You are considering investing in the SPY Exchange Traded Fund. This fund delivers returns that...
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You are considering investing in the SPY Exchange Traded Fund. This fund delivers returns that closely track the S&P 500 Stock Index. While the rate of return that the SPY will deliver in the future is uncertain, the mean or expected return is 7% per year. Your initial plan was to invest $50,000, using your own money. However, your broker says that she will loan you another $50,000 at a 4% interest rate, thereby allowing you to invest $100,000 in the SPY. (Just as an FYI, this is known as purchasing stock on margin).
The following questions can be answered conceptually without numbers, though it is possible to supply numbers if you wish.
Is the expected rate of return on your $50,000 personal investment larger with or without the loan from your broker?
Assume that the market does unexpectedly well, for example delivering a return of 25%. Is the rate of return on your $50,000 personal investment larger with or without the loan from your broker?
Assume that the market does unexpectedly poorly, for example delivering a return of -25%. Is the rate of return on your $50,000 personal investment larger with or without the loan from your broker?
Summarize the general principle at work here.
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