Pre-Issuance Hedge of a Corporate Bond with 10-Year Interest Rate Futures
An NBFC plans to raise ₹200 crore through a 10-year domestic bond issue in 45 days to fund infrastructure loans. The treasurer expects the benchmark 10-year G-Sec yield, currently 7.10%, to rise by 40 bps before pricing, which would raise the coupon by roughly the same amount. The NBFC's bonds typically trade at a 140 bps spread over the benchmark. To hedge, the desk shorts 10-year interest rate futures, whose notional is ₹2 lakh per contract and whose DV01 is ₹150 per contract per basis point. The planned cash bond's modified duration is 7.5 years and its DV01 is estimated at ₹15 lakh per basis point for the issue size. The futures contract expires in 40 days, before the planned issuance, and the desk can roll to the next series. The CFO wants to know the correct hedge ratio, the basis risk from hedging a corporate bond with a G-Sec future, and what happens if the credit spread widens while yields fall.
1. Calculate the futures hedge ratio and explain the adjustments the desk should make before trading.
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Cash DV01 = ₹200 crore × 7.5 × 0.0001 = ₹15,00,000 per basis point. Futures DV01 = ₹150 per contract per basis point. The naive hedge is 15,00,000 ÷ 150 = 10,000 contracts. That equalises DV01 for a parallel shift in the G-Sec curve. Adjustments: first, yield beta - if the NBFC's bond yield moves 1.1 bps for each 1 bp G-Sec move, use 11,000 contracts. Second, the futures contract tracks a notional or cheapest-to-deliver G-Sec, not the NBFC's 10-year bond; duration and convexity differ. Third, the 45-day issuance horizon is longer than the futures expiry, so the desk must roll and bear roll cost and basis. Fourth, the hedge should be scaled down if the issue size or spread changes. The desk should not treat 10,000 as a precise number; it is a starting point, and a small underhedge may be preferable to overhedging a corporate spread that the futures cannot capture.
2. Suppose G-Sec yields rise 30 bps but the NBFC's credit spread widens 25 bps. Quantify the residual and explain the lesson.
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Corporate yield change = +30 bps + 25 bps = +55 bps. Cash cost increase = 55 × ₹15 lakh = ₹8.25 crore. Futures loss = 30 bps × 10,000 × ₹150 = ₹4.50 crore. Net unhedged loss = ₹3.75 crore. The futures hedged the risk-free curve but not the credit spread. If the desk had used a yield beta of 1.1 and 11,000 contracts, the futures loss would be ₹4.95 crore and the net loss ₹3.30 crore - better, but still incomplete. A corporate issuer cannot fully hedge credit spread with a G-Sec future; it can only hedge the benchmark component. Alternatives include hedging a smaller notional, using a credit derivative if available, or accepting and disclosing the basis risk. The lesson is to measure the residual before the trade and not assume that a DV01-matched G-Sec hedge protects the all-in coupon.