SR 16500. You
supplied 60 percent, or SR 9900, and you borrowed the remaining SR 6600. At
the end of the year, you owe SR 6600 plus 8 percent interest, or SR 7128. If the
stock sells for SR 50, then your position is worth 300 * SR50 = SR 15000.
Deducting the SR 7128 leaves SR 7872 for you. Since you originally invested SR
9900, your dollar loss is SR 9900 - SR7872 = SR2028. Your percentage return is
– SR 2028/SR 9900 = -20.48 percent.
If you had not leveraged your investment, you would have purchased SR
9900/SR 55 = 180 shares. These would have been worth 180 * SR 50 = SR 9000.
You therefore would have lost SR 900; your percentage return would have
been – SR 900/SR 9900 = -9.09 percent, compared to the -20.48 percent that
you lost on your leveraged position.

9
6. Suppose the call money rate is 9 percent, and you pay a spread of 2 percent
over that. You buy 1,000 shares of Costco (COST) at SR60 per share, but you
put up only half the money. In three months, Costco is selling for SR63 per
share, and you sell your Costco shares. What is your annualized return
assuming no dividends are paid?

Solution:
you invested SR 60000, half of which, SR30000, is borrowed. How much do you
have to repay in three months? Here we have to adjust for the fact that the
interest rate is 11 percent per year, but you only borrowed the money for
three months. In this case, the amount you repay is equal to:
Amount repaid = Amount borrowed * (1 + interest rate year) t where t is the
fraction of a year. In our case, t would be 3 months/12 months, or .25. So,
plugging in our numbers, we get:
Amount repaid = Amount borrowed * (1 + interest rate per year) t
= SR30000 * (1 + .11).25
= SR30000 * 1.02643
= SR30792.90
So, when you sell your stock, you get SR63000, of which SR30792.90 is used to
pay off the loan, leaving you with SR32207.10. You invested SR30000, so your
riyal gain is SR2207.10, and your percentage return for your three-month
holding period is SR2207.10/SR30,000 = .0736, or 7.36 percent.
Finally, we have to convert this 7.36 percent to an annualized return. There are
four three-month periods in a year, so:
1 + EAR = (1 + holding period percentage return) m
= (1 + .0736)4
= 1.3285
So, your annualized return is 32.85 percent.
10
 Questions for practice

1. You buy 400 shares of stock at a price of SR75 and an initial margin of 45
percent. If the maintenance margin is 30 percent, at what price will you receive
a margin call?

2. You decide to buy 600 shares of stock at a price of SR43 and an initial margin
of 55 percent. What is the maximum percentage decline in the stock before
you will receive a margin call if the maintenance margin is 35 percent?

3. Suppose you want to buy 20000 shares of Intel Corporation at a price of

SR40 per share. You put up SR300000 and borrow the rest. What does your
account balance sheet look like? What is your margin?

4. Suppose you want to buy 30000 shares of Intel Corporation at a price of

SR50 per share. You put up SR400000 and borrow the rest. What does your
account balance sheet look like? What is your margin?

5. Carson Corporation stock sells for SR71 per share, and you’ve decided to
purchase as many shares as you possibly can. You have SR13,000 available to
invest. What is the maximum number of shares you can buy if the initial
margin is 60 percent?

6. You purchase 500 shares of 2nd Chance Co. stock on margin at a price of
SR53. Your broker requires you to deposit SR11,000. What is your margin loan
amount? What is the initial margin requirement?

11
7. In the previous problem, suppose you sell the stock at a price of SR62. What
is your return? What would your return have been had you purchased the
stock without margin? What if the stock price is SR44 when you sell the stock?

8. Repeat the previous two problems assuming the initial margin requirement
is 30 percent. Does this suggest a relationship between the initial margin and
returns?

9. You have SR12,000 and decide to invest on margin. If the initial margin
requirement is 55 percent, what is the maximum dollar purchase you can
make?

10. You buy 400 shares of stock at a price of SR75 and an initial margin of 45
percent. If the maintenance margin is 30 percent, at what price will you receive
a margin call?

11. You decide to buy 600 shares of stock at a price of SR43 and an initial
margin of 55 percent. What is the maximum percentage decline in the stock
before you will receive a margin call if the maintenance margin is 35 percent?

12. You’ve just opened a margin account with SR11,000 at your local
brokerage firm. You instruct your broker to purchase 600 shares of Smolira
Golf stock, which currently sells for SR46 per share. What is your initial margin?
Construct the equity account balance sheet for this position.

13. Margin Call Suppose you purchase 500 shares of stock at SR84 per share
with an initial cash investment of SR15,000. If your broker requires a 30
percent maintenance margin, at what share price will you be subject to a
margin call? If you want to keep your position open despite the stock price
plunge, what alternatives do you have?

12
14. Suppose you hold a particular investment for seven months. You calculate
that your holding-period return is 9 percent. What is your annualized return?

15. In the previous question, suppose your holding period was five months
instead of seven. What is your annualized return? What do you conclude in
general about the length of your holding period and your annualized return?

13