Australian Government, the Australian Office of Financial Management

Risk Models for Sovereign Debt Management

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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

Market Risk

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

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

Australia

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

Australia

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

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

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

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

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

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

Longer-Term Strategic Debt Management

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

Longer-Term Strategic 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

Longer-Term Strategic 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

Conclusions

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

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

Short-Term Tactical Debt Management

· Desirable risk measures:

    - Value At Risk (monte carlo simulation)

    - Extensive stress testing

Short-Term Tactical 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

Pricing Debt and Derivatives

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