Interest Rate Benchmark Review
CEO Presentation to market participants in Melbourne and Sydney
Download the Microsoft PowerPoint presentation 207kB
Interest Rate
Benchmark Review
Background
- Outcome of CGS Review
- Consider cost/risk outcomes
- Manage to an interest rate benchmark
– Current benchmark introduced in 1996- Substantial savings to the Commonwealth to date
- Benchmark explicitly determines cost/risk trade-off.
- Low debt environment very important
- AOFM announced suspension of IR swap program in February 2002
Agenda – September 29th
- Measurement issues
– Within-year variability in financing requirement
– Modified Duration as a single risk measure
– Nominal vs Inflation-linked debt - The New Interest Rate Benchmark
– Two tiered limit framework - Portfolio Profiles
– Current vs Benchmark
– Swap Activity
Within-year variability
- Large swings in short-term assets make duration volatile
– Short-term assets defease short-term liabilities - Previous approach focused on duration of total portfolio
– (Mod) Duration target range of 3.0 to 3.5 - Have been outside target range for sustained periods
– Nature of target range requires greater clarity
Within-year variability
Solution: Portfolio Split
- Split the portfolio for interest rate risk management purposes
– Long-Term Debt Portfolio (LTDP)- Include long-term debt and any long-term asset holding
- Manage the within-year financing requirement
- Average duration less than 0.5
- Transfers between portfolios are made on the basis of public information
– See Operational Notices section of AOFM website for rules- Transfer data will not be made available on a real-time basis
- Transfers should be verifiable
Solution: Portfolio Split
Duration as single risk measure
- Duration is a single summary measure of interest rate risk / proxy for average term to repricing
- Good measure for some interest rate shocks
- May be misleading for some shocks
- Detailed maturity/repricing profile of the portfolio is important
Solution: A second risk measure
- Use two measures of interest rate risk:
– Modified Duration
– Short-dated exposure- A measure of the proportion of the portfolio subject to immediate repricing when interest rates change
- We will not specify the precise portfolio
– Too prescriptive
– Too difficult to build a compliance and reporting framework
Nominal vs Inflation-linked debt
- Previous duration measure did not distinguish between inflation-indexed and nominal debt
- Distinction is more important as indexed debt becomes a larger proportion of the portfolio
- Different interest rate changes affect indexed and nominal debt differently…
Nominal vs Inflation-linked debt
- Real interest rates change with no change in inflation:
– inflation-indexed payments are stable
– indexed debt’s cost resembles nominal debt’s cost - Inflation changes:
– inflation-indexed payments change
– indexed debt’s cost resembles floating rate debt’s cost
Solution: Focus on nominal portfolio
- Focus on the nominal debt portfolio
– Express limit framework in terms of the nominal portfolio
– No direct control instruments available for indexed debt - Report modified duration and short-dated exposure measures for both types of shocks for the LTDP
- Note that these measures converge on the nominal portfolio measures as TIBs mature
Benchmark AUD Long-Term Debt Portfolio
- Two-tiered limit framework
– Operational Limits: Approved by Secretary to the Treasury
– Policy Limits: Approved by Treasurer - Transition period of up to three years may be required
Portfolio profiles contrasted
Current A$ LTDP
New Benchmark Portfolio
Duration = 2.5
Duration = 2.0
Portfolio profiles contrasted
Current A$ LTDP
New Benchmark Portfolio
Duration = 2.5
Duration = 2.0
Swap Activity 2003-04
- The swap program for 2003-04 is $6 billion to $10 billion.
– Long-end receiving of $2 billion to $4 billion
– Short-end paying of $4 billion to $6 billion - This will:
– reduce modified duration; and
– reduce short-dated exposure - Transition to the new benchmark will take up to 3 years
- Expected commencement: Next week
