Risk Models for Sovereign Debt Management
1 November 1999
Peter McCray
Australian Office of Financial Management
Contents
- 0.1 Market Risk
- 0.2 Australia
- 0.3 Australia
- 0.4 Australia
- 0.5 Longer-Term Strategic Debt Management
- 0.6 Longer-Term Strategic Debt Management
- 0.7 Longer-Term Strategic Debt Management
- 0.8 Longer-Term Strategic Debt Management
- 0.9 Longer-Term Strategic Debt Management
- 0.10 Longer-Term Strategic Debt Management
- 0.11 Benchmark Analysis
- 0.12 Benchmark Analysis
- 0.13 Benchmark Analysis
- 0.14 Longer-Term Strategic Debt Management
- 0.15 Longer-Term Strategic Debt Management
- 1 Conclusions
Market Risk
· The risk that debt service costs increase directly or the opportunity to reduce debt service costs is forgone as a result of movements in financial market prices
– A risk intrinsic to all debt and derivatives portfolios
Australia
· There are a number of market risk factors of relevance to the management of the Australian government’s debt portfolio:
– domestic and foreign interest rate risks
– exchange rate risk
Australia
· The need to define, measure and model market risk factors arises at three levels:
– determining longer-term strategic debt management policy
– evaluating the risk associated with tactical departures from this strategic policy
– correctly pricing debt and derivatives transactions
Australia
· The nature of the treatment of market risk depends substantially upon the particular goals and modus operandi of the sovereign
Longer-Term Strategic Debt Management
· Australia adopts an explicit market risk management approach that evaluates cost and risk of alternative long term debt management strategies
– Examines consequences of long term market risk positions
– Based on the trade-off between cost and risk, identifies a long term benchmark policy with explicit market risk characteristics
Longer-Term Strategic Debt Management
· Long term benchmark based on:
– analysis of the cost/risk of a wide range of potential strategies
– monte carlo simulation of market risk factors
– structural assumptions regarding risk premia and market volatility
· particular emphasis on robustness in selecting benchmark
Longer-Term Strategic Debt Management
· Definitions adopted for cost and risk have a significant influence on the recommended long-term strategy arising from this analysis
Longer-Term Strategic Debt Management
· A risk measure based upon volatility in the:
– market or economic cost of debt usually results in a minimum risk portfolio that has short duration
· volatility of NPV of debt dominate analysis
– cash or accounting cost of debt usually results in a minimum risk portfolio that has long duration
· volatility of debt cash flows dominate analysis
Longer-Term Strategic Debt Management
· This requires a decision as to what definition of market risk is relevant for a sovereign
– Cash flow or debt NPV volatility?
· In Australia’s case a balance has been struck
– Cost: long-term market cost of debt
– Risk: volatility of budgetary debt cost
Longer-Term Strategic Debt Management
· Australian analysis uses a budgetary cash debt cost concept modified to include amortized FX gains and losses on principal
– “Debt Financing Cost” – DFC
· Volatility is expressed by a Sharpe likelihood ratio of:
(Expected DFC – Threshold DFC)
Standard Deviation of DFC
Benchmark Analysis
Benchmark Analysis
Benchmark Analysis
Benchmark Analysis
Longer-Term Strategic Debt Management
· Merits
– Balance between a financial management focus and traditional debt service costs
– Tension between long-term market cost and risk based on short-term accounting cost volatility
· Avoids horizon problem with market cost volatility measures
– Methodology improvement over traditional mean-variance
Longer-Term Strategic Debt Management
· Challenges
– Sharpe likelihood ratio formulation of risk not intuitive
– Still need to define acceptable risk
– Changes to budget debt cost measures with accrual accounting
– A fiscal environment of surpluses
· Debt repurchases
Conclusions
· Make explicit decisions about market risks
· Context of Australia’s long term debt management strategy
· Balance long term cost cost savings against market risks
· Definition of risk appropriate to the fiscal environment
Short-Term Tactical Debt Management
· Currently, Australia does not take tactical views against its long-term benchmark
– Important public policy constraints on a sovereign debt manager
– Limits scope to take views on interest or exchange rates
· Policy contagion and signaling
· Dominance of sovereign in domestic markets
Short-Term Tactical Debt Management
· The appropriate risk methodology would probably be one that focussed on the risk associated with the volatility of the value added of tactical variations
– Volatility in NPV of debt more appropriate
– Relative to the “neutral” long-term debt management strategy
Short-Term Tactical Debt Management
· Desirable risk measures:
– Value At Risk (monte carlo simulation)
– Extensive stress testing
Pricing Debt and Derivatives
· Currently, not a major issue for Australia
– Do not trade in our own debt or derivatives
· Buying/selling with a profit motive
– Utilise auction / tender style processes to issue debt and derivatives
Last updated: 7 November 2013