Campus de Gualtar

4710-057 Braga – P School of Economics and Management

Financial Investments

Exercises – Chapter 3

1. Suppose you short-sell 100 shares of IBX, now selling at $200 per share.
a. What is your maximum possible loss?
In principle, potential losses are unbounded, growing directly with increases in the price of
IBX.
b. What happens to the maximum loss if you simultaneously place a stop-buy order at $210?
If the price of IBX shares goes above $210, then the stop-buy order would be executed,
limiting the losses from the short sale. The maximum possible loss per share is $10. The
total loss is: $10  100 shares = $1000.

2. Dée Trader opens a brokerage account and purchases 300 shares of Internet Dreams at $40
per share. She borrows $4000 from her broker to help pay for the purchase. The interest rate
on the loan is 8%.
a. What is the margin in Dée’s account when she first purchases the stock?
The stock is purchased for: 300  $40 = $12,000
The amount borrowed is $4,000. Therefore, the investor put up equity, or margin, of
$8,000.
b. If the share price falls to $30 per share by the end of the year, what is the remaining
margin in her account? If the maintenance margin requirement is 30 %, will she receive a
margin call?
If the share price falls to $30, then the value of the stock falls to $9,000. By the end of the
year, the amount of the loan owed to the broker grows to:
$4,000  1.08 = $4,320
Therefore, the remaining margin in the investor’s account is:
$9,000 − $4,320 = $4,680
Equity in account $9,000 － $4,320
The percentage margin is now: = = = 0.52 = 52%
Value of stock $9,000
Therefore, the investor will not receive a margin call.

c. What is the rate of return on this investment?

Ending equity － Initial equity

Rate of return =
Initial equity
$4,680 － $8,000
= = – 0.4150 = – 41.50%
$8,000

3. Old Economy Traders opened an account to short-sell 1,000 shares of Internet Dreams from
the previous question. The initial margin requirement was 50%. (The margin account pays no
 interest.) A year later, the price of Internet Dreams has risen from $40 to $50, and the stock
has paid a dividend of $2 per share.
a. What is the remaining margin in the account?
The initial margin was: 0.50  1000  $40 = $20000
As a result of the increase in the stock price Old Economy Traders loses:
$10  1000 = $10000
Therefore, margin decreases by $10000. Moreover, Old Economy Traders must pay the
dividend of $2 per share to the lender of the shares, so that the margin in the account
decreases by an additional $2000.
Therefore, the remaining margin is: $20000 – $10000 – $2000 = $8000-

b. If the maintenance margin requirement is 30%, will Old Economy receive a margin call?
Equity
Margin on short position =
Value of shares owed
$8,000
= = 0.16 = 16%
$50  1,000 shares

Because the percentage margin falls below the maintenance level of 30%, there will be a
margin call.

c. What is the rate of return on the investment?

Ending equity － Initial equity

The rate of return =
Initial equity

$8,000 － $20,000
= = – 0.60 = – 60%
$20,000

4. Suppose that you sell short 500 shares of XTel, currently selling for $40 per share, and give
your broker $15,000 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 XTel stock is selling at (i) $44; (ii) $40; (iii) $36? Assume that XTel pays
no dividends.
Initial Position

20000 20000
15000 15000
35000 35000

Price $44:

$13,000 － $15,000
20000 22000 Return = -0.1333
$15,000
15000 13000
35000 35000
Price $40:
$15,000 － $15,000
20000 20000 Return = = 0
$15,000
15000 15000
35000 35000
Price $36:
$17,000 － $15,000
20000 18000 Return = =0.1333
$15,000
15000 17000
35000 35000
b. If the maintenance margin is 25%, how high can XTel’s price rise before you get a margin
call?
Total assets on margin are the sum of the initial margin and the proceeds from the sale
of the stock: $20,000 + $15,000 = $35,000. Liabilities are 500P.

A margin call will be issued when:

$35,000－500P
= 0.25 or 25% when P = $56 or higher.
500P

c. Redo parts (a) and (b), but now assume that XTel also has paid a year-end dividend of $1
per share. The prices in part (a) should be interpreted as ex-dividend, that is, prices after
the dividend has been paid.
Price $44:

$12,500 － $15,000
20000 22000 Return = -0.1667
$15,000
500
15000 12500
35000 35000
Price $40:
$14,500 － $15,000
20000 20000 Return = = -0.033
$15,000
500
15000 14500
35000 35000
Price $36:
$16,500 － $15,000
20000 18000 Return = =0.1
$15,000
500
15000 16500
35000 35000

Total assets are $35,000, and liabilities are (500P + 500). A margin call will be issued
when:
$35,000－500P－500
= 0.25 or 25% when P = $55.20 or higher.
500P