Hi!

Can I check with you all if it is possible to use this formula for the question below? Thanks!

Formula: Call price = [(initial pr)(1- initial margin)] / (1-maintenance margin)

QUESTION

[question removed by admin]

Answer = B

Hi!

Can I check with you all if it is possible to use this formula for the question below? Thanks!

Formula: Call price = [(initial pr)(1- initial margin)] / (1-maintenance margin)

QUESTION

[question removed by admin]

Answer = B

The call price formula doesn’t apply here.

If the leverage ratio were 1.6, then the (original) equity investment was:

$22 ÷ 1.6 = $13.75,

so the investor borrowed:

$22.00 – $13.75 = $8.25.

If the total return were 12%, then the total amount in the investor’s account after the sale was:

$13.75 × 1.12 = $15.40.

The total amount in the investor’s account after the sale will be:

sale price + dividend – loan amount – interest

= sale price + $0.60 – $8.25 – $0.33

= sale price – $7.98.

Thus,

$15.40 = sale price – $7.98

sale price = $15.40 + $7.98 = $23.38.

Voilà!

Intuitively…

Since the leverage ratio is 1.6, your equity is $13.75 and the borrowed amount is $8.25 (or 60% of your equity).

I like to lay out a formula that makes sense to me:

X - $8.25 + $0.60 - $0.33 / $13.75 should equal 12%; solve for X and it gives you X = $9.63, and you add that to $13.75 to give you the full ending stock value of $23.38

Another way to calculate:

Return on equity = Leverage ratio x Asset Return - (Leverage ratio-1) x Return on debt

Asset return = (12% + (1.6-1) x 4%) / 1.6 = 9.0%

(selling price + dividend)/purchase price = 1.09

selling price = (1.09x22) - 0.60 = 23.38