CFA Level 1 - Securities Markets
Example: Determine the return on a margin trade
Assume that an investor purchased 500 shares of Newco's stock. The shares were trading at $50 when the transaction was executed. Assume the investor was able to sell the shares for $100. To determine the effect of the leverage with purchasing the shares on margin, compute the return on the transaction if (1) no margin was used and (2) 70% initial margin requirement was used. Assume no transaction costs.
If no margin was used, the initial cash outlay for the shares was $25,000 (500 shares at $50). The investor then sold the shares for $50,000 (500 shares at $100).
The return on the trade was thus ($50,000/$25,000) - 1 = 100%.
Given the initial margin requirement of 70%, the investor would need an initial cash outlay of $17,500 ($25,000 * 70%). The investor borrowed $7,500 ($25,000 * 25%) from the brokerage firm to complete the transaction.
The investor was then able to sell the shares for $50,000 (500 shares at $100). The investor then repays the amount borrowed of $7,500 and the remaining position would be equal to $42,500 ($50,000 - $7,500).
The return on the trade was thus ($42,500/$17,500) - 1 = 142.9%.