At the beginning of the day Ms. Theresa invested $33,400 of her own wealth for b

Question

At the beginning of the day Ms. Theresa invested $33,400 of her own wealth for buying shares of XYZ Inc, when the price of XYZ share was $24 per share. The initial margin is 60 percent. What is the maximum number (rounded to the two decimal points) of shares of XYZ she can buy? Suppose that, at the end of the day the price of XYZ share is $27 per share. What is the daily return in percentage? What will be your answer if the end of the day price of XYZ is $21 per share? If Ms. Theresa did not buy additional shares on margin, what would have been her daily returns when the next day price is $27 a share or $21 a share? Now, do you think that buying (taking long position) shares on margin is a risky strategy, equivalent to a double-edged sword? Why?

Explanation / Answer

Part 1:

Maximum number of shares of XYZ Theresa can buy = $33,400/(0.60*24)

                                                                                              = 2319.44 Shares

Suppose that, at the end of the day the price of XYZ share is $27 per share,the daily return in percentage:

= [2319.44 shares*(27-24)/33,400]*100

= 20.83%

Suppose that, at the end of the day the price of XYZ share is $21 per share,the daily return in percentage

= [2319.44 shares*(21-24)/33,400]*100

= -20.83%

Part 2:

If Ms. Theresa did not buy additional shares on margin, what would have been her daily returns when the next day price is $27 a share or $21 a share?

Maximum number of shares of XYZ Theresa can buy = $33,400/24

                                                                                              = 1391.67 Shares

Suppose that, at the end of the day the price of XYZ share is $27 per share,the daily return in percentage:

= [1391.67 shares*(27-24)/33,400]*100

= 12.50%

Suppose that, at the end of the day the price of XYZ share is $21 per share,the daily return in percentage

= [1391.67 shares*(21-24)/33,400]*100

= -12.50%

Part 3:

If shares are purchased on margin and if share price fall below maintenance margin requirement, then broker may ask for more margin money and on failing to provide such additional margin money broker may sell all the shares.

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