Leverage Ratio and Return
A trader pays $100 per share to buy 500 shares of a non-dividend-paying firm. The purchase is done on margin, and the leverage ratio at purchase is 3.0X. Three months later, the trader sells the shares for $90 per share. Ignoring transaction costs and interest paid on the margin loan, the trader’s 3-month return was closest to:
I went through the process of D/E of 3X means 3/4 is debt and 1/4 is equity so your margin (your money) is 25%. Using this method I got a loss of 40% after calculating the decrease in price and the repayment of the borrower money (75% * $37,500). However this is the explanation provided:
With a leverage ratio of 3 and a 10% decrease in share value, the investor’s return is 3 × –10% = –30%.
Can someone explain the logic behind this?
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