FINC311 Investments

Week 3: Chapter 3 Tutorial

Lecturer: Huong Dang huong.dang@canterbury.ac.nz

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 2013 Final exam question (Chapter 2 concept)
Q5: Mavis Borchard, principal of Borchard Investments, is discussing portfolio strategy with Wilford Tupper, a potential
client who walked into her office in the hopes of finding a shrewd way to invest $800,000. Tupper is an experienced
investor with other stock holdings, but he does not have the time to manage additional investment. Borchard then
recommends an enhanced indexing strategy. She suggests that Tupper start with 60 percent of his money in a market
index fund, then divide the remainder between two portfolio managers, one who manages accounts in a large-cap
blend style, and one who buys small-cap stocks with a value slant. Borchard expects the risk-free return to remain at 4.3
percent for the rest of the year and projects a market return of 12.7 percent and market risk of 18.6 percent for the
year. The following is some data on expectations for both investment managers. Assume the correlations between the
equity manager's active returns are zero.
Manager Expected Return Expected Risk
Large-cap blend manager 13.8% 27.5%
Small-cap value manager 17.5% 30.1%
This plan appeals to Tupper, but he is still not sure in what index he should invest. He is picky about his indexes and
would like any selections to meet a number of criteria:
• The index must be investable.
• Transaction costs must be low.
• The index value must be easy to track.
• Index construction must allow investors to mimic the index with minimal tracking risk (i.e. the risk of failing to track
closely to the index)
• The index must reflect the broader market as closely as possible.
To best meet Tupper's index requirements, Borchard should select which of the following?
• - a price-weighted index.
• - an equal-weighted index.
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• - a value-weighted index.
 Answer
• Borchard seeks an index that reflects the broader market as
closely as possible. This suggests a price-weighted index is
out, as nominal stock prices are somewhat arbitrary and quite
changeable, so the index's complexion can change simply
because of a stock split.
• Low transaction costs favor capitalization-weighted indexes
rather than equal-weighted indexes that must be rebalanced
more often.
• The investability requirement also weighs on equal-weighted
indexes, which tend to favor smaller stocks, which in turn may
offer less liquidity.
• That leaves a capitalization-weighted index. Most indexes are
easy to track.
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 Chapter 3 - Question 1
• What are the differences among a limit buy
order, a limit sell order, and a market order?
• Limit buy order: an order that purchases stock if the price falls below a
predetermined level. Limit sell order: sells stock when the price rises above a
predetermined level. Limit orders are not guaranteed to execute since the price may
not reach the trigger point. Market order: either a buy or sell order that is executed
immediately at the current market price

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 Question 3
• How does buying on margin magnify both the
upside potential and the downside risk of an
investment position?
• The use of leverage necessarily magnifies returns to investors. Leveraging
borrowed money allows for greater return on investment if the stock price
increases. However, if the stock price declines, the investor must repay the loan,
regardless of how far the stock price drops, and incur a negative rate of return.

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 Question 6
• Dee 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%.
• What is the margin in Dee’s account when she first
purchases the stock?
• 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?
• What is the rate of return on her investment?

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 Answers to Question 6
a. 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, 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
The percentage margin is now: $4,680/$9,000 = 0.52 = 52%
Therefore, the investor will not receive a margin call.

c. The rate of return on the investment over the year is:

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 Question 7
• Old Economy Traders opened an account to short
sell 1000 shares of Internet Dreams from the
previous problem. 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.
• What is the remaining margin in the account?
• If the maintenance margin requirement is 30%,
will Old Economy receive a margin call?
• What is the rate of return on the investment?
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 Answer to question 7
a. The initial margin was: 0.50  1,000  $40 = $20,000
As a result of the increase in the stock price Old Economy Traders loses:
$10  1,000 = $10,000
Therefore, margin decreases by $10,000. 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 $2,000. Therefore,
the remaining margin is:
$20,000 – $10,000 – $2,000 = $8,000

b. The percentage margin is: $8,000/$50,000 = 0.16 = 16%

c. The equity in the account decreased from $20,000 to $8,000 in one year,
for a rate of return of: (−$12,000/$20,000) = −0.60 = −60%

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 Question 9
• You are bullish on Telecom stock. The current market
price is $50 per share, and you have $5000 of your own
to invest. You borrow an additional $5000 from your
broker at an interest rate of 8% per year and invest
$10,000 in the stock.
• What will be your rate of return if the price of Telecom
stock goes up by 10% during next year? The stock
currently pays no dividends.
• How far does the price of Telecom stock have to fall for
you to get a margin call if the maintenance margin is
30%. Assume the price fall happens immediately

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 Answer to question 9
a. You buy 200 shares of Telecom for $10,000.
These shares increase in value by 10%, or $1,000.
You pay interest of: 0.08  $5,000 = $400
The rate of return will be:
$1, 000 − $400
= 0.12 = 12%
$5, 000
b. The value of the 200 shares is 200P. Equity is
(200P – $5,000). You will receive a margin call
when:
200 P − $5, 000
200 P
= 0.30  when P = $35.71 or lower

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 Question 10
• You are bearish on Telecom and decide to sell
short 100 shares at the current market price of
$50 per share.
• How much in cash or securities must you put into
your brokerage account if the broker’s initial
margin requirement is 50% of the value of the
short position.
• How high can the price of the stock go before you
get a margin call if the maintenance margin is
30% of the value of the short position
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 Answer to question 10
a. Initial margin is 50% of $5,000 or $2,500.
b. Total assets are $7,500 ($5,000 from the sale of
the stock and $2,500 put up for margin).
Liabilities are 100P.
Therefore, equity is ($7,500 – 100P).
A margin call will be issued when:

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 Question 11a, b, c, e
(You don’t have to do 11d)
• Suppose that Xtel currently is selling at $20 per share. You buy 1,000 shares
using $15,000 of your own money, borrowing the remainder of the purchase
price from your broker. The rate on the margin loan is 8%.
a. What is the percentage increase in the net worth of your brokerage account if
the price of Xtel immediately changes to: (i) $22; (ii) $20; (iii) $18? What is the
relationship between your percentage return and the percentage change in the
price of Xtel?
b. If the maintenance margin is 25%, how low can Xtel’s price fall before you get a
margin call?
c. How would your answer to (b) change if you had financed the initial purchase
d.
with only $10,000 of your own money?
What is the rate of return on your margined position (assuming again that you invest $15,000 of your own money) if Xtel is selling after 1 year at: (i) $22; (ii) $20; (iii) $18? What is the relationship between your percentage return and the percentage change in the price of Xtel? Assume that Xtel pays no dividends.

e. Continue to assume that a year has passed. How low can Xtel’s price fall before
you get a margin call?

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 Answer to question 11a
The total cost of the purchase is: $20 x 1,000 = $20,000
You borrow $5,000 from your broker and invest $15,000 of your own funds. Your
margin account starts out with equity of $15,000.
a. (i) Equity increases to: ($22 x 1,000) – $5,000 = $17,000
Percentage gain = $2,000/$15,000 = 0.1333, or 13.33%
(ii) With price unchanged, equity is unchanged.
Percentage gain = zero
(iii) Equity falls to ($18 x 1,000) – $5,000 = $13,000
Percentage gain = (–$2,000/$15,000) = –0.1333, or –13.33%
The relationship between the percentage return and the percentage change in the price
of the stock is given by:
% return = % change in price (Total investment/ Initial equity)
= % change in price x 1.333
For example, when the stock price rises from $20 to $22, the percentage change in
price is 10%, while the percentage gain for the investor is:
% return = 10% (20,000/15,000)= 13.33%
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Answer to question 11b

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Answer to question 11c

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Answer to question 11e

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 Question 12
• Suppose that you sell short 1,000 shares of Xtel, currently selling for $20 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) $22; (ii) $20; (iii) $18?
Assume that Xtel pays no dividends.
b. If the maintenance margin is 25%, how high can Xtel’s price rise before you get
a margin call?
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.

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Answer to 12a

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Answer to 12b

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Answer to 12c

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 Question 15
• You’ve borrowed $20,000 on margin to buy shares in Ixnay, which is now
selling at $40 per share. Your account starts at the initial margin requirement
of 50%. The maintenance margin is 35%. Two days later, the stock price falls to
$35 per share.
a. Will you receive a margin call?
b. How low can the price of Ixnay shares fall before you receive a margin call?

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 Answer to question 15
a. Will you receive a margin call?
You will not receive a margin call.
You borrowed $20,000 and with another $20,000 of your own equity you
bought 1,000 shares of Ixnay at $40 per share.
At $35 per share, the market value of the stock is $35,000, your equity is
$15,000, and the percentage margin is: $15,000/$35,000 = 42.9%
Your percentage margin exceeds the required maintenance margin

b.

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 Question 16
• On January 1, you sold short one round lot (i.e., 100 shares) of Four Sisters
stock at $21 per share. On March 1, a dividend of $2 per share was paid. On
April 1, you covered the short sale by buying the stock at a price of $15 per
share. You paid 50 cents per share in commissions for each transaction. What
is the value of your account on April 1?

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 Answer to question 16
The proceeds from the short sale (net of commission) were: ($21 x 100) – $50 = $2,050
A dividend payment of $200 was withdrawn from the account.
Covering the short sale at $15 per share costs (with commission): $1,500 + $50 = $1,550
Therefore, the value of your account is equal to the net profit on the transaction:
$2,050 – $200 – $1,550 = $300
Note that your profit ($300) equals (100 shares x profit per share of $3 – see details
below).
Your net proceeds per share ($3) were:
$21 selling price of stock
–$15 repurchase price of stock
–$ 2 dividend per share
–$ 1 (2 trades x $0.50 commission per share )
$3

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 Additional question 1
(past term test question)
• Jason Li purchased 500 shares of a company at $32
per share. The stock was bought on 75 percent
margin. One month later, Jason had to pay interest
on the amount borrowed at a rate of 2 percent per
month. At that time, Jason received a dividend of
$0.5 per share. Immediately after that he sold the
shares at $28 per share. He paid commissions of $10
on the purchase and $10 on the sale of the stock.
What was the rate of return on this investment for
the one-month period?

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 Additional question 1
(past term test question)
• Total cost of purchase 500*32=16000
• Equity invested=0.75*16000=12000
• Amount borrowed =4000
• Interest paid at month end=80
• Dividend received at month end =500*0.5=250
• Proceeds on stock sale 500*28=14000
• Total commissions paid 20$
• Net gain/ loss= -16000-80+250+14000-20=-1850
• Initial investment including commission on purchase 12010
• Return=-1850/12010=-15.4%

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 Additional question 2a
(past term test question)
• Suppose an investor is bullish (optimistic) on Micro$oft stock,
which is currently selling at $100 per share. The investor has
$10,000 to invest and expects the stock to go up in price by
30% during the next year. Ignoring any dividends and
commissions, the expected rate of return would thus be 30%
if the investor spent only $10,000 to buy 100 shares.
• If the investor borrows $10,000 from his broker and invest it
in the stock (along with his own $10,000). Assume the interest
rate is 9% per year. What is the rate of return if the stock goes
up 30%?

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 Answer
• The number of shares invested:
$20000/ $100= 200 shares
• If stock price increases by 30%, the value of
the position = 200 shares x $130= $26,000
• Interest paid= $10,000 x 9%= $900
• The ending equity value:
26,000-10,000-900=$15,100
• Return= (15,100-10,000)/10,000=51%
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 Additional question 2b
(past term test question)
• Suppose an investor is bullish (optimistic) on Microsoft stock,
which is currently selling at $100 per share. The investor has
$10,000 to invest and expects the stock to go up in price by
30% during the next year. Ignoring any dividends and
commissions. If the investor borrows $10,000 from his broker
and invest it in the stock (along with his own $10,000), what is
the rate of return if the stock goes down 30%? Assume the
interest rate is 9% per year.

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 Answer
• The number of shares invested:
$20000/ $100= 200 shares
• If stock price decreases by 30%, the value of
the position = 200 shares x $70= $14,000
• Interest paid= $10,000 x 9%= $900
• The ending equity value:
14,000-10,000-900=$3,100
• Return= (3,100-10,000)/10,000=-69%
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 Additional question 2c
(past term test question)
• Suppose an investor is bullish (optimistic) on Micro$oft stock,
which is currently selling at $100 per share. The investor has
$10,000 to invest and expects the stock to go up in price by
30% during the next year. Ignoring any dividends and
commissions. If the investor borrows $10,000 from his broker
and invest it in the stock (along with his own $10,000), what is
the rate of return if there is no change in the stock price?
Assume the interest rate is 9% per year.

• If there is no change in the stock price, he will lose 9%, the

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 Additional question 3
• Assume you sold short 100 shares of common
stock at $70 per share. The initial margin is
50%. What would be the maintenance margin
if a margin call is made at a stock price of
$85?
• Asset: $7,000 X 1.5 = $10,500;
[$10,500 – 100($85)]/100($85) = 23.5%.

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