You are bullish on Pharma stock. The current market price is $60 per share, and
ID: 2811563 • Letter: Y
Question
You are bullish on Pharma stock. The current market price is $60 per share, and you have $3,000 of your own to invest. You borrow an additional $3,000 from your broker at an interest rate of 5% per year and invest $6,000 in the stock. a. What will be your rate of return if the price of Pharma stock goes up by 15% during the next year? b. How far does the price of Pharma stock have to fall for you to get a margin call if the maintenance margin is 30%? Assume the price fall happens immediately so you don’t pay any interest on your loan. You are bullish on Pharma stock. The current market price is $60 per share, and you have $3,000 of your own to invest. You borrow an additional $3,000 from your broker at an interest rate of 5% per year and invest $6,000 in the stock. a. What will be your rate of return if the price of Pharma stock goes up by 15% during the next year? b. How far does the price of Pharma stock have to fall for you to get a margin call if the maintenance margin is 30%? Assume the price fall happens immediately so you don’t pay any interest on your loan. You are bullish on Pharma stock. The current market price is $60 per share, and you have $3,000 of your own to invest. You borrow an additional $3,000 from your broker at an interest rate of 5% per year and invest $6,000 in the stock. a. What will be your rate of return if the price of Pharma stock goes up by 15% during the next year? b. How far does the price of Pharma stock have to fall for you to get a margin call if the maintenance margin is 30%? Assume the price fall happens immediately so you don’t pay any interest on your loan.Explanation / Answer
(a) Current Market Price = $ 60, Equity Contribution = $ 3000, Debt Contribution = $ 3000
Total Investment Value = $ 6000
Rise in market price = 15 %
Final Investment Value = 6000 x (1.15) = $ 6900
Return on Investment = Final Investment Value - Margin Interest - Initial Borrowing - Equity Contribution = 6900 - (0.05 x 3000) - 3000 - 3000 = $ 750
Rate of Return = (Return on Investment / Equity Contribution) x 100 = (750 / 3000) x 100 = 25 %
(b) Initial Investment Value = $ 6000 and Price per Share = $ 60
Number of Shares Bought = 6000 / 60 = 100
Let the price below which margin call is received be $K
Maintenance Margin = 30 % which implies that the minimum reuired equity value of the account should be equal to 30% of the total investment account value. If not margin call would be induced.
Therefore, 100 x K x 0.3 > (100K - Debt)
30K > (100K - 3000)
3000> 70 K
K < 3000 / 70 ~ $ 42.86
Hence, if the price per share falls below $ 42.86 a margin call will be received.
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