Lesson 18 of 25 · 7 min

Why hedging a pledged position can reduce the line

Less risk and less capacity at the same time is not a contradiction; three separate mechanisms produce it.

This is the idea the track exists to land. A hedge that genuinely reduces economic risk can simultaneously reduce borrowing capacity, and the two facts do not contradict each other because they are measured by different parties using different inputs.

Three mechanisms, any of which is sufficient on its own:

The premium is paid from the line, so the balance rises while collateral does not.
The written leg consumes margin inside the pledged account, so part of the collateral is committed to another obligation.
The shares become encumbered by the hedge, and a schedule reduces or removes their advance rate because the lender's exit now runs through a contract it does not control.

Put the third mechanism in numbers. A pledged pool of $2,050,000 holds one name worth $861,000 at 42 percent, giving $361,620, and $1,189,000 of diversified collateral at 72 percent, giving $856,080. Lending value is $1,217,700, and against a $700,000 balance loan to value is 57.5 percent.

A put is bought for $38,700, drawn on the line, and the schedule marks the hedged shares as encumbered, cutting their advance rate from 42 to 30 percent. The name now contributes $861,000 × 0.30 = $258,300, so lending value is $1,114,380. The balance is $738,700, and loan to value is $738,700 ÷ $1,114,380 = 66.3 percent. Downside risk fell; loan to value rose 8.8 points.

Your risk and your capacity are computed from different things. A transaction that improves one can worsen the other, and nothing about the arithmetic is unusual when it does.

Key terms

Encumbered collateral: Pledged assets whose sale by the lender is complicated by another contract written on them. Schedules often discount them further.
Borrowing capacity: What the lending value permits you to draw. It is computed from advance rates, so it moves when a schedule's treatment of a holding moves.
Two-sided effect: A transaction that changes economic risk and collateral value in opposite directions.

Worked example

Risk down, loan to value up

Pledged pool $2,050,000: one name at $861,000 with a 42% advance rate, plus $1,189,000 of diversified collateral at 72%. Balance $700,000. A $38,700 put is drawn on the line and the name is re-rated to 30%. Illustrative schedule.

Lending value before: $1,217,700
Loan to value before: 57.5%
Name's lending value after re-rating: $258,300
Lending value after: $1,114,380
Balance after the premium is drawn: $738,700
Loan to value after: 66.3%

The position's worst case improved and its distance from a maintenance threshold shortened by 8.8 points. Both changes came from the same transaction.

Check yourself

Your lending value is $940,000 against a $600,000 balance. You buy a put for $26,000 drawn on the line, and the schedule re-rates the hedged holding so lending value falls to $868,000. What happens to loan to value?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.