Gerard Rouleau is studying for the Level 2 CFA examination. His friend, Sonia Fennell, is studying for Level 1. One weekday morning they are sitting at the local
Cafe drinking espresso when she asks him for help with the section on margin trading. Rouleau creates the following scenario: Assume Fennell purchases 1,000 shares of Xpressoh Inc. for $35 per share. The initial margin requirement is 50 percent and the maintenance margin is 25 percent One year later, she sells the stock for $42 per share. Rouleau asks Fennell to calculate the one-year return under two cases: first, assuming an all-cash transaction,and second, assuming she buys on margin. She is to ignore transaction and borrowing costs. The earnings retention rate is 100%.
Which of the following choices is closest to the correct answer? The return on an all cash transaction is:
Click on the arrows to vote for the correct answer
A. B. C. D.B
One quick (and less than intensive) way to calculate the answer to this on the examination (and is it very important to save time on the examination) is to first calculate the return if all cash, then calculate the margin leverage factor and then finally, multiply the leverage factor times the all cash return to obtain the margin return.
Calculations:
Step 1: Calculate All Cash Return:
Cash Return % = [(Ending Value / Beginning Equity Position) "" 1] * 100
= [(($42 * 1,000) / ($35 * 1,000)) "" 1] * 100 = 20%
Step 2: Calculate Leverage Factor:
Leverage Factor = 1 / Initial Margin % = 1 / 0.50 = 2.00
Step 3: Calculate Margin Return:
Margin Transaction Return = All cash return * Leverage Factor = 20% * 2.00 = 40%
Note: You can verify the margin return as follows:
Margin Return % = [((Ending Value - Loan Payoff) / Beginning Equity Position) "" 1] * 100
= [(([$42 * 1,000] "" [$35 * 1,000 * 0.50]) / ($35 * 0.50 * 1,000)) "" 1] * 100 = 40%