Margin Transaction

CFA Level I Equities
#1

Hello All,

I couldn’t understand this – why is the commission added to the equities and then subtracted twice? For instance,

Let’s say that I bought 1000 shares and held them for one year, when the stock pays dividend.

Purchase price = $20/share

Sale Price = $15/share

Shares purchased = 1000

Commission =$0.01/share.

Call money rate = 5%

Dividend = 0.01/share

Initial Margin requirement = 40%.

Now, the equity used = 40% of (20K) = 8K. However, the literature says that equity raised, or total initial investment = 8K + 10 (commission for buying). Moreover, while calculating return on equity, we subtract purchase commission and sales commission — i.e subtract 10 twice? This essentially means that we pay only for either purchase or sales because we add 10 and subtract 20, with net effect being -10. Why so?

Please share your thoughts.

Thanks in advance.

#2

Your initial investment is $8,010. Only $8,000 of that went into the ownership of the stock; the other $10 is an expense that’s lost forever.

When you sell the stock, you’ll pay another $10 in commissions; that’s an expense that’s lost forever.

The net is that you paid $20, not that you paid $10. You aren’t “adding 10 and subtracting 20”; you’re merely subtracting 20. Ten dollars of that was paid via an initial investment that’s $10 higher than the original equity in the stock; the other $10 was paid from the proceeds of the sale.

I think you might be confusing the extra $10 you coughed up at the beginning as somehow being returned to you (“because we add 10”); you’re paying that by investing $8,010 instead of investing $8,000.

#3

Thank you S2000magician! Your response makes perfect sense. Thank you so much.

#4

Cool!