Risk Models for Sovereign Debt Management

1 November 1999

Peter McCray
Australian Office of Financial Management

Risk Models for Sovereign Debt Management

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

This image is described by preceding text

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

This image is described by preceding text

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

This image is described by preceding text

Australia

· The nature of the treatment of market risk depends substantially upon the particular goals and modus operandi of the sovereign

This image is described by preceding text

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

This image is described by preceding text

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

This image is described by preceding text

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

This image is described by preceding text

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

This image is described by preceding text

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

This image is described by preceding text

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

This image is described by preceding text

Benchmark Analysis

Benchmark Analysis

Benchmark Analysis

Benchmark Analysis

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

Risk Models for Sovereign Debt Management

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

Risk Models for Sovereign Debt Management

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

Risk Models for Sovereign Debt Management

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

Risk Models for Sovereign Debt Management

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

Risk Models for Sovereign Debt Management

Short-Term Tactical Debt Management

· Desirable risk measures:

– Value At Risk (monte carlo simulation)

– Extensive stress testing

Risk Models for Sovereign Debt Management

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

Risk Models for Sovereign Debt Management

Last updated: 7 November 2013