dominicsoon.com/blog

As financial drama rages on the global stage, the Volkswagen-Porsche side plot has to be one of the more memorable ones.

“The huge rise in demand for Volkswagen shares came after Porsche disclosed its indirect, 31.5% stake in Volkswagen over the weekend, which it had built up via cash-settled options. When added to Porsche’s 42.6% direct stake, and the state of Lower Saxony’s 20.0% holding, investors who were shorting Volkswagen suddenly realized that there was only 5.0% of equity left with which to close their positions, or reverse their bets that Volkswagen’s shares would fall. Volkswagen’s shares skyrocketed on Monday and Tuesday as a result.”

To me, this illustrates that the popular market dogma that short-selling makes the market more efficient doesn’t hold if there are other barriers to efficiency - in this case, lack of perfect information. But of course, what you don’t know can’t hurt you. Even if you know the truth (in this case, that there have been more Volkswagen shares short-sold than those available), it doesn’t hurt you until everyone else knows it too. Then the drama begins.

A discussion on Marginal Revolution, with a comment from a reader which I found particularly helpful in explaining the whole saga.

To flesh out the cash settled options thing a bit:

1. Porsche buys (OTC) cash settled call options from Banks
2. Banks hedge their exposure by buying physical call options from MarketMakers
3. MarketMakers hedge their exposure by buying underlying shares of VOW on the Exchange

then:

4. MarketMakers lend the underlying to the HedgeHunds for a bit of profit
5. HedgeFunds sell the underlying back into the Exchange, buying Porsche

the cycle continues, and now the various parties start getting worried.

6. Porsche worries it could be owned by the HedgeFunds
7. The Banks worry the option expiration could be horrible as they are forced to sell off a huge VOW position to pay off the cash option obligation

so…

8. Porsche tells the market that it will acquire physical with cash at exercise
9. the Banks breath a sigh of relief - they are hedged nicely and price of the underlying will not fail near expiry - no need to panic sell
10. the HedgeFunds start buying back those shares from the Exchange they will need to return to MarketMakers
11. underlying price rises, MarketMakers now buy more shares too so they stay delta-hedged.

Suddenly, a “good” trade turned into a prisoners’ dilemma: one Porsche and lots of hedge funds means the funds couldn’t act in a co-ordinated fashion. Many start unwinding to protect themselves, and Porsche wins.

Who loses?

1. The HedgeFunds. The arb blew up.
2. The Exchange. Some HedgeFund counterparties default.
3. The MarketMakers. Nasty gamma there, hope they had good models.