Short Selling and Porsche’s €Multi-Billion Windfall
Short selling is basically the practice of selling borrowed shares, with the intention of purchasing them back later at a lower price. It amounts to placing a bet on the share price dropping, is a favoured move of hedge funds, and has been recently blamed for much of the current economic mayhem. However, when Porsche announced that, in addition to the 44% of Volkswagen’s shares it owned, it had secured control of another 31% through cash-settled call options, the invisible market in VW shares went ballistic. Why? Since the German state of Lower Saxony holds just over 20% of VW, Porsche’s disclosure meant that, in fact, there were only 5% of VW’s shares left on the market (’the Float’), whereas hedge funds had borrowed 13% of the shares and sold them short. It meant that, the hedge funds had to buy 13% of the shares and only 5% were available.. Porsche had cornered the market.
Having engineered the most vicious of “Short Squeezes”, the Porsche financial team waited three days before telling the hedge funds that they would release 5% of VW shares to get them off the hook—at a price.
VW’s shares peaked at €1,005 each, not their usual €250, as traders scrambled to cut their losses. For a short period, VW was valued at €296BN, which is higher than the €275BN value of Exxon Mobil – previously the world’s most valuable company.
What upset the hedge funds is that, because Porsche had not declared the proportion of VW shares it controlled, it’s likely that many of the funds that shorted VW had borrowed the shares from Porsche. It meant that traders may have been indirectly and inadvertently borrowing shares from Porsche, selling them to Porsche, buying them back from Porsche and then returning them to Porsche. The problem for the hedge funds is that the share price moved relentlessly upwards in the interim. There has been little Schadenfreude in Germany about the pasting handed out to the funds – market wisdom is that they took a €30billion loss in two days of trading in Volkswagen. Porsche probably made €10BN after fees
This financial manoeuvring by Porsche – legal, but hardly ethical – worked because only they knew where most of the VW shares were held. The hedge funds were sucked in because from September 2007 onwards VW shares outperformed all others in the sector. They thought a correction was overdue, bet heavily on it—and lost.
Porsche used their cash to buy call options – rights to buy at a fixed price at a future date. The squeeze helped them to profit hugely from hedge funds and exercise many of their call options. By January 2009 they owned 51% of the VW shares and the company was in their control – or at least it was until July
A quick word on Cash Settled Options?
Porsche bought Call Option contracts to buy VW shares at a specific date in the future and at a specific price. Reportedly they bought options on 31% of the shares. The option contract does not mean that they have to buy the shares. They might or might not exercise the option, depending on the price of the shares at the agreed date.
For example, leaving aside the cost of the option itself, if the shares are trading above the agreed price, investors will always exercise the option. They can buy the shares at a lower price than they presently trade in the market and immediately sell them and make a profit. If the shares are trading lower than the exercise price, they simply take no action and let the option expire. They have lost money – the cost of the option, but no more.
There are three kinds of option contracts, each with different conditions. Porsche bought European Options. When a European option is exercised, no shares change hands; they are cash settled. Owners of options with an intrinsic value receive that intrinsic value in cash. That cash is automatically deposited into the option owner’s account. Similarly, cash is removed from the account of investors who are short (sold, but did not repurchase) the option.
The settlement price (see below) of the VW Jul €260 call option is determined to be €264.59. Thus, the intrinsic value is 4.59 (difference between strike price and settlement price).
Owners of the SPX Jul 260 calls receive €459 for each option owned. (Each option is for 100 shares, so 4.59 x 100 = 459)
Owners of the SPX Jul 250 calls receive €1459 for each option owned. (14.59 x 100 = 1,459)
As a result of cash settlement, owners lose their options (due to expiration), but are compensated by collecting the intrinsic value of the option, in cash. Option sellers must pay that intrinsic value to satisfy their obligations under the contract. Cash settlement is far more convenient than buying and selling shares of stock, making expiration easier for most involved.