A manufacturer sells Rs 400 crore of trade receivables into a securitisation. Dilution from credit notes and returns averages 4% with a stressed peak of 9%, and defaults run at 2% with a stressed 6%. Size the reserve needed to protect senior investors at the stressed levels.

The reserve should be about Rs 60 crore, 15% of the pool: 9% for stressed dilution and 6% for stressed defaults. In the base case the two need only Rs 24 crore. Dilution is a separate loss because credit notes and returns cut invoices without any default, so a reserve sized on defaults alone, Rs 24 crore, would leave senior investors exposed to Rs 36 crore of stressed dilution.

A shop sells a fridge on credit, then the customer returns it, or gets a discount for a dent. The shop is owed less, but nobody has defaulted. Dilution is any reduction in a receivable that is not caused by the customer failing to pay: credit notes, returns, rebates and disputes. In a receivables deal the investors bought the invoice amounts, so every credit note is money they will not collect. It needs its own reserve because default statistics never see it, and because it tends to rise in the same months that defaults do, as distributors facing weak demand return stock and argue over prices.

Size each layer on its stressed level and add them, because in a bad period both arrive together. Dilution at 9% of Rs 400 crore needs Rs 36 crore and defaults at 6% need Rs 24 crore, so the reserve is Rs 60 crore, 15% of the pool. In practice this reserve is usually built as overcollateralisation: senior investors fund only Rs 340 crore against Rs 400 crore of receivables, and Ornavik receives the remaining Rs 60 crore later, as a deferred purchase price, if the pool collects in full. Rating agencies go further and apply stress multiples to historical peaks that rise with the rating sought; their published methods should be checked for the actual factors.

In most receivables deals the seller is contractually required to pay the trust for any dilution, called a deemed collection, since the credit note was its own decision. That promise is only as good as Ornavik itself, and the moment it is most needed, when Ornavik is in trouble and issuing credit notes to keep distributors, is the moment it is least able to pay. The dilution reserve covers exactly that case. A rating analyst would also look at commingling, the risk that collections sit in Ornavik's own accounts when it fails, at concentration in the largest distributors, and at whether credit note policy could change after the sale. Each can add to the reserve or call for a trigger that moves collections away from Ornavik early.