Risk Models for Sovereign Debt Management
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Peter McCray
Australian Office of Financial 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
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
