• Miller-Motte Technical College, Cary

• FIN 550

  Chapter 5: Problems 1, 2, 3, and 4. Chapter 3 4. You decide to sell short 100 shares of Charlotte Horse Farms when it is selling at its yearly high of $56. Your broker tells you that your margin requirement is 45 percent and that the commission on the purchase is $155. While you are short the stock, Charlotte pays a $2.50 per share dividend. At the end of one year, you buy 100 shares of Charlotte at $45 to close out your position and are charged a commission of $145 and 8 percent interest on the money borrowed. What is your rate of return on the investment? Value of short selling = Number of shares x Current selling price = 100 x $56 = $5,600 Required initial capital = Value of short selling x Margin requirement = $5,600 x 45% = $2,520 Borrowed fund = Value of short selling - Required initial capital = $5,600 - $2,520 = $3,080 Interest charge = Borrowed fund x Interest rate = $3,080 x 8% = $246.40 Total expenses = Commission of the sales of stocks + Commission of the purchase of stocks + Interest charge = $155 + $145 + $246.40 = $546.40 Total profit = Value of short selling - Value of purchased stocks + Dividend - Total expenses = $5,600 - 100 x $45 + 100 x $2.5 - $546.40 = $803.60 Rate of return=Total profit /Initial capital = $803.60/$2,520 = 31.89% 5. You own 200 shares of Shamrock Enterprises that you bought at $25 a share. The stock is now selling for $45 a share. a. You put in a stop loss order at $40. Discuss your reasoning for this action. b. If the stock eventually declines in price to $30 a share, what would be your rate of return with and without the stop loss order (ignore commissions)? a. Stop-loss is used by financial security traders as a risk management strategy to decrease loss in case the price of a security moves into unfavorable directions. It can be used to lock in the profit when the price of security starts retrieving back after the starting price increase. The reasoning behind entering a stop-loss order at $40 when stock is selling at $45 is to lock the profit. If the pricing of the stock starts falling back and falls to $40, the trader is ensured that the broker will automatically sell the stock and the trader will be able to lock profit price at $40. b. Return is calculated Return = Selling price − Initial cost/Initial cost ∗100 With stop-loss, the decline of stock to $30 will not effect the traders' profit because profit is locked in at $40. Return = $40− $25/ $25 ∗ 100 Rate of return = 60% Rate of return = 60% This study source was downloaded by 100000881504821 from CourseH