Question

Jessica has a margin account in which she deposits $300,000 (Equity). Assume that the initial margin requirement is 50% and that the margin maintenance is 15%. Jessica is planning to invest (long) in Ford stock which is currently selling at $40/share.

a)      Show that Jessica could purchase 15,000 shares, using the maximum allowable margin.

b)     Assume that the broker charges 5% annual interest rate, assume that the broker's fees are 0.3% of the total amount paid for the purchase and received upon the sale. A year later Jessica receives $1 per share dividend and sells the stock for $45/share. What is the rate of return on her investment?

c)       Will Jessica receive a margin call if the price of the Ford stock falls during the year to 19$/share? Justify.

please help me solve this exercise , thank you ...

Answer 1

a) As the initial margin requirement is only 50%,the value of shares which can be bought from the amount of $300,000 = $300000/0.5 = $600,000

Price of one share = $40

So, no of shares which can be bought = $600000/$40 = 15000

So Jessica can buy a maximum of 15000 shares, using the maximum allowable margin

b) Amount borrowed from broker = $600000 - $300000 =$300000

Charges paid to broker = 5% *$300000 =$15000

Broker's fees = 0.3% * $600000 = $1800

Total Amount realised per share = $45+$1 = $46

Value realised by selling 15000 shares = $46*15000 = $690000

Profit = $690000- $600000 - $15000 -$1800 = $73200

Rate of return = $73200/$300000 = 24.4%

c) Loss to Jessica = (40-19)*15000 = $315000

Balance in margin account = $300000 - $315000 = -$15000

So, she will receive a margin call as the balance is negative , whereas the minimum balance should be = $19*15000 shares * 15% = $42750