Question

1. Suppose you invest $1000 of your own money and borrow the maximum amount available to you on margin and also invest that money. The initial maintenance requirement is 50%.

1. (10 points) What is the total amount invested?
2. (10 points) The asset you purchase immediately goes up 8%. What is the return on your invested money?
3. (10 points) Instead of what happens in (b) above, the price of the asset rises 16% over the first year. You pay 5% interest on your margin account. What is the return on your investment?
4. (10 points) If the stock price was originally $10/share and the maintenance margin is 30%, what is the lowest the stock price can go before there is a margin call?

Answer 1

a) Total Amount Invested = Own Money + Borrowed = Own Money/Initial Margin Requirement = 1000/50% =$2000

b) Return on Invested Money = Return/Initial Margin Requirement = 8/50% = 16%

c) Return = [Return for 1 year in $ - Interest on Margin Loan]/Invested Money = [(2000*16%)-(1000*5%)]/1000 = [320-50]/1000 = 270/1000 = 27%

d)

Margin Call will be triggered when Value of Investment falls below [Margin Loan/(1-Maintenance Margin)] = 1000/(1-0.3) = $1428.57

Therefore, Margin Call will be triggered when Price falls below [Above Value of Investment/Qty] = 1428.57/(2000/10) = 1428.57/200 = $7.1428 i.e. $7.15 is the Lowest Price. At $7.14, Margin Call will occur