Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

How to borrow $10 million against forged shares

James Altucher narrates a fascinating story about how a guy claiming to be related to Middle Eastern royalty almost succeeded in borrowing $10 million from a fund manager against forged shares representing $25 million of restricted stock of a private internet company (h/t Bruce

To me the red flag in the story was that the borrower agreed without a murmur to the outrageous terms that the fund manager asked for:

  • 15% interest, paid quarterly
  • the full loan is due back in two years
  • $600,000 fee paid up front.
  • 25% of all the upside on the full $25 million in shares for the next ten years

Assuming that the loan is for all practical purposes without recourse to any other assets of the borrower because of the uncertainties of local law, all this can be valued using call and put options on the stock. The upside clause is just 25% of an at-the-money call option on the stock. The default loss is just the value of a put with a strike of $10 million. To discount the interest payments, we need the risk neutral probability of default which I conservatively estimate as the probability of exercise of the two year put option (In fact, the interest is paid quarterly and some interest payments will be received even if the loan ultimately defaults).

For simplicity, I assume the risk free rate to be zero which is realistic for the first two years, but probably undervalues the ten year call. To add to the conservatism, I assume that the volatility of the stock is 100% for the first two years (life of the loan) and drops sharply to 30% for the remaining life of the ten year period of the call option. Taking the square root of the weighted average variance gives the volatility of the call option to be 52%. Since it is an internet stock, one can safely assume that the dividends are zero.

Under these assumptions, the fund manager expects to lose $3 million (put option value) out of the $10 million loan, but expects to make $3.7 million on the call, $1.4 million in interest and $0.6 million upfront fee. That is a net gain of $2.7 million or 27%. If the short term volatility is reduced to 50%, the default loss drops to less than $0.5 million and the net gain rises to 52%. Even if the short term volatility is raised to 160% (without raising the long term volatility), the deal still breaks even.

If a deal looks too good to be true, it usually is. The fund manager should have got suspicious right there.

As an aside, forged shares were a big menace in India in the 1990s, but we have solved that problem by dematerialization. (It is standard while lending against shares in India to ask for the shares to be dematerialized before being pledged.) The Altucher story suggests that the US still has the forged share problem.


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