Australian Government, the Australian Office of Financial Management

Interest Rate Benchmark Review

CEO Presentation to market participants in Melbourne and Sydney

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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
    – Review of benchmark recently completed
    • Benchmark explicitly determines cost/risk trade-off.
    • Low debt environment very important
    – Managing to new benchmark means re-entry into IR swap market
    • 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
    – Cash Management Portfolio (CMP)
    • 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

Questions?

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