BF 2201 Investments

Fall 2021
Professor Qifei Zhu

Lecture 2
Margin trading, short selling,
and return calculation
 Class at a glance
• Trading costs
• Margin trading
– Borrow money to buy stocks
– Margin requirement 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 𝑃𝑜𝑠𝑖𝑡𝑖𝑜𝑛
𝐿𝑜𝑎𝑛 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝐶𝑎𝑠ℎ
– When are margin calls triggered? =
1 − 𝑀𝑀𝑅

• Short sells
– Sell stocks that you do not own
– Need to post margin as well 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 𝑃𝑜𝑠𝑖𝑡𝑖𝑜𝑛
𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑔𝑖𝑛 𝐴𝑐𝑐𝑜𝑢𝑛𝑡
– When are margin calls triggered? =
1 + 𝑀𝑀𝑅
• Calculate returns
$ %
– Arithmetic average return HPR !"# = ∑ HPR (
% &'$
!
(")
– Geometric average return HPR )*+ = ∏,('$ 1 + HPR ( −1

BF2201 L2-2
Chapter 3

Securities Markets
 3.7 Trading Costs
Commission: fee paid to broker for making the transaction

Spread: cost of trading with dealer

– Bid: price dealer will buy from you
– Ask: price dealer will sell to you
– Spread: ask – bid

BF2201 L2-4
 Brokerage commission
Minimum Trading Fees
Commission Under $50,001-
Fees Above $100,000
$50,000 $100,000

$25 0.28% 0.22% 0.18%

CGS-CIMB Securities

Citibank Brokerage $28 0.25% 0.20% 0.18%

DBS Vickers $25 0.28% 0.22% 0.18%

KGI Securities $25 0.28% 0.22% 0.18%

$23.75 0.27% 0.21% 0.17%

LIM & TAN Securities
Maybank Kim Eng $25 0.28% 0.22% 0.18%
OCBC Securities $25 0.28% 0.22% 0.18%

Phillip Securities $25 0.28% 0.22% 0.18%

(POEMS)

RHB Securities $25 0.28% 0.22% 0.18%

SAXO Capital Markets $15 0.12%

Standard Chartered $10 0.20%

UOB Kay Hian $25 0.28% 0.22% 0.20%
 “….The JPMorgan service will offer any bank customer at least 100
free stock or exchange-traded-fund trades for a year, with no
account minimums, said bank spokesman Darin Oduyoye….”

“…Schwab charges $4.95 a trade, and TD Ameritrade and E*Trade

charge $6.95, according to their websites…”

BF2201 L2-6
 Trading costs

• Implications?

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 3.8 Margin Trading
http://www.youtube.com/watch?v=0SGGSqOZhps&feature=related

• Definition: What is buying on margin?

• Why buy a stock on margin?

BF2201 L2-9
 3.8 Margin Trading

http://www.youtube.com/watch?v=0SGGSqOZhps&feature=related

Definition: What is buying on margin?

borrowing money to purchase stock.
Interest will be paid on the loan.

Why buy a stock on margin?

Not enough money
When Investors are Bullish and with to magnify gains

BF2201 L2-10
 Margin trading magnifies the returns

• Frank buys Google stock at 70% margin

• Google shares currently trade at $500

With margin Without margin

Google price = $600 100/350=28.5% 20%
Google price = $400 -100/350=-28.5% -20%

BF2201 L2-11
 Trading on Margin
Assets Liabilities + Equity
Position value = stock price Loan amount
* # of shares
(Amount of interest)
Equity

Margin = Equity/Position Value

BF2201 L2-12
 Trading on Margin
1. Equity must exceed the Initial Margin Requirement (IMR)
when the stock is bought and Maintenance Margin Requirement
(MMR) while the position is open.
2. Equity = Position value - loan - interest on loan + additional
cash
3. Margin call (investor required to add cash to bring up to IMR):
Occurs when the current value of equity equals or is less than the
maintenance margin requirement.
4. Ignore interest if considering scenarios immediately after a
purchase. Include interest if considering scenarios over a time
period.

BF2201 L2-13
BF2201 L2-14
 Example question
Q4. Dee Trader buys 300 shares of Internet Dreams at $40
per share. She borrows $4000 from the broker to pay for
the purchase. Interest rate on the loan is 8%. Compute
(a) Margin in her account when she first buys the stock
(b) If share price falls to $30 per share by the year end, what
is her margin?
(c) What is the rate of investment for her?

1. (a) 33.3%, (b) 52%, (c) 58.5%

2. (a) 66.7%, (b) 52%, (c) -37.5%
3. (a) 33.7%, (b) 52%, (c) -61.0%
4. (a) 66.7%, (b) 52%, (c) -41.5%
5. (a) 66.7%, (b) 52%, (c) -61.0%

BF2201 L2-15
 Q4 Explanation
Initial Position
Stock 300x$40 =$12000 Borrowed $4000
Equity $8000
(a) Initial margin = (300x$40-$4000)/(300x$40) = 66.7%
Position at $30
Stock 300x$30 =$9000 Borrowed $4000+4000*8%
Equity $?? ($4680)

(b) Margin = (300x$30-$4000-$4000x0.08)/(300x$30) = 52%

Notice: We need to factor in interest because it has accrued by the year end
(c) Rate of investment
= (Final value – borrowed– interest) / Initial investment
= ($9000 –$4000 – 8%*$4000) / $8000 -1
= - 41.5% 𝑬𝒒𝒖𝒊𝒕𝒚 − 𝑬𝒒𝒖𝒊𝒕𝒚
𝒕"𝟏 𝒕
𝑹𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏 =
𝑬𝒒𝒖𝒊𝒕𝒚𝒕
BF2201 L2-16
 Q5. An investor puts up $5,000 but borrows an equal amount of
money from their broker to double the amount invested to
$10,000. The broker charges 7% on the loan. The stock was
originally purchased at $25 per share and in one year the investor
sells the stock for $28. The investor's rate of return was ____.

1. 24%
2. 18.5%
3. 17% Zoom poll!
4. 8.5%
5. None of the above

BF2201 L2-17
 IN CLASS Q5 Explanation
Initial Position
Stock 400x$25 =$10000 Borrowed $5000
Equity $5000

Position at $28
Stock 400x$28 =$11200 Borrowed $5000+5000*7%
Equity $??

• #shares bought=$10000/$25 = 400

• Amount borrowed=$5000
• Interest on loan=0.07*$5000=$350
• Investment value at the end =(11200-5000-350)=5850
• Investment value at the beginning = 5000
• Rate of return= (5850/5000) - 1 = 17%

BF2201 L2-18
 Margin Call
Margin call: notification from broker to add additional funds or
have your position liquidated.
• A declining stock price reduces the investor's equity.

A margin call will occur when:

𝐸𝑞𝑢𝑖𝑡𝑦
≤ 𝑀𝑀𝑅
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 𝑃𝑜𝑠𝑖𝑡𝑖𝑜𝑛

(𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 𝑃𝑜𝑠𝑖𝑡𝑖𝑜𝑛 − 𝐿𝑜𝑎𝑛 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝐴𝑑𝑑 𝐶𝑎𝑠ℎ)

≤ 𝑀𝑀𝑅
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 𝑃𝑜𝑠𝑖𝑡𝑖𝑜𝑛

𝐿𝑜𝑎𝑛 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝐶𝑎𝑠ℎ

𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 𝑃𝑜𝑠𝑖𝑡𝑖𝑜𝑛 =
1 − 𝑀𝑀𝑅

BF2201 L2-19
 Margin Trading
Margin Trading: Initial Conditions
X Corp Stock price = $70
50% Initial Margin (IMR)
40% Maintenance Margin (MMR)
1000 Shares Purchased

Initial Position

Stock $70,000 Borrowed $35,000

Equity $35,000

BF2201 L2-20
 Margin Trading
Stock price falls to $60 per share (1000 shares)
New Position
Stock $60,000 Borrowed $35,000
Equity $25,000

Margin% = $25,000 / $60,000 = 41.67%

*This calculation assumes the interest rate for the borrowed funds equals
zero.
Margin Call: How far can the stock price fall before
a margin call? (MMR = 40%)
Market Value = Borrowed / (1 – MMR)
Market Value = $35,000 / (1 – 0.40) = $58,333
BF2201 L2-21
 Margin Trading
With 1000 shares, the stock price at which we
receive a margin call is $58,333 / 1000 = $58.33
New Position at
margin call
Stock $58,333 Borrowed $35,000
Equity $23,333

% Margin = $23,333 / $58,333 = 40%

How much cash must you put up?
To restore the IMR of 50% you will need
equity = 50% x $58,333 = $ 29,167
You have equity = $23,333
so you top up = $29,167-$23,333 = $5,834
BF2201 L2-22
 New Question: You borrowed $20,000 and buy 500 shares
of Facebook stocks at $100 per share (IMR=60%). The
interest rate is 15%. After one year, Facebook price drops to
$90. The MMR is 50%. (1) Is the margin call triggered? (2) If
so, how much do you have to top up?
Zoom poll!
A. Not triggered
B. Triggered; $5,000
C. Triggered; $500
D. None of the above

BF2201 L2-23
 Initial Condition
Position value $100*500=$50,000 Loan: $20,000
Equity: $30,000

After one year

Position value $90*500=$45,000 Loan: $20,000
Interest: $20,000*15%=$3,000
Equity:$45,000-20,000-3,000=$22,000

Current margin: $22,000/$45,000=48.9%<MMR=50%

Need to top up to: $45,000*60%(IMR)=$27,000

$27,000-22,000=$5,000

BF2201 L2-24
 3.9 Short Sales

BF2201 L2-25
 Short Sales: Mechanics
1. Borrow stock from a broker/dealer, must
post margin
2. Broker sells stock. Deposits proceeds
and margin into a margin account
• You are not allowed to withdraw the proceeds until
you ‘cover.’
3. Covering or closing out the position:
• Buy the stock.
• Return the stock title back to the party from which
it was borrowed

BF2201 L2-26
 Short Sales
1. Short Sale: Borrow stock, sell stock in the market, receive
cash (and later cover).

2. IMR and MMR requirements similar to buying on margin

3. After you enter into a short sale:

Initial Margin Account = Proceeds from sale
+ cash for initial margin requirements
Equity = Initial Margin Account - Market Value of Stock Position
- Dividends paid after opening trade

4. Liable for any cash flow: Dividends on stocks

BF2201 L2-27
 Short Sales
Assets Liabilities + Equity
Proceeds from short sales Position value = stock price
* # of shares
Cash for IMR (Amount of dividends)
Equity

Margin = Equity/Stock Position Value

BF2201 L2-28
 Short Sales: Example
You sell short 100 shares of stock priced at $60
per share.
§ The proceeds of $6000 must be pledged to
broker.
§ You must also pledge 50% margin.
§ You put up $3000. Now you have $9000
invested in margin account.
Assets Liabilities + Equity
Proceeds from short sales Position value = stock price
($6000) * # of shares ($6000)
Cash for IMR (Amount of dividends)
($3000)
Equity ($3000)

BF2201 L2-29
 Short Sales: Example
At what price does a Margin Call occur?
Maintenance margin requirement (MMR) is 30% of
market value
Equity
MMR
Market Value
Price at margin call:
(Total Margin Account Market Value)
MMR
Market Value
Total Margin Account 9000
Market Value 6923
1 MMR (1 0.3)

Price at margin call: $6,923 / 100 shares = $69.23

BF2201 L2-30
 Short Sales: Example
The amount to restore to initial margin?
Market Value = Total Margin Account / (1 + MMR)
Market Value = $9,000 / (1 + 0.30) = $6,923

Restore (50% initial margin):

Current equity: Total Margin Account - Market Value
$9,000-$6,923 = $2,077 (can verify 2,077/6,923=30%)
Necessary equity: ($6,923 * 0.5) = $3,461.5
Difference: $3,461.5 - $2077 = $1,384.5

BF2201 L2-31
 Q8. On Jan 1, you sold short one round lot (i.e. 100 shares) of
Zenith stock at $14 per share. On Mar 1, a dividend of $2 per
share was paid. On Apr 1, you covered the short sale by buying
the stock at a price of $9 per share. You paid 50 cents per share in
commissions for each transaction. What is your net profit?

1. $200 Zoom poll!

2. $400
3. $250
4. $450
5. None of the above

BF2201 L2-32
 IN CLASS Q8 Solutions
On Jan 1, you sold short one round lot (i.e. 100 shares) of
Zenith stock at $14 per share. On Mar 1, a dividend of $2
per share was paid. On Apr 1, you covered the short sale
by buying the stock at a price of $9 per share. You paid 50
cents per share in commissions for each transaction.
What is your net profit on Apr 1?

Note that your profit ($200) equals (100 shares profit per share of $2). Your net proceeds
per share was:
$14 selling price of stock
–$ 9 repurchase price of stock
–$ 2 dividend per share
–$ 1 2 trades $0.50 commission per share
$ 2

BF2201 L2-33
 Q9. You sell short 400 shares of Google that are currently
selling at $100 per share. You post the 50% margin required
on the short sale, and the maintenance margin requirement
is 25%. At what price would you receive a margin call
(assume the margin call happens immediately)?

A. $112.94 Zoom poll!

B. $120
C. $137.14
D. $147.69
E. None of the above

BF2201 L2-34
 • Market value at margin call
= Initial margin account/(1+MMR)
= ($400*100+50%*$400*100)/(1+25%)
=$60,000/125%
=$48,000

• Google per share price at margin call

=$48,000/400
=$120

BF2201 L2-35
 Big picture: Is short selling “bad”?

• Companies, investors, and sometimes policy makers

complain about short selling.
• Short selling has been restricted in various countries
during different periods of time.

• However, short sellers serve an important function in the

financial market: unearth financial frauds
• Example: Luckin Coffee, Wirecard
• https://www.youtube.com/watch?v=EdYpXuwGVFg

BF2201 L2-36
 Extra: “Short Squeeze”

• When short sellers close their position, they purchase

stocks to return the shares to the lenders
• If many short sellers close their positions at the same
time, their purchases can push up the price
• This is called “short squeeze”

https://www.youtube.com/watch?v=F8rwmS4Y17c

BF2201 L2-37
Chapter 5

Risk and Return:

Past and
Prologue
 5.1 Rates of Return

1. Holding period returns.

HPRt = (Pt – Pt-1 + Dt ) / Pt-1
Pt: Price of asset (for example a stock) at t (today)
Pt-1: Price of asset at t-1 (for example yesterday, last month, etc)
Dt: Dividends paid from t-1 to t

2. Arithmetic and geometric rates of return.

$ %
Return""# = ∑ HPR (
% &'$

Return)!/ = ∏,('$ 1 + HPR ( $/, −1

3. The difference between arithmetic average and geometric average

increases with return volatility (AAR=GAR if no volatility).

BF2201 L2-39
 Arithmetic Average (AAR)
Definition of Arithmetic Average: Sum of the per period returns
divided by the number of periods.
$ %
HPR !"# = ∑ HPR (
% &'$

1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

Assets under management at 1.0 1.2 2.0 0.8
start of the quarter ($million)
Holding Period Return (%) 10.0 25.0 (20.0) 25.0

Arithmetic Average = (10% + 25% - 20% + 25%) / 4 = 10%

BF2201 L2-40
 Geometric average (GAR)
*
)
(*)
HPR $%& = 3 1 + HPR ' −1
'()

Example of a1stmutual
Quarterfund’s
2nd Quarter 3rd Quarter
quarterly 4th Quarter
performance:
Assets under management at 1.0 1.2 2.0 0.8
start of the quarter ($million)
Holding Period Return (%) 10.0 25.0 (20.0) 25.0

Example:
HPRGEO = [(1+0.10)x(1+0.25)x(1-0.20)x(1+0.25)]1/4-1 = 0.0829 = 8.29%

BF2201 L2-41
 Geometric average (GAR)
*
)
(*)
HPR $%& = 3 1 + HPR ' −1
'()

Example of a1stmutual
Quarterfund’s
2nd Quarter 3rd Quarter
quarterly 4th Quarter
performance:
Assets under management at 1.0 1.2 2.0 0.8
start of the quarter ($million)
Holding Period Return (%) 10.0 25.0 (20.0) 25.0

Nice interpretation of geometric average return:

$1 grows into (1+0.10)x(1+0.25)x(1-0.20)x(1+0.25)=$1.375
will be the same as
(1+0.0829)x(1+0.0829)x(1+0.0829)x(1+0.0829) =$1.375

BF2201 L2-42
 High Volatility Returns:
t=0 t=1 t=2

Price of stock $1 $2 $1
Return (2-1)/1 =100% (1-2)/2 = -50%
AAR = (100%+(-50%))/2 = 25%
GAR = [(1+100%)(1-50%)]1/2 -1 =(1) 1/2 -1 = 0%
AAR is higher than GAR

Low Volatility Returns:

t=0 t=1 t=2

Price of stock $1 $1.20 $1.44

Return 20% 20%
AAR = 20%, GAR =[(1.20)(1.20)]1/2 -1 = 20%
When volatility equals zero, AAR = GAR
BF2201 L2-43
 Kahoot Question
The holding period return for Year 1, 2, and 3 are -5%,
12%, and 23%. What is the arithmetic average annual
return?
A. 6%
Zoom poll!
B. 10%
C. 12%
D. 15%
E. None of the above

BF2201 L2-44
 Q2: The following are rates of return for a risky portfolio for
several recent years. Assume that the stock pays no
dividends. What is the geometric average return for the
period (beginning of 2005 to beginning of 2008)?
Year Beginning of year #shares bought or sold
price
2005 $50 100 bought
2006 $55 50 bought Zoom poll!
2007 $51 75 sold
2008 $54 75 sold

1. 0.74%
2. 2.60%
3. 2.87%
4. 2.21%
5. None of the above
BF2201 L2-45
 Q2 Solution
Year Beginning of year #shares bought or sold
price
2005 $50 100 bought
2006 $55 50 bought
2007 $51 75 sold
2008 $54 75 sold
Year 1: (55-50)/50 = 10%
Year 1: (55-50)/50 = 10%
Year 2: (51-55)/55 = -7.27%
Year 2: (51-55)/55 = -7.27%
Year 3: (54-51)/51 = 5.88%
Year 3: (54-51)/51 = 5.88%
GAR = [(1.10)(1-0.0727)(1.0588)]⅓ ⅓- 1 = 2.60%
GAR = [(1.10)(1-0.0727)(1.0588)] - 1 = 2.60%

Note: Both AAR and GAR ignore the effects of trading on portfolio
returns.
FYI: The dollar weighted average does reflect the effects of trading on portfolio
returns. HOWEVER, we will not assess on the dollar weighted average return.

BF2201 L2-46
 Recap: What we learned?

• What is margin trading; how to calculate profits

from margin trading?
• What is short selling; how to calculate profits
from short selling?
• Arithmetic average return vs. geometric average
return. How to calculate them?

Next week: Expectation, standard deviation,

normal distribution…refresh your knowledge on
statistics!
BF2201 L2-47