Lorenzo Bretscher Derivatives Spring 2022

1. The investment fund Rusty Bear enters a short position to sell 10,000 shares of Microsoft for
50$ per share. The initial margin is 80% of the initial stock price and the maintenance margin
is 70% of the current stock price. Rusty Bear trades by putting the minimum amount of cash
on the margin account to satisfy the initial requirement.

a) What is the maximum possible profit the position Rusty Bear can get at maturity? What
is the maximum possible loss? Suppose that if the price falls below 20$, Rusty Bear will
be squeezed out and be forced to liquidate its position. What are the maximum profit
and loss in this case?
b) What is the minimum security price pM that will lead to a margin call? Would you
receive a margin call if the price is greater than pM ? Would your answer to the last
question change in the case of a long position in the very same stock?
c) What is the value of pM if the initial amount of cash in the account would be 500,000$
instead?
d) On the first two weeks the price of the futures goes down by 10%, and Rusty Bear
interprets this as a bearish sign for Microsoft and is willing to strengthen its position.
The requirements to short a contract are now a 75% maintenance margin, and a 85%
initial margin. What is the minimum amount of cash Rusty Bear needs to add to its
account to short additional 5,000 shares?

Solution

a) The maximum profit that Rusty Bear can obtain is in the case the price goes to zero,
that is 10, 000 · 50 = 500, 000$. The maximum loss is unbounded, since there is no
theoretical bound for price increases. If the company expects to be squeezed out at
20$, the maximum profit is 10, 000 · (50 − 20) = 300, 000$. The maximum loss is still
unbounded.
b) A margin call for a short position occurs if
decrease in stock value max cash reduction
! "# $ ! "# $
10000 · (p − 50) ≥ 10000 · 0.8 · 50 − 10000 · 0.7 · p

where p is the stock price at a given point in time. Solving with equality yields pM =
52.94$. The following picture illustrates the margin account balance:

1
Lorenzo Bretscher Derivatives Spring 2022

Because the position is short, the value of the account decreases with the price, so every
price p > pM activates a margin call. Vice versa, with a long position, a margin call
occurs for every price p < pM .
c)
decrease in stock value
max cash reduction
! "# $ ! "# $
10000 · (p − 50) ≥ 500000 − 10000 · 0.7 · p

Solving with equality yields pM = 58.82$.

d) The price at the end of the first two weeks is p = 50 · (1 − 0.1) = 45$. To short 5,000
additional shares, the new initial margin requirement must be satisfied. Therefore the
minimum additional cash C to be added must be such that no margin call is triggered
on the two contracts, that is
Initial margin Excess cash wrt maintenance margin Extra cash from Profits
! "# $ ! "# $ ! "# $
C = 5000 · 0.85 · 45 − [10000 · 0.8 · 50 − 10000 · 0.7 · 45 + (50 − 45) · 10000]

This yields C = 56, 250$.