“The loan-stock instrument (LSI) combines fixed rate instruments (loans, etc.) with other financial instruments that have higher volatilities and returns (stocks, mutual funds, currencies, derivatives, options, etc.). This new loan depends on the value of underlying security (for example, stock) in such a way that when underlying security increases, the value of loan decreases and backwards. The procedure to create a risk free portfolio and a technique to fairly price the LSI is described. … Creation of the risk free portfolio is possible because the change in the underlying security offsets the change in the value of the loan (or the amount that the borrower has to repay). The new financial instrument takes an advantage of the fact that on average the stock market grows in time. It is beneficial for both the borrower and the lender. The LSI is more attractive for the borrower than the traditional loan is due to the decrease in the amount that has to be repaid.” ¹

¹ SOURCE: A New Loan-Stock Financial Instrument (ResearchGate)

How Securities-Based Loans (Stock Loans) Work

A Stock Loan (i.e. a Loan-Stock Instrument (LSI) or Loan Stock) is a relatively new financial instrument that leverages the higher returns possible with stocks, or stock-like instruments, to create a Loan-like (i.e. a fixed-rate) Loan-Stock Instrument (LSI) that is beneficial for both Lenders and Borrowers. The new financial instrument takes advantage of the fact that on average the stock market grows over time.

For example, a Lender (e.g. a Bank or Private Lender) will give a Borrower a certain amount in cash as a Loan. At the same time the Lender will also buy a certain amount of Stock or Stock-like security (e.g. an ETF or Mutual Fund). The Borrower will make periodic payments that will depend on the Loan amount and the value of the underlying Stock.

The philosophy behind this procedure to create a risk-free (i.e. hedged) portfolio is quite similar to the Black-Scholes formalism in option theory. Creation of the risk-free (i.e. hedged) portfolio is possible because the change in the underlying security offsets the change in the value of the Loan (i.e. the amount that the Borrower has to repay).

A Stock Loan (i.e. a Loan-Stock Instrument (LSI) or Loan Stock) combines fixed-rate instruments (e.g. Loans, etc.) with other financial instruments that have higher volatilities and returns (e.g. Stocks, Mutual Funds, Currencies, Derivatives, Options, etc.). A Stock Loan depends on the value of underlying security (e.g. Stock) in such a way that when the value of the underlying security increases, the value of the Loan decreases.

To reiterate: On average the stock market always seems to go up. Therefore, according to the described idea, with a Stock Loan (i.e. a Loan-Stock Instrument (LSI) or Loan Stock) the Borrower will have to repay less than he/she would in a traditional Loan situation. Thus the financial benefit of this Loan strategy for the Borrower is obvious (at least on average). The Borrower enjoys a lower cost of the Loan that might be associated with increased risk - i.e. depending upon the exact Stock/Equity used as collateral, volatile market conditions, other significant factors such as whether (and how) the Borrower hedges his/her own risk, etc.

It is important to understand that financial benefits with a Stock Loan (i.e. a Loan-Stock Instrument (LSI) or Loan Stock) for both the Borrower and the Lender come from an additional investment (i.e. a hedge) in a stock market that is associated with a particular Loan and from the Lender's ability to construct the risk-free (i.e. hedged) portfolio by properly balancing the relative amounts of the Loan and the underlying security. The situation is quite similar to the situation that arises when a risk-free (i.e. hedged) portfolio (that consists of an Option and an underlying security) is created in Option Theory.

With a Stock Loan (i.e. a Loan-Stock Instrument (LSI) or Loan Stock) when the value of the underlying security increases the amount that the Borrower has to repay correspondingly decreases compared to the amount to be repaid when a traditional Loan is employed. Conversely, when the value of the underlying security decreases the amount that the Borrower has to repay correspondingly increases. However, with a Non-Recourse Loan, the Borrower always has the option of walking away from repayment of the Loan without any penalties whatsoever.

The Lender benefits from higher returns that are not accompanied by increased risk (since the Lender will be hedging risk). The Lender's market risk (i.e. risk of losing capital) could still be minimal and independent of the underlying security value. This is achieved by constructing a risk-free (i.e. a hedged) portfolio that consists of the Loan and the proper amount of the underlying security.

For the Lender, the attractiveness and financial benefit manifest in terms of the market share among Borrowers. In addition, the Lender can charge an extra premium (and/or from profit via hedging the risk of the stock collateral). The Borrower's willingness to pay such an additional premium (if any - THERE ARE NO EXTRA PREMIUMS WITH OUR LOANS) is due to the reduced total Loan repayment amount as described above.

However, the Lender takes very significant risk offering a Non-Recourse Loan (as we do) using Stock as collateral since the default risk for the Lender increases when compared with the risk to Lenders who offer traditional Recourse Loans. If the Stock value decreases, the possibility that the Borrower may default increases. However, since on average the stock market goes up, this risk decreases with time. The Lender can further insure against default risk by charging a premium (if any - THERE ARE NO EXTRA PREMIUMS WITH OUR LOANS) and/or hedging the risk.

A Stock Loan (i.e. a Loan-Stock Instrument (LSI) or Loan Stock) is beneficial for both the Borrower and the Lender. For the Borrower, the LSI is more attractive than the traditional Loan because of the decrease in the amount that has to be repaid (i.e. as the Stock value rises over time on average). An additional benefit of a Non-Recourse Loan, the Borrower always has the option of walking away from repayment of the Loan without any penalties whatsoever.

Such financial instruments that can be used as the underlying security for collateral in a Stock Loan (i.e. a Loan-Stock Instrument (LSI) or Loan Stock) include - but are not limited to - Stocks, generic Mutual Funds, Mutual Funds based on Stock Indices such as Dow Jones Industrial Average (DJIA), Currencies, different kind of Derivatives like Futures, Forwards, and different kinds of Options, etc. The mathematical pricing model outlined by A. Morozovsky, R. Narasimhan, and Y. Kholodenko (2000) is equally applicable to all these cases.

As a financial instrument - contrary to the traditional Loan - the value of a Loan-Stock Instrument (LSI) is coupled to (and therefore depends on) the value of an underlying Stock. A Borrower borrows from a Lender a given Loan amount based on the terms and conditions of the Loan-Stock Instrument (LSI). The Borrower then makes periodic payments based on the value of the underlying security and the amount borrowed.

The Loan-Stock Instrument (LSI) can be viewed as the instrument in which the Lender invests in the stock market on behalf of the Borrower. If so, one can ask why wouldn't the Borrower invest for his/her self? The answer is very simple: The Borrower does not have money to do so. To have money invested on his/her behalf, the Borrower has to pay to the Lender in the form of an additional premium to the Lender.

Under the assumption of the continuous re-balancing of the number of shares, the amount of money that the Lender has (without additional premium) will be exactly the same as the growth of a normal fixed-rate Loan. This is due to the fact that the change in the underlying security will offset the change in the value of the new Loan security (i.e. the amount that the Borrower has to repay in the Loan-Stock Instrument (LSI)).

This means that if the underlying security price increases, the value of the new Loan-security will decrease in such a way that the sum of the two amounts will grow exponentially in time with the same rate as the fixed-rate Loan would. The opposite is also true: if the Stock price decreases then the value of the new Loan-security (i.e. the amount that the Borrower has to repay) will increase in such a way that the sum will again grow in exactly the same way as the traditional fixed-rate Loan would.

Therefore, in order to offer an Loan-Stock Instrument (LSI) at a profitable ROI, a strategy for the Lender to earn some additional return has to be specified. The Lender proceeds to hedge the risk as follows:

1. At the time when the Loan is initiated the Lender also buys some units of an underlying security (e.g. shares of Stock).
2. The Lender periodically changes the number of shares of the underlying security depending on its value. For example, the Lender might want to recalculate the number of shares held (and therefore buy or sell some shares of Stock) at the end of a certain period of time (e.g. a year) based on the value of the underlying Stock at that time.
3. Based on the financial benefits of the Loan-Stock Instrument (LSI) for the Borrower, the Lender can still competitively afford to charge an additional premium from the Borrower. Of course the amount of the premium could not exceed the financial benefit that the Borrower obtains in the LSI when compared with a traditional Loan.

This Loan-Stock Instrument (LSI) must have the following properties in order to exist and be marketable:

1. The amount of debt should decrease with time faster than it would when a traditional Loan is employed. If not, the Borrower will not be interested in the LSI - unless a investment exit-strategy is desired, or if another suitable hedge strategy is employed to reduce risk and/or lock in a guaranteed profit for the Borrower.
2. The value of the LSI should depend on the value of the underlying security.
3. One should be able to create a risk-neutral (i.e. hedged) portfolio on the basis of this LSI in order to price it as a security.

Furthermore, the Loan-Stock Instrument (LSI) grows in time with the fixed-interest rate r. Therefore a new kind of Bond can be created that combines the LSI (i.e. Loan-like instrument) and Stock (or Stock-like instrument). This new Bond portfolio could be packaged and sold to interested third parties.

References: A. Morozovsky, R. Narasimhan, and Y. Kholodenko, "A New Loan-Stock Financial Instrument", 2000, pp. 1-9.