Borrowing fees

To sell a share short, a fund must first deliver that share. It does not own it. So it has to borrow it from somebody who does.

Nobody lends for free. The fee charged for the loan of the securities is the borrowing fee. The workbook defines it exactly that way: the fee incurred by the fund in order to borrow the securities for the purpose of short positions or short sale. It is an additional cost to the fund.

Now the distinction that earns marks. A fund in a hedged strategy usually pays two different costs with similar names.

Borrowing cost is interest on borrowed money. It is charged as a rate per year on the cash the fund borrowed.

Borrowing fee is the charge for borrowed shares. It is quoted per share.

There is a third leak too. While the fund is short, any dividend the company declares is not the fund's. The short seller forgoes it, because the fund is on the wrong side of the shares.

Three separate costs, three separate lines in the working. Miss one and the return is wrong.

Section 11.2.3 uses borrowing fees inside the convertible arbitrage strategy, where a Category III AIF goes long a convertible security and short the same company's equity shares.

The definition. Borrowing Fees is the Fees incurred by the Fund, in order to borrow the securities for the purpose of short positions or short sale. This is an additional cost to the Fund.

The three costs of the hedge, as the workbook separates them:

The workbook states the logic of the first and third alongside the second. Borrowing cost of 10% will be incurred to the extent of leverage taken by the fund when investing in the convertible bonds. And dividends declared by the company will not accrue to the investor, as the investor has a short position in the equity shares. Against all three sits the one income the structure generates for certain: the coupon interest on the bond will be an additional risk-free income for the fund.

The workbook's Example 11.6 in full. Fund CAS, a Category III AIF, on 1 April 2022:

On 31 March 2023 the share price is Rs 42.50, the bond price Rs 1,050, and a dividend of Rs 2 per share has been declared.

Read the size of the borrowing fee. At Rs 2,50,000 it is the second largest cost in the whole structure, behind only the Rs 8,00,000 of interest on borrowed cash. It is larger than the dividend foregone and it consumes almost half the Rs 6,25,000 profit on conversion. A candidate who omits it reports a return of 40% instead of 27.50%.

And the alternative outcome. The workbook notes that had the equity price decreased, the fund would not have converted the bonds into equity, and would have squared off the short position in equity shares, with a net gain of 15%. The borrowing fee is paid in that case too. It is the price of holding the short, not a charge on the profit.

Godavari Arbitrage Fund, a Category III AIF, runs the same structure at a larger size.

On 1 July it buys Rs 4,00,00,000 of an 11% convertible bond of Kalinga Chemicals Ltd — 40,000 bonds of Rs 1,000 face value — funded with Rs 1,00,00,000 of its own capital and Rs 3,00,00,000 borrowed at 9% per annum. The conversion ratio is 20:1 and Kalinga's share trades at Rs 50, so 20 shares are worth Rs 1,000 and the conversion is fairly priced at the start, exactly as in the workbook's own example.

The fund shorts 2,00,000 Kalinga shares at Rs 50. The securities lender charges a borrowing fee of Rs 4 per share.

Twelve months on, Kalinga has paid a dividend of Rs 3 per share and the share trades at Rs 54.

Now look at what the fee alone costs. Rs 8,00,000 is:

Leave the borrowing fee out and total income reads Rs 35,00,000, an ROI of 35.00% instead of 27.00%. Eight percentage points, from one line.

And the fee is fixed while the market is not. Had Kalinga fallen to Rs 46 instead of rising, the fund would not convert; it would square off the short at a Rs 8,00,000 gain rather than a loss. The borrowing fee would still have been Rs 8,00,000, unchanged. The fee buys the right to hold the position, whichever way it goes.

A sizing lesson. Doubling the short from 2,00,000 to 4,00,000 shares doubles the fee to Rs 16,00,000. In a strategy the workbook calls a hunt for riskless profit, a per-share fee scales linearly with the hedge and can quietly consume the spread the arbitrage was set up to capture.

Chapter 11 (Investment Strategies, Investment Process and Governance of Funds), section 11.2.3 on the Convertible Arbitrage Strategy, defines borrowing fees in the notes under Example 11.6 and uses it as a line in the worked computation.

The question is a computation question: you are given the number of shares shorted and a fee per share, and the borrowing fee is a deduction in arriving at total income and the return on investment. Expect the definitional discriminator too — borrowing fees are for borrowing securities; borrowing cost is interest on borrowed money — and the third line, dividend foregone, which a short seller loses. The workbook's own figures are ready-made: 50,000 shares at Rs 5 is Rs 2,50,000, against an ROI of 27.50%.

• Borrowing fees and borrowing cost are two different things. Fees are for borrowed securities, quoted per share. Cost is interest on borrowed cash, quoted as a rate per annum. The workbook lists them as separate lines in the same table.
• Dividend foregone is a third, separate deduction. A short seller does not receive the dividend. It is not part of the borrowing fee.
• The fee is paid whichever way the share moves. It is the cost of holding the short, not a share of the profit.
• It is charged per share, so it scales with the size of the short, not with the value of the long leg.
• Omitting it overstates the return. In Example 11.6, leaving out the Rs 2,50,000 turns 27.50% into 40%.
• The coupon on the convertible is income, not an offset to the fee. The workbook calls it an additional risk-free income for the fund.
• This is the borrower's side of the transaction. Stock lending and borrowing describes the SEBI scheme itself, where the same payment is the lender's fee.