Question

Stock A’s stock is expected to earn a 10% return with a 20% volatility over a one-year period. You have decided to purchase today $18,000 worth of this stock on margin, by borrowing $12,000 at 5% risk-free interest rate and using $6,000 of your own money to make the purchase. The above information implies that the range of realized returns on your investment, with a rise or fall of the stock’s return over the year: a) Will not be affected b) Will double c) Will triple d) Will quadruple e) None of the above

Answer 1

If you are buying on margin, you end up paying only a part of the price. In the given question, we paid only $6,000 or 1/3rd of the price of stock A. In case the share price increases or decreases, all the profit or loss is transferred to you. Hence, even though you paid only 1/3rd for the share, you will loose for the entire share price amount.

If we are borrow $12,000 and pay $6,000 oursleves, the returns will be tripped i.e $18,000/$6,000.

The above information implies that the range of realized returns on your investment, with a rise or fall of the stock’s return over the year-

C) Will triple

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