Risks and Pricing of Lending Against Shares

(The following article appeared on CNBCTV18 online on February 25, 2019 - link below:

https://www.cnbctv18.com/market/the-risks-and-pricing-of-lending-against-shares-2399741.htm )

Risks and Pricing of Lending Against Shares

Let’s take a look at a topical subject – lending to promoters against the collateral of shares.

Consider a promoter seeking a Rs. 1,000 crore loan against Rs. 1,500 crores worth of his shares as the sole collateral.

The shares are well traded currently, and he promises to top up the collateral if needed, to maintain a 150% cover on the principal.

There are governance issues around ensuring adequate disclosure of this effective pledging of promoter shares – but let’s keep them aside for now.

In this note, instead, we ponder the following questions. What is the payoff of this loan to the lenders? Given the payoff, how should they price such a lending?

The lender’s payoff

As long as the underlying share collateral is worth more than the loan and accrued interest, lenders are assured of a fixed return.

The risk arises if there is a sharp fall in the price and liquidity of the shares, and the promoter cannot or does not top up collateral. We have seen this play out in a couple of high-profile cases in recent times.

There is an adverse correlation risk that the lenders have to contend with – if the promoter was to face economic stress, the underlying share collateral would likely be stressed as well.

It is important for the lenders to be cognizant of this unique payoff of this type of lending. They receive a fixed return against a high equity risk on the downside.

The building blocks of this lending

Such a lending against shares is a combination of two blocks.

First, there is a basic secured lending.

Second, overlaying the secured lending, the borrower effectively has the right to be freed of the obligation to repay the loan by simply giving up the collateral posted.

This is especially peculiar to lending against shares, since the borrowing is usually by a ring-fenced special purpose vehicle that has no assets other than these shares.

In other words, if the collateral value were to suddenly shrink by 33% from Rs. 1,500 crores to Rs 1,000 crores and lower, the borrower is commercially better off defaulting on the loan.

Effectively, therefore, the lender has sold the borrower an equity option to sell the underlying shares at 67% of current market price.

Ironically, most lenders who are comfortable lending against shares to promoters would be extremely uncomfortable with the thought of writing equity options.

Pricing lending against shares

Assume that 10% p.a. is a fair rate for a 1-year regular secured loan to the promoter.

How does one price a 1-year equity option on the underlying stock at a strike price of 67% of current price?

In Indian markets, while there is some equity option trading on exchanges, there isn’t adequate liquidity for these kind of odd strike prices and tenors for any reliable pricing.

If we assume implied volatility of say 16% annualized (which in option-speak, means that the underlying stock prices on average move by 1% on a day-on-day basis over the year), the value of the option is indeed negligible.

However, option traders will tell you that for strikes such as 67% of the current market price, we cannot assume “normal” volatility. If stock prices do get to 67% of the current market price, we can be quite sure the market will be very volatile at that point. In fact, liquidity in that counter would likely be severely impacted as well.

Traders adjust for these “fat tails” by factoring in much higher than usual volatility for these kinds of off-market strikes.

If we assume an average 2% day-on-day volatility, the option price moves up to 1.0% of the notional. If we assume an average 3% day-on-day volatility, the option price moves up to 3.6% of the notional. If we assume an average 4% day-on-day volatility, the option price moves up to an astonishing 7.2% of the notional.

Some of the stocks that are currently in trouble exhibit daily volatility of even more than 4%.

Depending upon the implied volatility range assumed above, the fair rate for a 1-year lending against shares could range between 10% and 18%.

Lenders simply do not consider this embedded optionality, and instead barely adjust the pricing from the core secured lending rate.

At just the core 10% secured loan rate, such a loan would be extremely valuable to the borrower, who practically buys the equity option for free.

Summary

Lenders have to take cognizance of the peculiar, asymmetric payoff while lending to promoters against shares. When the going is benign, they receive a fixed debt-type return. When the promoter is in trouble, however, they face adverse correlated equity market "wrong-way" risks of a sharp fall in the value and liquidity of the underlying collateral.

Lenders sell an implicit equity option in such transactions, and they would be relying on the kindness of markets and the goodwill of the promoter to not exercise the option.

Lenders must ensure this payoff and risk is suitable and appropriate to their operations, and that they charge appropriately for such structures. Complacent gut-feel is not the best way to price embedded derivatives.