If you are unable to pay the full loan amount in cash, the broker will unwind your trade and use the proceedings to pay for the loan. If the proceeding is not enough to pay off the loan, you are required to top up the difference with cash. Therefore, you need to hold a minimum amount of readilyavailablecashtotopupthisdifference,ifyoudonotwanttobeservedwithabankruptcy order by your broker. Your broker has offered you a $1,000,000 interest-free loan and you used the loan to execute trades in $300,000 of Microsoft (MSFT), $200,000 of Goldman Sachs (GS) and $500,000 of Lending Club (LC) stocks on 29-Nov-2019 at the following prices,

QUESTION

If you are a trader making use of leverage to trade, it is very important that you risk manage your trade very carefully as you are trading with borrowed funds. You need to ensure that you hold sufficient cash in case your broker informs you of their intention to recall the loan, i.e. to return all borrowed funds.

Assume that you are given one trading day to raise the cash for the loan amount.

If you are unable to pay the full loan amount in cash, the broker will unwind your trade and use the proceedings to pay for the loan. If the proceeding is not enough to pay off the loan, you are required to top up the difference with cash. Therefore, you need to hold a minimum amount of readilyavailablecashtotopupthisdifference,ifyoudonotwanttobeservedwithabankruptcy order by your broker. Your broker has offered you a $1,000,000 interest-free loan and you used the loan to execute trades in $300,000 of Microsoft (MSFT), $200,000 of Goldman Sachs (GS) and $500,000 of Lending Club (LC) stocks on 29-Nov-2019 at the following prices,

1) Calculate and appraise the amount of cash that you need to fork out from your pocket, in Cases A and B, if your dealer decides to recall the loan when the hypothetical stock prices of the three stocks are given as follows respectively:

2) Hence, making use of the historical stock prices, suggest how you would appraise the amountofcashyoushouldholdtomanagethiscashshortfallfor99%ofthecases.Explain your methodology and the resulting amount of cash clearly. Document and explain any assumptions you have made in your evaluation.

Please quote cites and strictly follow APA formatting and style guidelines.

ANSWER

Risk Management in Leveraged Trading: Evaluating Cash Shortfall Scenarios

Introduction

Leverage trading involves borrowing funds from a broker to amplify potential returns. However, it carries the inherent risk of facing a cash shortfall if the broker decides to recall the loan. This essay aims to calculate and appraise the amount of cash needed to cover potential loan recalls in two hypothetical cases (Segal, 2023). Furthermore, it explores a methodology to estimate the amount of cash required to manage the cash shortfall in 99% of cases using historical stock prices.

Calculation and Appraisal of Cash Required in Cases A and B

To determine the cash required in Cases A and B, we need to calculate the value of the trades executed using the loan and compare it with the hypothetical stock prices.

Case A: The value of trades executed using the loan in Case A is: MSFT: $300,000 * ($152.00 – $151.38) = $186,000 GS: $200,000 * ($225.00 – $221.35) = $730,000 LC: $500,000 * ($14.00 – $13.81) = $95,000

The total value of trades executed using the loan in Case A is $1,011,000. If the broker recalls the loan, this amount would be used to pay off the loan. Since the loan amount is $1,000,000, there would be a surplus of $11,000. Therefore, no additional cash would be required in Case A.

Case B: Following the same calculations, the value of trades executed using the loan in Case B is: MSFT: $300,000 * ($150.00 – $151.38) = -$414,000 GS: $200,000 * ($220.00 – $221.35) = -$270,000 LC: $500,000 * ($13.60 – $13.81) = -$105,000

The total value of trades executed using the loan in Case B is -$789,000. In this case, the proceeds from unwinding the trades would not be sufficient to cover the loan amount of $1,000,000. Therefore, an additional cash injection of $1,000,000 – (-$789,000) = $1,789,000 would be required to avoid bankruptcy.

Estimating Cash Required for 99% of Cases

To estimate the amount of cash required to manage the cash shortfall in 99% of cases, historical stock prices can be utilized. The methodology involves calculating the maximum potential loss (MPL) for each stock and summing them.

Assumptions

Historical stock prices are representative of future price movements.

The historical data used is reliable and accurate.

The loan recall occurs at the end of the trading day.

No additional trades or changes in positions occur during the trading day.

Using historical stock prices, we can calculate the MPL for each stock

MSFT: $300,000 * (Max Price – $151.38) GS: $200,000 * (Max Price – $221.35) LC: $500,000 * (Max Price – $13.81)

To manage the cash shortfall in 99% of cases, we need to determine the value of Max Price for each stock. By analyzing the historical data, we can identify the worst-case scenarios where the stock prices experienced the most significant drops. We choose the price corresponding to the 1st percentile of the historical data as Max Price.

For example, if the historical data for MSFT shows that the stock price dropped to $120.00 at the 1st percentile, we would use this value as Max Price. Similarly, we calculate Max Price for GS and LC based on their historical data at the 1st percentile.

Once we have determined the Max Price for each stock, we can calculate the total MPL. This total represents the worst-case scenario for the cash shortfall.

Conclusion

Effective risk management is crucial when trading with leverage. In the given hypothetical cases, we found that no additional cash would be required in Case A, while an additional $1,789,000 would be needed in Case B to avoid bankruptcy (Chen, 2023). To estimate the cash required to manage the cash shortfall in 99% of cases, historical stock prices can be utilized. By selecting the worst-case scenario prices at the 1st percentile, we can calculate the maximum potential loss for each stock and sum them to determine the total cash needed (Watt, 2014). This methodology provides a proactive approach to risk management, enabling traders to maintain sufficient cash reserves to navigate potential loan recalls effectively.

References

Chen, J. (2023). Risk: What It Means in Investing, How to Measure and Manage It. Investopedia. https://www.investopedia.com/terms/r/risk.asp 

Segal, T. (2023). Operational Risk Overview, Importance, and Examples. Investopedia. https://www.investopedia.com/terms/o/operational_risk.asp 

Watt, A. (2014, August 14). 16. Risk Management Planning. Pressbooks. https://opentextbc.ca/projectmanagement/chapter/chapter-16-risk-management-planning-project-management/