Interest-rate risk

Interest-rate risk comprises the risk that the development in interest rates will lead to higher government debt servicing costs. The concept of interest-rate risk also covers refinancing risk, which is the risk that debt has to be refinanced at a time with unfavourable market conditions or particularly unfavourable borrowing terms for the central government.

As stated above, interest-rate risks are managed on the basis of strategic benchmark for duration and rate fixing. These measures for interest-rate exposure are discussed in more detail below.

Duration

In government debt management, duration is used as a measure of the portfolio’s average fixed interest period. Interest-rate changes affect the duration, although the actual fixed interest period is unchanged by interest-rate changes. For that reason, duration is also calculated using a fixed discount rate. The strategic benchmark for 2004 concerning duration is:

● A duration band at 3.0 years +/–0.5 years, i.e.a symmetrical band around the duration level at end-2003. The wide band is used to capture the effect of interest-rate changes on duration.

● A duration band (calculated at a fixed discount rate) of 3 years +/–0.25 years.

Within the year, management of the duration of the central government debt, calculated on the basis of a fixed discount rate, is applied. Duration calculated by using the current discount rate must still comply with the wider band of 3.0 years +/–0.5 year.

Duration has been reduced by approximately 1 year since 1998. The reduction should be seen in the light of the decline in government debt. The budgetary significance of the risk of rising interest rates on the government debt is thereby reduced. This has led to a strategic decision to change the weighing of costs against risk towards shorter duration.

Interest-rate fixing and redemption profile

As an average measure, duration contains no information on the dispersion of the portfolio’s interest-rate exposure over time. The duration target is therefore supplemented with a measure for interest-rate fixing. Interest-rate fixing at a given time comprises the redemptions due within the coming year, as well as the amount of the floating-rate debt and the swap portfolio, for which a

new rate of interest is to be fixed within the following year. All other things being equal, the exposure should be smoothed from year-to-year in order to avoid fixing a new rate of interest on a relatively large proportion of the portfolio in a year when interest rates are extraordinarily high.

Interest-rate fixing as a percentage of GDP is an indicator of the central government’s “real” exposure. Higher GDP can be expected to render the government less sensitive to the development in interest rates, e.g.as a result of a larger taxation base.

Given the objective to spread and thus reduce the central government’s interest-rate exposure, the government debt policy is aimed at ensuring comparatively smooth redemptions on the debt after new issues in the next few years. This contributes to maintaining a stable borrowing programme with liquid on-the-run securities of even size and reducing refinancing risk.

The redemption profile is smoothed via buy-backs and issuance policy.

Management of interest-rate exposure

The risk profile of the portfolio is managed independently of the issuing strategy by means of interest-rate swaps and buy-backs. Interest-rate swaps are used to move interest-rate exposure from one maturity segment to another, while buy-backs are used to smooth the redemption profile and thus the size of the interest-rate exposure in individual years. Thus, interest-rate swaps make it possible to achieve an interest-rate exposure different from that determined by the maturity distribution of the original issues.

The development in interest rates over the year may justify a change in the exposure of the portfolio, and likewise shifts may occur in the relative attractiveness of the various instruments. To enable a flexible response to a given development, limited scope for deviations around the strategic benchmarks is allowed. For example, duration may be changed within a fixed band, and issues in the various maturities may be larger or smaller within fixed limits. Using this scope does not reflect short-term tactical positioning or an attempt to “beat” the market by exploiting diverging expectations regarding future market developments.

Given that the central government is a dominant issuer (player) in the domestic bond market, performance measurement does not encompass comparison of the cost relative to that of a specific benchmark portfolio constructed on the basis of domestic bond issues. However, the central government borrowing strategy is evaluated; for example, by examining the issuance of government securities together with the development in market rates.

Quantification of risk

GDM’s simulation model is applied as a scenario model and a stochastic simulation model (the CaR model). The difference between the two applications of the model is that while the scenario model is deterministic and only considers a single interest-rate scenario, the CaR model allows for the simulation of a large number of interest-rate scenarios.

Interest costs and risk are measured in nominal terms, i.e.,as periodised cash-flows, as the focus is on financial debt-service costs. The development in the annual debt-service costs and key portfolio figures are simulated over a 10-year horizon in the models for various assumptions concerning the government debt management strategy and the government’s budget balance.

Annex 10.A contains a more detailed description of the structure of the model.

In the CaR model, 2 500 scenarios for the central government’s annual interest costs are simulated 10 years ahead. In this way, statistical distributions of annual interest costs and expected interest costs and risks can be calculated.

Expected future annual costs of a given strategy are calculated as the mean value of calculated costs. The risk is summarised in two measures:

absolute CaR and relative CaR. Absolute CaR for a given year states the maximum costs with a probability of 95 per cent, i.e.the 95 percentile of the cost distributions. Relative CaR is the difference between absolute CaR and the mean value. Relative CaR is thus a measure of the maximum increase in costs from the mean value for a given year, with a probability of 95 per cent.

The development of costs and risk over time depends on a number of factors, including the development in the size of the portfolio and its composition. Another key calculation factor is the length of the time horizon as the uncertainty about interest rates increases with time. The dispersion of the simulated distribution of annual interest costs increases therefore with longer time horizons.

A new risk measure, conditional CaR (relative and absolute), has been introduced in 2003 to remove this horizon effect from our risk calculations and to take into account that risk in a given future year depends on developments leading up to that year. The aim is an assessment of the central government’s interest-rate risk from year-to-year for different strategies that are not affected by the chosen calculation horizon. Conditional CaR makes it easier to compare the risk development in individual years because risk is measured over the same horizon. In addition, tail CaR, i.e.the mean of costs in a given year given that costs are higher than absolute CaR, has been introduced as a new risk measure. The key measures used in the analysis of cost and risk are shown in the table below.

Analysis of different borrowing strategy scenarios and CaR analysis are used to support the decision making at the quarterly meetings between GDM and the Ministry of Finance. As the results are sensitive to the assumptions regarding the future central government budget balances simulations stress tests are conducted for alternative paths of government budget balances in order to examine the robustness of the results. In addition, different interest-rates inputs are used.