Securities Lending Strategies, Valuation of Term Loans using Option Theory

Contents 1 Abstract 2 2 Introduction 2 2. 1 Abstract We develop models to price long term loans in the securities lending business. These longer horizon deals can be viewed as contracts with optionality embedded in them and can be priced using established methods from derivatives theory, becoming to our limited knowledge, the first application that can lead to greater synergies between the operations of derivative and delta-one trading desks, perhaps even being able to combine certain aspects of the day to day operations of these seemingly disparate entities. We develop a heuristic that can mitigate the loss of information that sets in, when parameters are estimated first and then the valuation is performed, by directly calculating the valuation using the historical time series. We run numerical simulations to demonstrate the practical applicability of these models. These models are part of one of the least explored yet profit laden areas of modern investment management. We illustrate how the methodologies developed here could be useful for inventory management. All these techniques could have applications for dealing with other financial instruments, non-financial commodities and many forms of uncertainty. Admittedly, our initial ambitions to produce a normative theory on long term loan valuations are undone by the present state of affairs in social science modeling. Though we consider many elements of a securities lending system at face value, this cannot be termed a positive theory. For now, if it ends up producing a useful theory, our work is done. Existing studies on securities lending fail to fully consider the full extent to which lending desks bridge the demand and supply gap by setting loan rates and managing inventory by finding securities externally or using the positions of other trading desks within the same firm. [Kashyap (2016a) has a recent and comprehensive review of the literature on short selling and the stock loan space; D'Avolio (2002); Jones and Lamont (2002); and Duffie, Garleanu, and Pedersen (2002) have more details on the mechanics of the equity lending market. Appendix 11 has a brief background on securities lending. End notes (2) and (3) have more details on the historical evolution of securities lending.] A more complete study on the effects of short selling must look to incorporate the actions of the main players and how they look to alter their cost structure or the 2 demand/supply mechanisms, by pulling the above levers they have at their …