Series 7 Exam Question 55: Answer and Explanation

Question: 55

A client opens a margin account by selling short 1,000 shares of DIMCO common stock at $30 per share. Six months later with DIMCO trading at $26 per share, how much does this client have in excess equity?

• A. $0
• B. $2,000
• C. $4,000
• D. $6,000

Correct Answer: D

Explanation:

D. This client would have to deposit 50% (the Regulation T requirement) of the amount of securities shorted. Because the investor is shorting $30,000 ($30 × 1,000) shares, they would have to deposit $15,000 ($30,000 × 50%) to meet the call. Start by setting up the equation like this:

$\begin{array}{c}\text{ SMV }+\text{ EQ }=\text{ CR}\\ \text{\$30,000}+\$15,000=\$45,000\end{array}$

The SMV (short market value) is $30,000. The EQ (Equity) is the 50% that the investor had to deposit as a result of shorting the securities. The CR (credit balance) is the total when adding the SMV + EQ.

$\begin{array}{c}\text{ SMV }+\text{ EQ }=\text{ CR}\\ \sout{\text{\$30,000}+\$15,000=\$45,000}\\ \text{ \$26,000}+\$19,000=\$45,000\\ (\$26,000\times \text{50\%)}=\underset{¯}{\text{\$13,000}}\\ \text{\$6,000 excess equity}\end{array}$

The stock price dropped to $26, so you have to change the SMV to $26,000 ($26 × $1,000). Because the CR remains the same as the SMV changes, the EQ had to increase to $19,000 ($45,000 – $26,000) to make the equation balance. Next, take the $26,000 SMV and multiply it by 50%, and you'll see that the investor only needs to have $13,000 in EQ to be at 50% of the SMV. Since the EQ is $19,000, the investor has $6,000 in excess equity (SMA), which can be withdrawn as cash or used to purchase or short more securities.