Rate-Rise Exposure on a ₹500 Crore Portfolio and a Planned ₹3,000 Crore Issuance
IRFC must repay a large maturing obligation in FY 2027-28 and plans to raise ₹3,000 crore through 10-year bonds in about three months. Meanwhile treasury holds ₹500 crore of investments: ₹300 crore in the 7.40% 2033 G-Sec (modified duration 6.2) and ₹200 crore in AA-rated 5-year NBFC paper (modified duration 4.4, trading at a spread of 145 bps over G-Sec). The house economist expects a 50 bps rise in the benchmark yield over the next quarter and a 40 bps widening of AA spreads. Ten-year G-Sec futures are available (notional ₹2 lakh per contract, modified duration 6.4), as is a 5-year pay-fixed OIS at 6.60%. Two dealers quote the AA paper: one at a flat 9.15% yield, the other at 9.45%. The investment committee wants the mark-to-market damage quantified and a decision on hedging and valuation.
1. Quantify the expected mark-to-market loss and compute the futures position needed to hedge the G-Sec holding, including the expected hedge outcome and the basis risk.
Read the worked answer
Expected loss (modified duration approximation).
- G-Sec: 300 × 6.2 × 0.0050 = ₹9.30 crore
- AA paper, rate effect: 200 × 4.4 × 0.0050 = ₹4.40 crore
- AA paper, spread effect: 200 × 4.4 × 0.0040 = ₹3.52 crore
- AA subtotal = ₹7.92 crore; total expected loss = ₹17.22 crore
Futures hedge of the G-Sec leg. Number of contracts = (portfolio value × MD) ÷ (contract notional × contract MD) = (300 crore × 6.2) ÷ (₹2,00,000 × 6.4) = 18,60,00,00,000 ÷ 12,80,000 = 14,531 contracts (sell).
Expected outcome. Futures gain = 14,531 × 2,00,000 × 6.4 × 0.0050 = ₹9.30 crore, exactly offsetting the G-Sec loss under a parallel shift. The hedge is a short futures position: if yields rise, the futures price falls and the short gains.
Basis risk. The futures track the cheapest-to-deliver 7.26% 2033 G-Sec, while IRFC holds the 7.40% 2033 - a close but not identical instrument. Residual risk arises from (i) coupon and price differences between the CTD and the held bond, (ii) non-parallel curve moves (the hedge assumes a parallel shift), and (iii) rollover cost if the hedge is extended beyond the front contract. Corporate bonds cannot be hedged with G-Sec futures: their spread is the dominant risk and is uncorrelated with the benchmark.
Conclusion. Hedge the ₹300 crore G-Sec leg with approximately 14,531 short futures; accept or separately manage the ₹7.92 crore corporate-bond exposure.
2. Compare the futures hedge with the pay-fixed OIS, and recommend a strategy that also addresses the planned ₹3,000 crore issuance.
Read the worked answer
OIS comparison. Paying fixed at 6.60% on ₹300 crore for five years gains roughly 300 × 4.3 (the annuity-based duration of a 5-year par swap) × 0.005 = about ₹6.45 crore in a 50 bps sell-off - less than the ₹9.30 crore needed. More importantly, it hedges the 5-year point of the curve, whereas the G-Sec exposure sits at roughly 8 years. The duration and tenor mismatch leaves most of the risk unhedged. The OIS is the right tool only if the exposure itself were a five-year floating liability.
Recommendation for the portfolio. Use the 10-year G-Sec futures for the ₹300 crore holding; they match the tenor far better. Alternatively, sell the G-Sec outright if the view is strong and liquidity permits - that removes both market and operational basis risk. For the AA paper, either sell into the better dealer quote or accept the ₹7.92 crore mark-down; do not attempt to hedge it with futures.
Recommendation for the ₹3,000 crore issuance. This is the larger exposure: a 50 bps rise on ₹3,000 crore over 10 years is roughly 3,000 × 8.5 × 0.005 = ₹127 crore of additional annualised cost. A forward-starting pay-fixed swap (starting in three months, 10-year tenor) locks the issue cost now; at a indicative 6.90–7.05% it converts an unknown future coupon into a known one. A pre-hedge using short 10-year futures is an alternative but must be rolled and is subject to basis risk. Hedge 50–60% of the planned issue, not 100% - over-hedging a forecast issuance that may be downsized creates a speculative position, and Ind AS 109 cash-flow-hedge designation requires a highly probable forecast.
Governance point. Document the hedge rationale and the forecast issuance before executing; an undocumented 'pre-hedge' is the classic source of a market-risk scandal.
3. How should the AA paper be valued at year-end if no trades occur, given the two dealer quotes, under Ind AS 113?
Read the worked answer
Principle. Ind AS 113 defines fair value as the price received to sell an asset in an orderly transaction at the measurement date - an exit price, not an entry price or a cost-based mark.
Choosing between the quotes. The 9.15% quote (a lower yield means a higher price) is the more favourable price for IRFC; the 9.45% quote is the price at which the dealer is willing to buy. In an exit-price framework the relevant evidence is what a buyer would pay - so the 9.45% yield is the better indication. If 9.15% is only an indicative 'axe' and not executable, it is not valid evidence of fair value.
Hierarchy. If the dealer quotes are binding, executable and recent, the measurement is Level 2 (observable inputs other than quoted prices in an active market). If the market is inactive, the quote is stale, or the dealer refuses to trade size, the input becomes unobservable and the instrument moves to Level 3.
Valuation technique. Discount the contractual cash flows at the benchmark G-Sec yield plus a credit spread derived from a matrix of comparable AA NBFC issues, adjusted for tenor, subordination and liquidity. Cross-check against the dealer quotes and the last traded price.
Disclosures and controls. Disclose the technique, the significant unobservable inputs (spread, liquidity premium), a sensitivity of ±25 bps on the spread, and any transfers between levels. Restrict day-1 gains from a Level 3 mark to the extent they depend on unobservable inputs. Have the valuation approved by an independent valuation committee, with the dealer's own mark used only as corroboration - never as the sole input.