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 his shares worth Rs 1,500 crore as sole collateral. The shares are well traded, and he promises to top up the collateral if needed to maintain a 150 percent cover on the principal.
Of course, 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, let's ponder the following questions. What is the payoff of this loan to the lenders? Given the payoff, how should they price such 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 were to face economic stress, the underlying share collateral value and liquidity 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 lending against shares is a combination of two building blocks.
First, there is a basic secured lending.
Second, there is an embedded equity option in the hands of the borrower, who can desist from repaying the loan by simply forgoing 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 percent from Rs 1,500 crore to Rs 1,000 crore or lower (ignoring the interest due), 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 percent of the current market price.
Ironically, most lenders who are comfortable lending against shares to promoters would be extremely uncomfortable with the thought of writing out equity options.
Pricing Lending Against Shares
Assume that 10 percent per annum is a fair rate for a one-year regular secured loan to the promoter.
How does one price a one-year equity option on the underlying stock at a strike price of 67 percent of the current price?
In Indian markets, while there is some equity option trading on exchanges, there isn’t adequate liquidity for these kinds of odd strike prices and tenors for any reliable pricing.
If we assume implied volatility of say 16 percent annualised (which in option-speak, means that the underlying stock prices on average move by 1 percent 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 percent of the current market price, we cannot assume “normal” volatility. If stock prices do get to 67 percent of the current market price, we can be quite sure the market will be very volatile at that point, and that 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 percent day-on-day volatility, the option price moves up to 1 percent of the notional. If we assume an average 3 percent day-on-day volatility, the option price moves up to 3.6 percent of the notional. If we assume an average 4 percent day-on-day volatility, the option price moves up to an astonishing 7.2 percent of the notional.
Some of the stocks that are currently in trouble exhibit daily volatility of even more than 4 percent.
Depending upon the implied volatility range assumed above, the fair rate for a one-year lending against shares could range between 10 percent and 18 percent.
Lenders simply do not consider this embedded optionality, and instead, barely adjust the pricing from the core secured lending rate.
At just the 10 percent secured lending rate, such a loan would be extremely valuable to the borrower, who practically buys the embedded equity option for free.
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 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 stakeholders, and that they charge appropriately for such structures. Complacent gut-feel is not the best way to price embedded derivatives.
Ananth Narayan is Associate Professor-Finance at SPJIMR.