Case 099Stress testing and scenariosHard

A debt fund with Rs 5,000 crore of assets, 15% liquid, faces 30% redemptions in a week and sells illiquid bonds at a 4% discount once cash runs out. Compute the loss borne by the investors who stay, and explain the first-mover problem.

The situation

Lirasand Debt Fund, an open-ended credit fund, has assets of Rs 5,000 crore: Rs 750 crore in treasury bills and overnight money, and Rs 4,250 crore in corporate bonds that trade rarely. It has 50 crore units at a NAV of Rs 100.

After a downgrade of one issuer in the sector, investors ask to redeem 30% of the fund, Rs 1,500 crore, within a week. The fund pays from liquid assets first, then sells bonds; buyers will only take them at 4% below the value at which the fund marks them. Redemptions are paid at the NAV struck before the sales. Tools such as swing pricing and redemption gates exist under the regulator's framework; confirm the current rules before relying on any of them.

Your task

What loss do the remaining investors bear, what does the fund look like afterwards, and why does this create a run?

Quick check

Who bears the loss from selling bonds at a 4% discount?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The stayers lose about Rs 31.25 crore, 0.89% of their holding, and are left in a fund that is now entirely illiquid. Rs 750 crore of liquid assets pays half the redemptions; raising the other Rs 750 crore needs Rs 781.25 crore of bonds at a 4% discount. Leavers get Rs 100 a unit; stayers are left at Rs 99.11. Because leaving early is rewarded, every investor has a reason to leave first. Swing pricing that charges leavers about 2.0% removes that reward.

Step 1How does the fund raise Rs 1,500 crore?

Liquid assets go first because they cost nothing to sell. Rs 750 crore of bills and overnight money pays half the redemptions; the other Rs 750 crore needs bonds sold at 96% of their marked value, so the fund must sell Rs 781.25 crore of bonds at book value to raise it, a loss of Rs 31.25 crore. That is the price of turning a rarely traded bond into cash in a week when everyone else is trying to do the same.

The relationship
Bonds sold=7501−0.04=781.25Loss=781.25−750=31.25 crore\text{Bonds sold} = \frac{750}{1 - 0.04} = 781.25 \qquad \text{Loss} = 781.25 - 750 = 31.25 \text{ crore}
750cash still needed after liquid assets are used, Rs crore
0.04discount to marked value that buyers demand
781.25bonds at marked value the fund must sell
What it says in wordsTo raise Rs 750 crore at a 4% discount the fund gives up Rs 781.25 crore of bonds, and the Rs 31.25 crore gap is the loss.
Leavers take the liquid assets; stayers keep the loss and the illiquid restIlliquid bonds 4,250Liquid 7505,000BeforeIlliquid bonds 3,4693,469After, for the stayersPaid to leavers 1,500750 of liquid assets750 from selling 781of bonds at 4% offloss 31.250% liquid: the next redemption is a fire sale
Lirasand pays Rs 1,500 crore of redemptions with all Rs 750 crore of liquid assets and Rs 781 crore of bonds sold for Rs 750 crore, leaving the stayers Rs 3,469 crore of assets that are entirely illiquid.
Step 2Who bears the loss, and what is the fund left with?

Leavers are paid at the NAV struck before the sales, Rs 100 a unit. The Rs 31.25 crore loss therefore falls on the 35 crore units that stay: their assets are Rs 3,468.75 crore, a NAV of Rs 99.11, down 0.89%. Worse is the shape of what is left: no liquid assets at all. If the sale price becomes the new mark for similar bonds, the remaining Rs 3,469 crore falls another Rs 139 crore and NAV to about Rs 95.14.

Step 3Why does this create a run?

Picture a queue at a bank counter with not enough cash for everyone: those at the front are paid in full, those at the back wait for assets to be sold. The first-mover advantageThe gain an investor gets by redeeming before others, because early leavers are paid from liquid assets at full value while the costs of later sales fall on whoever remains. is built into this fund: the first 15% leave with cash at full value, the next 15% are paid at full value while the stayers bear the sale loss, and the stayers own a fund with nothing liquid left. Every investor who sees this has a reason to redeem first, which is how a 30% redemption becomes 50%.

Who pays for the fire sale, with and without swing pricingNo swing pricingRs 100.00Leavers getRs 99.11Stayers keep97Swing pricing, 2.0%Rs 98.00Leavers getRs 100.00Stayers keep97
Without swing pricing Lirasand's leavers get Rs 100.00 a unit while stayers are left at Rs 99.11; charging leavers a swing of about 2.0% pays them Rs 98.00 and keeps the stayers at Rs 100.00, removing the reward for leaving first.

Close with the tools, and what each does. Swing pricing charges leavers their own trading cost: solving for a price that leaves stayers whole gives Rs 98.00 a unit, a 2.0% adjustment. An exit load does something similar more crudely; a redemption gate slows the queue; a side pocket ring-fences a single defaulted bond. The durable fix is sizing liquid assets to a redemption stress in advance, not choosing a tool after the queue forms.

Where candidates lose it

The frequent slip is saying the redeeming investors take the discount. At a NAV struck before the sales they do not; the cost is left behind, which is exactly why leaving first pays.

The second is stopping at a 0.89% loss and calling it small. The larger problem is that the fund now has no liquid assets, so the next redemption is a fire sale from the first rupee; interviewers want the liquidity shape of the fund after the event, not only the loss.

What the interviewer asks next

  • Another 10% of the original fund redeems the next week at a 6% discount. What do the remaining investors lose?
  • How much would the fund have needed in liquid assets to meet 30% without any fire sale?
  • Would you gate the fund or apply swing pricing here? What are the risks of each?

Company names and figures are illustrative.