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You think that the stock of Fleetwood Corp is likely to rise within the next six months from its current price ($19
You think that the stock of Fleetwood Corp is likely to rise within the next six months from its current price ($19.00 bid and $20.00 ask), and you want to maximize the amount of profit from your investment.
So, you will use a margin account to borrow on margin in order to buy as many shares as you can. Your initial margin requirement is 45%, and you have $90,000 of your own money to invest in the shares. The minimum (maintenance) margin is 30%, and Fleetwood does not pay dividends. (Ignore interest for this problem.)
- If you buy Fleetwood on margin with the maximum margin loan, what is the maximum number of shares you can buy?
- Suppose you bought the maximum number of shares of Fleetwood as in (1).
- Assume that immediately after your purchase, Fleetwood’s share price drops to $18.00 per share. Calculate your new margin. Will you receive a margin call?
- How far can the price drop before you will receive a margin call?
- If the stock price falls to $14.00, you calculate that you would get a margin call. If that happens, how much in additional funds would you need to add to your account to respond to the margin call?
Hints:
- New funds needed = Original loan – Maximum loan given market value
- Maximum loan = (1 – minimum margin) (Market value of shares)
- When a margin call occurs, the margin balance must be bumped up to the minimum (maintenance) margin to avoid your broker selling some of your shares.
Expert Solution
In order to have the maximum loan margin, we need to ensure the initial margin requirement is completely met from the cash reserve of $90,000
Initial Margin requirement = 45%
So 45% of total purchasing power = $90,000
Total Purchasing power = $90,000/45% = $200,000
Maximum Margin taken = 200,000-90,000 = 110,000
Ask price of 1 share = $20
So maximum number of shares that can be bought = $200,000/$20 = 10,000
a) After price drops to $18, value of total shares = 10,000 * 18 = $180,000
So Value of self Equity = 180,000 - Margin Taken = 180,000 - 110,000 = 70,000
So new margin = 70,000/180,000 = 38.89%
Since the maintenance margin is 30%, so there will be no margin call.
b) Maintenance Margin = 30%
Let Margin call be received when Self equity is x
So x / (x + 110,000) <30%
or 0.7x < 3300
or x < 47142.85
So total value of shares = 47142.85 + 110,000 = 157142.85
So Cost of each share = 157142.85/10,000 = 15.71
So if the cost of each share falls below $15.71, there will be a margin call.
c) If the value of each share falls to $14, then total value of investment = 14 * 10,000 = 140,000
So Value of own security = 140,000 - 110,000 = 30,000
Minimum of own security to be maintained = 30% of 140,000 = 42,000
So additional funds needed = 42,000 - 30,000 = 12,000
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