One of the more peculiar stories of late in these times of turbulent financial markets is how, briefly, Volkswagen became the biggest company in the world. In the process, hedge funds around the world suffered losses estimated at over US$35 billion.
Over the last few years, Porsche has been building a stake in Volkswagen. By November 2007, the size of their stake had reached 31%, much of which was achieved by means of share options* rather than direct share purchases. Significant increases in the Volkwagen share price meant that these options delivered large profits for Porsche, prompting criticism that the company was acting more like a hedge fund than a car manufacturer.
In response, many real hedge funds took the view that, in the light of the ongoing financial crisis, the share price had risen too far and so began betting against Volkswagen. For critics of short-selling, this should have been very bad news for the Volkswagen share price. But things do not always go the way hedge funds plan and events turned out very differently.
In October 2008, Porsche revealed that they had effectively built their holding in Volkswagen up to 74%. In most countries, share-holdings of this size would be subject to continuous disclosure requirements. While Germany is no exception, Porsche had taken advantage of a loophole which exempted cash-settled options (as opposed to options which allow the holder to purchase shares) from these reporting requirements. This had allowed them to build their enormous stake while leaving the rest of the market in the dark.
The problem for the short-selling hedge funds was that all of the banks who had transacted these options with Porsche would had been buying Volkswagen in order to hedge their positions. So, although Porsche did not directly hold 74% of Volkswagen, these shares were effectively tied up. Add to this the 20% stake held by the German state of Lower Saxony and only 6% of the shares in Volkswagen were available for trading in the market. Given that hedge funds had short-sold around 12% of shares in Volkswagen (unwittingly selling to the banks hedging the options they had sold), the Porsche announcement was the equivalent of shouting “Fire!” in a crowded theatre. Every hedge fund manager started running for the door, desperately trying to buy back Volkswagen shares to close out their short positions.
As a result, the Volkswagen share price soared, briefly trading over €1005 (Euro), then closing on 28 October at €945. This put the market capitalisation of Volkswagen at around US$370 billion, more than Exxon Mobil’s capitalisation of around US$340 billion, thereby making Volkswagen the biggest company in the world for a day.
Humiliated hedge fund managers cried foul, claiming the event made the German exchange the laughing stock of financial markets. While the share price has since fallen back to a mere €392, it has been estimated that the experience cost hedge funds around the world over US$35 billion** and, needless to say, generated further profits for Porsche. No doubt some of the fuming hedge fund managers would have found insult to add to their injury as they stared at the Porsche logo on their steering wheel as they drove home.
*UPDATE: Michael Michael has asked for an explanation of share options, so here is a brief explanation. A “call” option is a financial contract which gives the buyer of the option the right to purchase shares at a specified price (called the “strike” price) on a specified date (called the “expiry” date). For example, consider a call option on Volkswagen with a strike price of €200 expiring in three months time. If the share price of Volkswagen at the time was €185, this call option might cost around €2. In three months time, the share price had risen to €220, the holder of the option could “exercise” the option, buying shares from the option seller for €200. Since these shares could immediately be sold for €220 in the market, the option holder has made a profit of €18 (€20 less the €2 cost of the option). If the share price at expiry was only €190, there would be no point exercising the option and they would expire worthless. Exercising these options involves the direct purchase of shares and they are referred to as “physically settled”. A variation would be a “cash settled option”. This is very similar but, in the €200 call option example, rather than buying shares from the option seller, the holder of the option would be paid €20 (the difference between the market price and the strike price). If the Volkswagen share price goes up, the value of a call option goes up as well (whether physically or cash settled), so the buyer of the option makes money and the seller of the option loses money. For this reason, if the seller of the option wants to “hedge” this risk (i.e. reduce the risk as much as possible), one approach is to buy shares, which is exactly what the banks which sold options to Porsche did. Since a holder of a call option has the right to purchase shares in the future, it is common for regulators to require such options to be subject to disclosure rules for large holdings. At first glance, it may not seem necessary to include cash-settled options in this requirement as the options do not involve any direct share transactions. However, as this Porsche/Volkswagen example shows there are in fact very good reasons to include cash-settled options.
**UPDATE: This figure is almost certainly an over-estimate and the real figure is likely to be closer to US$20 billion (thanks for pointinf this out Mark).