Investments - Finance 4466

Fall 2020
Assignment 1 – Due: Oct 20, 10 am in Brightspace Dropbox (Assignment 1 Folder)

100 Points Total

Problem 1 (5 Points)
Find the price of a six-month (180-day) U.S. T-bill with a par value of $100,000 and a bank
discount yield of 8.86 percent.

SOL: The bill has a maturity of one-half year, and an annualized discount yield of 8.86%.

Therefore, its actual percentage discount from par value is 8.86% x 0.5 = 4.43%.

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The bill will sell for $100,000 x (1– .0443) = $95,570.

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Problem 2 (15 Points)
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Josh Next opened an account to short-sell 3,000 shares of Sun Spots shares. The initial
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margin requirement was 50 percent. (The margin account pays no interest). A year later, the
price of Sun Spots has risen from $45 to $50, and the stock has paid a dividend of $3 per
share.
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a. What is the remaining margin in the account (in dollars and percentage)?
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b. If the maintenance margin requirement is 25 percent, will Josh Next receive a margin
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call?
c. What is the rate of return on the investment?
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Solution: (15 Points Total)

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a. The initial margin was 0.50  3,000  $45 = $67,500.

The firm loses $5  3,000 = $15,000 due to the increase in the stock price therefore the
margin falls by $15,000.
Moreover, the firm must pay the dividend of $3 per share, which means the margin
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account falls by an additional $9,000.

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So remaining margin is $43,500 (43,500/$150,000 = 0.29=29%) (5 Points)

b. The percentage margin is $43,500/$150,000 = 0.29, so there is no margin call. (5 Points)
c. The margin in the account fell from $67,500 to $43,500 in one year, for a rate of return of
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$24,000/$67,500 = 0.35555 = 35.56%. (5 Points)

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 Problem 3 (7 Points)
Consider the three stocks in the following table. Pt represents price at time t, and Qt
represents shares outstanding at time t. Stock Omega splits two for one in the last period.

　 P0 Q0 P1 Q1 P2 Q2

Alpha 88 100 94 100 96 100

Gamm
a 48 200 46 200 45 200

Omega 102 200 110 200 55 400

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a. Calculate the rate of return on a price-weighted index of the three stocks for the first

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period (t=0 to t=1).
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b. What must happen to the divisor for the price-weighted index in year 2?
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c. Calculate the price-weighted index for the second period (t=1 to t=2).
Solution:
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a. The index at t = 0 is (88 + 48 + 102)/3 = 79.333. At t = 1, it is 250/3 = 83.333, for a rate of

return of 5.04%. (2 Points)
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b. In the absence of a split, stock Omega would sell for 110, and the index would be 250/3
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= 83.333. After the split, Omega stock sells at 55. Therefore, we need to set the divisor d
such that 83.333 = (94 + 46 + 55)/d, meaning that d = 2.34. (3 Points)
c. The value of the index after the split is (96 + 45 + 55) /2.34 = 83.76.
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The return is (83.76-83.33)/83.33 = 0.516% (2 Points)

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Problem 4 (6 Points)

Suppose that you sell short 300 shares of Starsnow, now selling at $80 per share.
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a. What is your maximum possible loss?

b. What happens to the maximum loss if you simultaneously place a stop-buy order at
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$89?
Solution:
a. In principle, potential losses are unbounded, growing directly with increases in the
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price of Starsnow. (3 Points)

b. If the stop-buy order can be filled at $89, the maximum possible loss per share is $9. If
Starsnow’s shares go above $89, the stop-buy order is executed, limiting the losses
from the short sale.(3 Points)

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 Problem 5 (22 Points)
Suppose the Xenon (XO) currently is selling at $90 per share. You buy 300 shares, using
$20,000 of your own money, and borrow the remainder of the purchase price from your
broker. The rate on the margin loan is 6 percent.
a. What is the percentage increase in the net wealth of your brokerage account if the price
of XO immediately changes to (1)$98; (2)$90; (3)$82? What is the relationship between
your percentage return and the percentage change in the price of XO?
b. If the minimum margin is 30 percent, how low can XO’s price fall before you get a margin
call?
c. How would your answer to (b) change if you had financed the initial purchase with only

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$15,000 of your own money?
d. What is the rate of return on your margined position (assuming again that you invest

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$15,000 of your own money) if XO is selling after one year at (1) $98; (2) $90; (3)$82?
What is the relationship between your percentage return and the percentage change in

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the price of XO? Assume that XO pays no dividends.
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e. Continue to assume that a year has passed. How low can XO price fall before you get a
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margin call?
Solution:
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Cost of purchase is $90 x 300 = $27,000. You borrow $7,000 from your broker, and
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invest $20,000 of your own funds. Your margin account starts out with a net worth of
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$20,000.
a. (i) Net worth rises by $2,400 from $20,000 to $98 x 300 – $7,000 = $22,400.
Percentage gain = $2,400/$20,000 =0 .12 = 12% (2 Points)
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(ii) With unchanged price, net worth remains unchanged.

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Percentage gain = zero (2 Points)

(iii) Net worth falls to $82 x 300 – $7,000 = $17,600.
Percentage gain = -$2400/$20,000= -12% (2 Points)
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The relationship between the percentage change in the price of the stock and the
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investor’s percentage gain is given by:

% gain = % change in price x = % change in price x 1.35
(2 Points).
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For example, when the stock price rises from 90 to 98, the percentage change in price is
8.89%, while the percentage gain for the investor is 1.35 times as large, 12%:
% gain = 8.89% x (27,000/20,000) = 12%

b. The value of the 300 shares is 300P. Equity is 300P – 7000. You will receive a margin

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 call when:
(300p – 7000)/300p = .3 or when P = $33.33 (2 Points)

c. The value of the 300 shares is 300P. But now you have borrowed $12,000 instead of
$7,000. Therefore, equity is only 300P – $12,000. You will receive a margin call when
(300p – 12000)/300p = .3 or when P = $57.14 (2 Points)

With less equity in the account, you are far more vulnerable to a margin call.
d. The margin loan with accumulated interest after one year is $12,000 x 1.06 = $12,720.
Therefore, equity in your account is 300P – $4,200. Initial equity was $15,000. Therefore,
your rate of return after one year is as follows:

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(300×$ 98−$ 12,720 )−$ 15,000

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$15,000

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(i) = .112, or 11.2%. (2 Points)

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(300×$ 90−$ 12720)−$ 15,000
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$ 15,000
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(ii) = -.048, or -4.8%. (2 Points)

(300×$82−$12,720)−$15 , 000
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15 ,000
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(iii) = -.208, or -20.8%. (2 Points)

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The relationship between the percentage change in the price of Xenon and investor’s
percentage return is given by:
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% gain = x = x 1.8 (2 Points)

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For example, when the stock price rises from 90 to 98, the percentage change in price is
8.89%, while the percentage gain for the investor is
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8.89% x (27,000/15,000) = 8.89 x 1.8 = 6%

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e. The value of the 300 shares is 300P. Equity is 300P – (15,000 + 15,000*.06Int) =
300P – 12,720. You will receive a margin call when
300 P−12 ,720
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300 P = .3 or when P = $60.57 (2 Points)

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 Problem 6 (12 Points Total)
Suppose that you sell short 300 shares of CYSCO (CY), currently selling for $90 per share,
and give your broker $20,000 to establish your margin account.
a. If you earn no interest on the funds in your margin account, what will be your rate of
return after one year if CY stock is selling at $98? Assume that CY pays no dividends.
b. If the minimum margin is 30 percent, how high can CY’s price rise before you get a
margin call?
c. Redo part (a) and (b), now assuming that CY’s dividend (paid at year-end) is $3 per
share.
Solution:
a. The gain or loss on the short position is (–300 x ΔP). Invested funds are $20,000.

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Therefore, rate of return = (–300 x ΔP)/20,000. The returns in each of the three

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scenarios are:

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Rate of return = (–300 x 8)/20,000 = – 0.12 = –12%. (2 Points)

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b. Total assets in the margin account are $27,000 (from the sale of the stock) + $20,000
(the initial margin) = $47,000; liabilities are 300P. A margin call will be issued when
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47 , 000−300 P
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300 P = 0.30, or when P = $120.51. (4 Points)

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c. With a $3 dividend, the short position must also pay $3/share x 300 shares = $900 on
the borrowed shares. Rate of return will be (–300 x ΔP - 900)/20,000.
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Rate of return = (–300 x 8 – 900)/20,000 = – 0.165 = –16.5%. (2 Points)

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Total assets (net of the dividend repayment) are $47,000 – 900, and liabilities are 300P.
A margin call will be issued when
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47 , 000−900−300 P
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300 P = .30, or when P = $118.20 (4 Points)

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Problem 7 (25 Points)

Suppose you find the following information for stock ORG:

 The minimum margin requirement =30%

 Current stock price = $50 per share

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  No dividend is expected within a year
 The interest rate on a margin loan is 6% per annum
 No interest paid on accounts from short sales

You have an assessment of the ORG price probability distribution next year as below:

Bear Market Normal Market Bull Market

Probability 0.2 0.5 0.3

ORG price 45 55 66

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You bought 600 shares of the stock with $15,000 of your own fund.

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a) What would be your rate of return on this investment if you sell the stock for $62.50 one
year later? rs e
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b) What would be the stock price when a margin call occurs (assuming you don’t pay any
interest on the margin loan)?
c) What are the expected return and standard deviation of the stock, respectively?
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d) What are the expected return and standard deviation of your investment?
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Solution: (25 Points)

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Cost of investment total: 600 x $50.00 = $50,000

Margin: $15,000 (50%)
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Borrowed: $15,000
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a). HPR = [600x(62.5 – 50) – (15,000x0.06)]/ $15,000 = 6,600/15,000 = 44% (2 Points)

b) 0.3 = Equity/Assets = (A – L) / A = (600xP – 15,000)/600xP
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180xP = 600xP – 15,000

P = $35. 71 (4 Points)
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c). E(Price1) = 0.2x46 + 0.5x55 + 0.3x66 = $56.3

E(r) = (56.3 – 50)/50 = 12.6% (2 Points)
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Variance = 0.2 (-0.1 – 0.126)2 + 0.5 (0.1-0.126)2 + 0.3 (0.32-0.126)2 =

=0.010215 + 0.000338 + 0.011291 = 0.021844
St. Dev. = (0.021844)1/2 = 0.1478 = 14.78%. (4 Points)

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 d). Your Expected Return (Bear market):
[600 x (45 – 50) – (15,000x0.06)]/ $15,000 = -3,900/15,000 = -25% (2 Points)

Your Expected Return (Normal market):

[600x(55 – 50) – (15,000x0.06)]/ $15,000 = 2,100/15,000 = 14% (2 Points)

Your Expected Return (Bull market):

[600x(66 – 50) – (15,000x0.06)]/ $15,000 = -1,495/15,000 = 58% (2 Points)

Your Overall Expected Return:

0.2(-9.97%) + 0.5(14%) – 0.3(58%) = 22.406% (2 Points)

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Your Expected Variance:

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0.2(0.0997 – 0.22406)2 + 0.5(0.14 – 0.22406)2 + 0.3(0.58 - 0.22406)2 =

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= 0.003093 + 0.003533 + 0.038008 = 0.044634

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St. Dev. = (0.044634)1/2 = 0.211258 = 21.13%. (5 Points)

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Problem 8 (8 Points) rs e
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You are considering the choice between investing $50,000 in a conventional 1-year bank CD
offering an interest rate of 5% and a 1-year Inflation plus CD offering a 1.5% per year plus the
rate of inflation. Explain your answer clearly in words.
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a). Which is the safer investment? (2points)

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b). Can you tell which offers the higher expected return? (2points)
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c). If you expect the rate of inflation to be 3% over the next year, which is the better
investment? Why? (2 points)
d). If we observe a risk-free nominal interest rate of 5% per year and a risk-free real rate of 1.5%
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on inflation-indexed bonds, can we infer that the market’s expected rate of inflation is 3.5% per
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year? (2points)

SOL:
a. The “Inflation-Plus” CD is the safer investment because it guarantees the purchasing
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power of the investment. Using the approximation that the real rate equals the nominal
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rate minus the inflation rate, the CD provides a real rate of 1.5% regardless of the inflation
rate.
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b. The expected return depends on the expected rate of inflation over the next year. If the
expected rate of inflation is less than 3.5% then the conventional CD offers a higher real return
than the inflation-plus CD; if the expected rate of inflation is greater than 3.5%, then the
opposite is true.

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 c. If you expect the rate of inflation to be 3% over the next year, then the conventional CD offers
you an expected real rate of return of 2%, which is 0.5% higher than the real rate on the inflation-
protected CD. But unless you know that inflation will be 3% with certainty, the conventional CD is
also riskier. The question of which is the better investment then depends on your attitude
towards risk versus return. You might choose to diversify and invest part of your funds in each.

d. No. We cannot assume that the entire difference between the risk-free nominal rate (on
conventional CDs) of 5% and the real risk-free rate (on inflation-protected CDs) of 1.5%
associated with the uncertainty surrounding the real rate of return on the conventional CDs. This
implies that the expected rate of inflation is less than 3.5% per year.

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