CHAPTER 2

Investment Process
Questions and Problems

1. Calculating Margin (LO3, CFA4) Carson Corporation stock sells for $17 per share, and you’ve
decided to purchase as many shares as you possibly can. You have $31,000 available to invest.
What is the maximum number of shares you can buy if the initial margin is 60 percent?

Answer:

Initial Margin= 0.60 Cash = $31000 price of share =$17

Maximum investment = $31,000 / 0.60 = $51,667

Total investment = $51,667

Number of shares = $51,667 / $17 per share = 3,039.22 (or 3,039) shares

Number of shares=3,039 shares

-----------------------------------------------------------------------------------------------

2. Margin (LO3, CFA4) You purchase 275 shares of 2nd Chance Co. stock on margin at a price of
$53. Your broker requires you to deposit $8,000. What is your margin loan amount? What is the
initial margin requirement?

Answer:

Remember:

Margin loan- borrowed money

Margin requirement- The minimum amount of money that a client must have on deposit,

either in cash or approved securities

number of shares= 275 price of share =$53 Deposit =$8000

Remember: Amount borrowed=total investment -deposit

Margin loan = ($53 × 275) – $8,000 = $6,575

Amount borrowed= $6,575

Initial Margin requirement = $8,000 / ($53 × 275) = .5489, or 54.89%

Initial Margin requirement=54.89%

----------------------------------------------------------------------------------------------

3. Margin Return (LO3, CFA4) In Problem 2, suppose you sell the stock at a price of $62. What is
your return? What would your return have been had you purchased the stock without margin?
What if the stock price is $46 when you sell the stock?

Answer:

Terminal price = $62

Remember: Without margin= selling price-purchasing price / purchasing price

Without margin = ($62 – $53) / $53 = 16.98%

Without margin=16.98%

With margin= ((selling price*number of shares)- (purchasing price* number of shares))/deposit

With margin = {($62 × 275) – ($53 × 275)} / $8,000 = 30.94%

With margin=30.94%

Terminal price = $46

Without margin = ($46 – 53) / $53 = –13.21%

Without margin= –13.21%

With margin = {($46 × 275) – ($53 × 275)} / $8,000 = –24.06%

With margin= –24.06%

---------------------------------------------------------------------------------------

5. Margin Purchases (LO3, CFA4) You have $22,000 and decide to invest on margin. If the initial margin
requirement is 55 percent, what is the maximum dollar purchase you can make?

Answer:

Cash =$22,000 initial margin = 55%

Maximum purchase= $40,000

--------------------------------------------------------------------------------------

6. Margin Calls (LO3, CFA4) You buy 500 shares of stock at a price of $38 and an initial margin of 60
percent. If the maintenance margin is 30 percent, at what price will you receive a margin call?

Answer:

Maintenance margin: is the minimum amount of equity that must be maintained in a margin account

Margin call: a demand by a broker that an investor deposit further cash or securities to cover possible
losses.

Number of shares= 500 Price= $38 Initial margin= 60% maintenance margin= 30%

Remember: Amount borrowed= total investment -deposit

Amount borrowed= Number of shares*price of share - Number of shares*price of share*initial margin

Amount borrowed = (500 × $38) - (500 × $38) (0.60) = $7,600

Amount borrowed= $7,600

Margin call price = ($7,600 / 500) / (1 – 0.3) = $21.71

Margin call price= $21.71 .

At any price below $21.71 your margin will be less than 30% and you will be subject to a margin call.

Therefore, $21.71 is the lowest possible price that could be reached before you are subject to a margin
call.

------------------------------------------------------------------------------------

*The 10,000 shares of Intel cost &300,000. You supply only &200,000. So how much you will borrow?

How much the price of stock? How your balance sheet looks like? And what is your margin?
 Assets Liabilities and account equity

10000 shares $300,000 Margin loan $100,000

Account equity 200,000

Total $300,000 Total $300000

Margin = $200 000 / $300,000 = 67%

Stock price = $30

--------------------------------------------------------------------------------------------

8. The stock of Flop Industries is trading at $48. You feel the stock price will decline, so you short 1,000
shares at an initial margin of 60 percent. If the maintenance margin is 30 percent, at what share price
will you receive a margin call?

Answer:

Remember: A short position is generally the sale of a stock you do not own.

Investors who sell short believe the price of the stock will decrease in value.

Proceeds from short sale = 1,000 × $48 = $48,000

Initial deposit = $48,000 (0.60) = $28,800

Remember: Account value = Short Proceeds + Initial margin deposit

Account value = $48,000 + $28,800 = $76,800

Margin call price (SHORT SELLING ONLY) = Short Proceeds + Initial margin deposit / [ (number of shares)
+ (maintenance margin x number of shares)]

Margin call price = $76,800 / [1,000 + (0.30 × 1,000)] = $59.08

----------------------------------------------------------------------------------

9. Margin Calls on Short Sales (LO4, CFA5) You short sold 1,000 shares of stock at a price of $36 and an
initial margin of 55 percent. If the maintenance margin is 35 percent, at what share price will you receive
a margin call? What is your account equity at this stock price?

Answer:

Proceeds from short sale = 1,000 ($36) = $36,000

Initial deposit = $36,000 (0.55) = $19,800

Account value = Shares value + Initial deposit

Account value = $36,000 + $19,800 = $55,800

Margin call price (SHORT SELLING ONLY) = Shares value+ deposit/ [ (number of shares) + (maintenance
margin x number of shares)]

Margin call price = $55,800 / [1,000 + (0.35 × 1,000)] = $41.33

Remember: Account equity = Account value – DEPOSIT

Account equity = $55,800 – (1,000 × $41.33) = $14,470

-------------------------------------------------------------------------------------------------

19. Annualized Returns (CFA1) Suppose you hold a particular investment for seven months. You
calculate that your holding period return is 14 percent. What is your annualized return (EAR)?

Answer:

Remember: EAR= (1+Holding Period Percentage Return)m - 1

EAR = (1 + 0.14)12/7 – 1 = 25.18% 25%

-----------------------------------------------------------------------------------------------------

20. Annualized Returns (CFA1) In Problem 19, suppose your holding period was five months instead of
seven. What is your annualized return? What do you conclude in general about the length of your
holding period and your annualized return?

Answer:

EAR = (1 + 0.14)12/5 – 1 = 36.95%

The shorter the holding period, the larger the EAR for a given holding period return.

-----------------------------------------------------------------------------------------
Answer:

Assets Liabilities and account equity

3039.22x$17 shares $51,667.00 Margin loan $20,667

Account equity 31,000

Total $51,667.00 Total $51,667.00

Stock price = $24

Assets Liabilities and account equity

3039.22 sharesx24 $72,941.28 Margin loan $20,667

Account equity 52,274.28

Total $72,941.28 Total $72,941.28

Margin = $52,274.28 / $72,941.28= 71.67%

Stock price = $14

Assets Liabilities and account equity

3039.22x14 shares $42,549.08 Margin loan $20,667

Account equity 21,882.08

Total $42,546.08 Total $42,546.08

Margin = $21,882.08 / $42,546.08 = 51.43%

------------------------------------------------------------------------------------
12. You’ve just opened a margin account with $20,000 at your local brokerage firm. You instruct your
broker to purchase 500 shares of Landon Golf stock, which currently sells for $60 per share. What is your
initial margin? Construct the equity account balance sheet for this position.

Answer:

Answer:

Proceeds from short sale = 750($96) = $72,000

Initial margin deposit = $72,000(0.60) = $43,200

Total assets = Total liabilities and equity = $72,000 + 43,200 = $115,200

Cost of covering short = 750($86.50) = $64,875 (buy back the shares from market at this price)

Account equity = $115,200 – 64,875 = $50,325

Cost of covering dividends = 750($0.75) = $563

Dollar profit = $50,325 – 43,200 – 563 = $6,563

Rate of return = $6,563 / $43,200 = 15.19%