FIN 3210 Module 2 Written Assignment: Margin, Short Sales and the True Cost of a Mutual Fund Example

Borrowed Money and Small Fees: Margin, Short Selling and Mutual Fund Costs for a Trenton Household

Student Name

B.S.B.A. in Finance, Thomas Edison State University

FIN-3210: Security Analysis and Portfolio Management

Mentor Name

Month Day, Year

Borrowed Money and Small Fees: Margin, Short Selling and Mutual Fund Costs for a Trenton Household

Question 1: How Trades Are Executed

Investors trade through brokers, who route orders to exchanges or other trading venues where buyers and sellers are matched electronically. A market order executes immediately at the best available price; a limit order sets the highest price a buyer will pay or the lowest a seller will accept and executes only if the market reaches it. Bodie et al. (2017) note that the bid-ask spread is an implicit trading cost, small for heavily traded stocks and wider for thinly traded ones. Barber and Odean (2000) found that households who traded heavily underperformed the market after costs, a caution for anyone tempted by margin trading.

Question 2: Buying on Margin

Suppose the electrician buys 400 shares at $50, paying $10,000 of his own money and borrowing $10,000 from his broker at 8 percent, the 50 percent initial margin. The maintenance margin is 30 percent.

A 20 percent move in the stock produces a 32 percent gain or a 48 percent loss. Margin magnifies both outcomes, and the interest cost means even an unchanged price loses money.

Setting (400P − $10,000) / 400P equal to the 30 percent maintenance level gives a call price of $35.71. Below that price, the broker demands more cash or sells the shares.

Question 3: Selling Short

Short selling reverses the order of a trade: the investor borrows shares, sells them and hopes to buy them back later at a lower price. If an investor shorts 200 shares at $80 with 50 percent margin, the account holds the $16,000 of proceeds plus $8,000 of the investor's own money. With 30 percent maintenance margin, a call comes when ($24,000 − 200P) / 200P = 0.30, or P = $92.31. Unlike a purchase, a short sale has no limit on its potential loss, because the price can rise without limit.

Question 4: Types of Investment Companies

Question 5: What Fees Cost Over Time

The couple has $50,000 to invest for 20 years and expects the underlying portfolio to earn 7 percent a year before costs. They compare a broad index fund with a 0.05 percent expense ratio and an actively managed fund with a 5.75 percent front-end load and a 1.00 percent expense ratio.

The difference, about $40,600, is the cost of the load and the extra expenses, assuming the active fund earns the same gross return. To break even, the active fund would need to beat the index fund by more than a percentage point a year for 20 years. Carhart (1997) found that the persistence in mutual fund performance is explained mostly by common factors and expenses rather than by managers' skill, so few funds can be expected to do that consistently.

Conclusion

Margin and short selling magnify returns in both directions and expose investors to forced sales. Fees, by contrast, work slowly but surely, reducing wealth every year. For a household saving for retirement, low-cost diversified funds and no borrowing to buy stocks are the prudent default.

References

Barber, B. M., & Odean, T. (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. Journal of Finance, 55(2), 773-806. https://doi.org/10.1111/0022-1082.00226

Bodie, Z., Kane, A., & Marcus, A. J. (2017). Essentials of investments (10th ed.). McGraw-Hill Education.

Carhart, M. M. (1997). On persistence in mutual fund performance. Journal of Finance, 52(1), 57-82. https://doi.org/10.1111/j.1540-6261.1997.tb03808.x