Old Economy Traders opened an account to short-sell 1,000 shares of Internet Dre

Question

Old Economy Traders opened an account to short-sell 1,000 shares of Internet Dreams at $45 per share. The initial margin requirement was 50%. (The margin account pays no interest.) A year later, the price of Internet Dreams has risen from $45 to $49.50, and the stock has paid a dividend of $5.40 per share.

a. What is the remaining margin in the account?

Remaining margin            $

b-1. What is the margin on the short position? (Round your answer to 2 decimal places.)

Short margin             %

b-2. If the maintenance margin requirement is 30%, will Old Economy receive a margin call?

c. What is the rate of return on the investment? (Negative value should be indicated by a minus sign. Round your answer to 2 decimal places.)

Rate of return             %

Explanation / Answer

a). The initial margin was: $45 ×1,000 ×0.50 = $22,500.

As a result of the $4.50 increase in the stock price, Old Economy Traders loses: $4.50 ×1,000 shares =$4,500.

Moreover, Old Economy Traders must pay the dividend of $2 per share to the lender of the shares: $5.40×1,000 shares = $5,400.

The remaining margin in the investor’s account therefore decreases to: $22,500 – $4,500 – $5,400 = $12,600.

b-1). Margin on short position = Equity/Value of shares owed

= ($12,600/$49.50)/1,000 shares = .2545 = 25.45%

b-2). Because the percentage margin falls below the maintenance level of 30%, there will be a margin call.

c). The rate of return = (Ending equity – Initial equity)/Initial equity

= ($12,600 – $22,500)/$22,500= –0.44 = –44%

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