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) Susan would like to purchase XYZ stock, which currently has a price of $40. The...

  1. ) Susan would like to purchase XYZ stock, which currently has a price of $40. The stock is expected to pay a $2 dividend one year from today. Susan can either pay $40 using cash, or borrow $15 from her brokerage firm and pay the remaining $25 using her cash. The annual interest rate on the margin loan is 8%. Assume that the stock price in one year is $28, immediately after paying the dividend.
  1. If Susan buys this stock with 100% cash, what was her % return over this one-year period?
  2. If Susan buys this stock on margin (using the $15 loan), what was her % return over this one-year period?
  3. What does this example illustrate about the risks associated with margin trading?   If the stock market is efficient, will any rational investor trade using margin loans?
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Answer #1

A. 100% cash return = -25%
B. Cash + Borrowing $15 return = -28.5%
C. That is risk associated with trading on margin is that it magnifies the volatility on both sides.
You either get:
1.more return than original return or
2. Less return than the original return. (As in this case).
If the stock market is efficient, there is no chance for abnormal profits, so an investor would not trade on margin.

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