Rating Downgrade and a Redemption Deadline
A dealer's treasury holds ₹40 crore face value of a 7.9% corporate bond maturing in June 2029. The bond is rated AA+ and is carried at a yield of 8.10%, with modified duration of 4.1. A rating agency downgrades the issuer to AA- and places it on negative watch. The dealer's credit desk expects the yield to widen by 70-90 basis points over the next week. The bond's bid-ask spread is normally 10 bps but has widened to 35 bps; the dealer can repo the bond at 8.75% against a 10% haircut, or hedge with 10-year interest-rate futures. The treasury has a ₹25 crore redemption due in five business days and plans to sell the bond to meet it. The dealer's risk limit for a single AA- issuer is ₹15 crore. The bond's current market price is ₹99.15 per ₹100 face value.
1. Estimate the mark-to-market loss from a 70 bp and a 90 bp yield widening. How does the bid-ask spread affect the realisable value?
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Market value = ₹40 crore × 99.15/100 = ₹39.66 crore. Approximate price change = -modified duration × change in yield × market value.
70 bp widening: 4.1 × 0.0070 × 39.66 = ₹1.138 crore, or about 2.87%. 90 bp widening: 4.1 × 0.0090 × 39.66 = ₹1.463 crore, or about 3.69%. These are mark-to-market losses before transaction costs.
The bid-ask spread has widened to 35 bps in yield terms. Selling at the bid rather than mid costs approximately 4.1 × 0.0035 × 39.66 = ₹0.569 crore. So if the dealer sells after a 90 bp widening, the realised loss could be around ₹1.463 crore + ₹0.569 crore ≈ ₹2.03 crore. The spread is not a separate market move; it is the cost of immediacy and should be included in the sell-versus-hold decision.
2. Should the dealer sell, repo, or hedge? Show the constraints.
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The risk limit for a single AA- issuer is ₹15 crore, but the dealer holds ₹40 crore. Even before the redemption, the position is ₹25 crore over limit, so the dealer must reduce at least ₹25 crore. The ₹25 crore redemption due in five days also requires cash. Selling at least ₹25 crore solves both the limit breach and the liquidity need; the remaining ₹15 crore is within the AA- limit.
Repo would raise cash-10% haircut on ₹40 crore gives ₹36 crore-but it does not reduce credit risk or the limit breach, and the repo rate of 8.75% is above the bond's 7.9% coupon, creating negative carry. Hedging with 10-year IRFs reduces interest-rate risk but does not hedge the credit spread widening that is the main risk after a downgrade. It also does not fix the limit breach. The best sequence is to sell ₹25 crore in tranches to limit market impact, retain no more than ₹15 crore, and use IRFs only as an overlay on the retained position if the desk wants to separate rate risk from credit risk.
3. If the dealer hedges the remaining ₹15 crore with 10-year IRFs, calculate the approximate hedge ratio and explain the residual risk.
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Use DV01 matching. Bond DV01 = ₹15 crore × 4.1 × 0.0001 = ₹61,500 per basis point. Assume the 10-year IRF has modified duration of 7.5 and contract notional of ₹10 lakh; futures DV01 = ₹10,00,000 × 7.5 × 0.0001 = ₹750 per basis point. Hedge ratio = 61,500 / 750 ≈ 82 contracts. Equivalently, notional hedge = ₹15 crore × 4.1/7.5 ≈ ₹8.2 crore.
The residual risk is mainly credit spread risk: the expected 70-90 bp widening is issuer-specific and will not be offset by a government-securities futures hedge. There is also basis risk between the corporate bond yield and the IRF, rounding risk from 82 contracts, and margin/liquidity risk on the futures. If the downgrade leads to a further spread blowout, the IRF hedge may protect against a general rise in rates but not against the credit loss. The dealer should treat the IRF as a rate-risk overlay, not as a credit hedge.