You Can’t Just Call Loans Options

A pretty ordinary way for a hedge fund to invest is that it borrows money from a bank and uses that money, along with the fund’s own equity, to buy stuff. If the stuff goes up the hedge fund pays back the bank’s loan and keeps the profits. If the stuff loses value the hedge fund takes the loss, reducing its equity. If the stuff loses a lot of value then the equity will reach zero, the loan won’t get paid back, and the bank will eat the rest of the loss. If the fund puts up $20 and borrows $80 from the bank, it can buy $100 worth of stuff. If that stuff ends up being worth $120, the hedge fund doubles its money to $40 (ignoring interest on the loan); if it ends up being worth $90 the hedge fund only gets back $10 of its original $20; if it ends up being worth $50 then the hedge fund loses its $20 and the bank loses $30.1

This has, roughly speaking, the profile of a call option: If the stuff is worth more than the amount of the bank’s loan, the hedge fund has all the upside; if it’s worth less, the hedge fund’s downside is floored at the amount of equity it put up.2 (You can think of the strike price as being the amount of the loan and the option premium as being the amount of the fund’s equity plus the interest on the loan.) It’s not really an option on anything; generally, the hedge fund does not buy one stock or bond and just hold it for years. But you can think of it as a call option on the hedge fund’s entire portfolio as it changes from time to time.