Explanation:
Initial Assets = Cash ($100). Equity = $80.
When shorting the stock for $100:
$100 from the short sale, which is held as a restricted asset (collateral).$50 from its own cash as initial margin, which remains an asset (segregated margin account).$50.$100.New Assets = Free Cash ($50) + Margin Account ($50) + Short Sale Proceeds ($100) = $200.
New Liabilities = Bank Debt ($20) + Short Position ($100) = $120.
New Equity = Assets - Liabilities = 200 - 120 = $80.
Leverage = Assets / Equity = 200 / 80 = 2.50.
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$100 in Cash, $20 in Debt, and Equity of $80. Assume Lever Brothers creates a short position in a stock, borrowing $100 of the security and selling it. It has thus created a liability equal to the value of the borrowed stock, and an asset, equal in value, consisting of the cash proceeds from the short sale. The cash cannot be used to fund other investments, as it is collateral; the broker uses it to ensure that the short stock can be repurchased and returned to the stock lender. It remains in a segregated short account, offset by the value of the borrowed stock. The stock might rise in price, in which case the $100 of proceeds would not suffice to cover its return to the borrower. Lever Brothers must therefore in addition put up margin of $50. After the trade, what is the leverage in the firm’s economic balance sheet?A
1.25
B
1.50
C
1.75
D
2.50
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