3. You are bullish on Telecom stock. The current market price is $40 per share,

ID: 2649775 • Letter: 3

Question

3. You are bullish on Telecom stock. The current market price is $40 per share, and you have $10,000 to invest. If the margin limit is 50% and you borrow the maximum from your broker at 4% interest, and invest everything in Telecom,

(a) what will your return be if you hold the stock for a year and the price goes up to $50? Show your calculation including the cost of interest

(b) how far does the price have to fall for you to have a margin call if the maintenance margin is 30%? Show your calculation.

Explanation / Answer

You are bullish on Telecom stock.

The current market price is $40 per share

You have $10,000 to invest and The margin limit is 50% so total maximum telecom stock purchase will be of $ 20,000 ($ 10,000/50%).

You have $10,000 to invest so you can borrow the maximum $ 10,000 from your broker at 4% interest, and invest everything in Telecom.

(a) what will your return be if you hold the stock for a year and the price goes up to $50? Show your calculation including the cost of interest

Figures in $

Particualrs

Amount

Total cost of investment (A)

20000

Price per share (today) (B)

Total number of shares (A/B) (C)

500

Price per share (after yr 1) (D)

total value of investment yr 1 (C*D) (E)

25000

Increase in value of investment (E-A) (1)

5000

Cost of borrowing (2)

400

($10000*0.04)

Net profit (1-2) $

4600

Answer : return will be $ 4600

(b) how far does the price have to fall for you to have a margin call if the maintenance margin is 30%? Show your calculation.

Initial margin is 50% and Initial margin balance is $ 10,000

Maintenance margin is 30%. Margin call will be triggered if margin balance goes below $ 6000 ($ 10000 * 30/50).

Total reduction in margin balance required is $ 4000 ($ 10,000 - $ 6000)

So total value reduction in investment required is $ 8000 ($ 4000 * 100/50)

Total number of shares : 500 (as calculated in Answer a)

Fall in price per share required is $ 16 ($ 8000/500)

Answer : Fall in price per share required is $ 16. So price should be less than $24 per share ( $ 40 - $ 16) to trigger margin call.