Margin Purchase You are bullish on GE and expect a rise in its share price in on
ID: 2384504 • Letter: M
Question
Margin Purchase
You are bullish on GE and expect a rise in its share price in one year. Since you have only $10,000 available, you want to get a margin loan. The annual interest rate on margin loan is 4% and your broker requires a maintenance margin of 35%.
A) If you borrow as much as you could within the legal limit (set by Fed), how many shares could you purchase at $20 per share?
B) If GE stock falls to $17 per share at the end of the first year, would you get a margin call? (For this part, ignore GE’s dividends.) What is your rate of return?
Explanation / Answer
Amount available with investor = $ 10000
If shares are purchased by using the above amount are given as collateral for taking a Margin Loan the maximum amount of margin that can be given as per Fed regulation U is restricted to 50% of the current market value of the investment. That is the investor should provide atleast 50% of the amount required to enter into the transaction.
Total Value of transaction which can be done by investor = $ 10000 / 0.50 = $ 20,000
Answer to (A)
Current Market Value of stock = $ 20
Amount Available with Investor = $ 10,000
Amount taken as Margin Loan = $ 10,000 / 50% - $ 10,000 = $ 10,000
Total Amount available for Investment = $ 20,000
Number of shares which can be purchased with this amount = $ 20000 / $ 20 = 1,000
Answer to (B)
Purchase price of stock = $ 20
Initial Margin requirement (for margin loan) = 50%
Maintenance Margin requirement = 35%
Price at which a margin call will be issued = Purchase Price * (1-Margin)/(1- Maintenance Margin)
= 20 * (1 - 0.5) / (1 - 0.35) = 20 * 0.5 / 0.65 = $ 15.38
Price at the end of one year = $ 17
Since the price at the end of the year $ 17 is higher than $ 15.38 no margin call will be issued.
Sale value of 1000 shares at $ 17 = 1000 * 17 = 17000
Repayment of Amount borrowed = $ 10000
Balance amount available to investor = $ 17000 - $ 10000 = $ 7000
Amount invested by investor (excluding margin) = $ 10000
Gain / (Loss) = Net Sale value - Investment amount = 7000 - 10000 = (3000)
Rate of Return = (Gain(Loss)/investment amount) * 100 = (-3000 / 10000) * 100 = -30%