Chapter 9

Risk Management in 2009

Management of the central government's interest-rate risk in 2009 should be viewed in the context of the new borrowing initiatives at the end of 2008, the crisis in the financial markets and greater uncertainty concerning the government finances. The point of departure for manage-ment of interest-rate risk in 2009 is to conclude interest-rate swaps for up to DKK 20 billion. It should, however, be taken into consideration that the swap markets have not been functioning well for some time.

The central government raises foreign debt with the size of the foreign-exchange reserve in mind. To minimise the exchange-rate risk, the central government's foreign debt portfolio is exposed solely in euro.

In 2008, the financial crisis and downgradings of some of the central government's swap counterparties highlighted the management of credit risk. Regular monitoring of credit risk has been intensified, and counterparty ratings are supplemented with e.g. developments in stock prices and CDS spreads. In 2009, Government Debt Management plans to conclude new collateral agreements with a view to reducing the government's credit exposure further.

Interest-rate risk 9.1

The overall objective for Government Debt Management is to achieve the lowest possible long-term borrowing costs, while taking the degree of risk into account. A major risk factor with regard to Danish government debt is the interest-rate risk, i.e. the risk of higher interest costs as a result of the development in interest rates.

Management of interest-rate risk in 2008
Risk analysis in 2008 showed that it was possible to reduce the interest-rate risk on the government debt portfolio without any significant increase in the expected interest costs. Consequently, the duration target band for the government debt portfolio was increased by 0.25 year to 3.25 years ± 0.5 year. Use of interest-rate swaps in risk management was conditional upon normalisation of the swap markets.

Growing financial turmoil meant that the swap market deteriorated and therefore Government Debt Management did not conclude any interest-rate swaps in 2008. The central government's issuance strategy resulted in an average duration until mid-November of 3.0 years without transaction of interest-rate swaps, cf. Chart 9.1.1.

Duration, 2008	Chart 9.1.1

Towards the end of the year, Government Debt Management opened a 30-year bond in response to indications of large investor interest from the insurance and pension sector, cf. Chapter 3. The proceeds of approximately DKK 90 billion were deposited in the central government's account at Danmarks Nationalbank. This led to build-up of the government's gross portfolios and a mismatch between the durations of assets and liabilities so that the duration of the government debt portfolio increased substantially, cf. Table 9.1.1.

In consultation with the Ministry of Finance it was decided that Government Debt Management should not counter the increase in duration as the costs of concluding interest-rate swaps were extraordinarily high. The short-term swap spread was 100-200 basis points higher than the long-term swap spread, cf. Chart 9.1.2.

6-month and 10-year Danish swap spreads	Chart 9.1.2
Note: Swap spreads calculated as 10-day moving averages.

Management of interest-rate risk in 2009
Management of the central government's interest-rate risk in 2009 should be viewed in the context of the new borrowing initiatives at the end of 2008, the crisis in the financial markets and greater uncertainty concerning the government finances. The point of departure for government risk management is that the absolute interest-rate risk of the central government is low as a result of the pronounced decline in government debt in recent years. On the basis of Ministry of Finance projections of government finances, low interest costs are expected in the coming years, cf. Chart 9.1.3.

Government debt portfolio and net interest costs	Chart 9.1.3
Source: Denmark's Convergence Programme 2008, Ministry of Finance and own calculations.

The starting point for determining the central government's interest-rate risk at the government debt meeting in December 2008 was a high balance of the central government's account. Consequently, a new interest rate will be fixed on more assets than liabilities in 2009, corresponding to higher interest-rate fixing on assets than on liabilities. This results in negative interest-rate fixing, cf. Box 9.1. Negative interest-rate fixing entails that the central government's interest costs fluctuate more than when interest-rate fixing is close to zero. By transacting interest-rate swaps for up to DKK 20 billion annually, the central government achieves interest-rate fixing that is closer to zero.

Analyses in the Cost-at-Risk model
The duration and interest-rate fixing of the debt portfolio are measures describing the central government's exposure to changes in interest rates. In order to calculate the central government's interest-rate risk, the probability of interest-rate changes needs to be taken into account.

The interest-rate risk on the overall debt portfolio is analysed using Government Debt Management's Cost-at-Risk model (CaR). Compared with a situation where no interest-rate swaps are concluded, CaR calculations show that conclusion of interest-rate swaps for DKK 20 billion annually reduces the expected interest costs by approximately DKK 275 million without increasing the risk, cf. Chart 9.1.4. The CaR calculations thus support the analysis of interest-rate fixing. Interest-rate swaps contribute to a better match between the central government's assets and liabilities, thereby reducing the interest-rate risk.

A major assumption in connection with the CaR analysis is normalisation of the swap markets. Otherwise, the central government's interest-rate risk will primarily be determined by its issuance strategy and the development in the government budget balance.

Costs and risk with and without interest-rate swaps	Chart 9.1.4

Exchange-rate risk 9.2

The central government raises foreign debt with the foreign-exchange reserve in mind. Exchange-rate risk is the risk that the value of the government debt in kroner increases as a result of changes in exchange rates. The foreign government debt is exposed solely in euro, which entails a low exchange-rate risk due to Denmark's fixed-exchange-rate policy vis-à-vis the euro. In addition, Danmarks Nationalbank's foreign-exchange reserve is predominantly exposed in euro, cf. Chapter 11.

In 2008, the central government raised loans and issued Commercial Paper in euro and dollars. It has concluded currency swaps and forward contracts in connection with its foreign borrowing in dollars, so that its exchange-rate risk is solely in euro.

Re-lending to Danish Ship Finance is normally denominated in dollars, but the exchange-rate risk is hedged by transacting currency swaps from kroner to dollars, whereby the payment flow corresponds to the redemptions on the re-lending, cf. Chapter 8. As a result, the re-lending in dollars does not entail any exchange-rate risk for the central government.

Credit risk 9.3

Credit risk is the risk of a financial loss as a consequence of a counterparty's default on its payment obligations. The central government is exposed to credit risk because interest-rate and currency swaps are included in the management of the risk on the government debt. When a swap is transacted, its market value is zero, but over time the market value may become either positive or negative for the central government, depending on the development in interest and exchange rates. If the market value develops in favour of the central government it will have a credit exposure on the counterparty. If the counterparty goes into liquidation or defaults on the contract, the central government may lose its claim on the counterparty. The framework for the central government's credit management is outlined in Box 9.2. A more detailed account is included in the Appendices.

Intensified monitoring of the central government's credit exposure
The financial turmoil in 2008 highlighted the handling of the central government's credit risk. Uncertainty in relation to the credit rating of its swap counterparties has increased. A bank may now drop from a high to a very low rating – or even go bankrupt – considerably faster. For example, Lehman Brothers' rating was A+/A1 immediately before it filed for protection under Chapter 11.

As a result of the market turmoil, monitoring of the government's credit exposure has been intensified. Among other measures, the long-term ratings of the rating agencies are supplemented with monitoring of developments in counterparty stock prices and CDS spreads ¹. Changes in stock prices and CDS spreads can give a quick indication of the counterparties' abilities to meet their payment obligations.

Counterparties assessed to involve greater risk are monitored more closely on an "observation list". Only in special circumstances are new swaps transacted with counterparties on this list.

The central government's swap portfolio in 2008
In 2008, the central government concluded 13 new swaps with a total principal of DKK 30 billion. Most of them were concluded in connection with foreign borrowing in dollars, which has been swapped to euro. In addition, currency swaps from kroner to dollars have been concluded for small amounts in connection with re-lending to Danish Ship Finance. At end-2008, the swap portfolio comprised 360 swaps with 21 counterparties, with a total principal of DKK 170 billion, cf. Table 9.3.1.

The development in the market value of the central government's swaps reflects fluctuations in interest and exchange rates. Interest-rate swaps are typically used to restructure debt from long to short duration, which means that the central government primarily pays interest at a floating rate and receives interest at a fixed rate. The market value of the government's portfolio of interest-rate swaps thus increases when interest rates decline.

The market value of the government's currency swap portfolio is primarily affected by the exchange rate of the dollar. In 2008, currency swaps were used in connection with foreign borrowing as well as re-lending in dollars to Danish Ship Finance. As a result of the fixed-exchange-rate policy, the central government's portfolio of currency swaps between kroner and euro does not give rise to major fluctuations in market value.

In 2008, the market value of the government's swap portfolio increased by DKK 3.3 billion, cf. Table 9.3.2, mainly as a result of falling interest rates.

Credit exposure of the swap portfolio
The credit exposure of the swap portfolio is calculated on the basis of the current exposure and the value of the collateral pledged. The current exposure is the sum of the positive market values stated on a net basis for the individual swap counterparties. In 2008, the credit exposure increased by DKK 1.7 billion to DKK 3.0 billion, cf. Chart 9.3.1.

Credit exposure on the government swap portfolio	Chart 9.3.1

Swap counterparty diversification
The central government reduces the risk of losses by using a large number of swap counterparties. Furthermore, a large number of swap counterparties contributes to ensuring price competition. At end-2008 the outstanding swaps were distributed on 21 counterparties, of which one counterparty rated AAA had a market share of 14 per cent, cf. Chart 9.3.2.

SWAP PORTFOLIO broken down BY THE CENTRAL GOVERNMENT'S COUNTERPARTIES	Chart 9.3.2

Credit quality in 2008
The central government's credit exposure in 2008 was distributed on counterparties with lower ratings than in previous years. At end-2008, 30 per cent of the credit exposure was distributed on counterparties rated AAA, a drop by almost 15 percentage points from the previous year, cf. Chart 9.3.3.

The central government's credit exposure by counterparty rating	Chart 9.3.3
Note: Where a counterparty has different ratings with the different agencies, the lowest rating is applied.

During 2008, Fitch Ratings, Moody's and Standard & Poor's performed a total of 38 downgradings of 12 of the central government's counterparties. Of the six most frequently used counterparties at end-2008, with a total market share exceeding 50 per cent, four were downgraded in 2008. Three of them were downgraded two levels from AA to A+, so that the volume of outstanding swaps with counterparties rated A+ has increased considerably.

Updating the central government's credit risk management
Central-government credit-risk management has been adjusted only slightly since the introduction of unilateral collateral agreements in the late 1990s. As this area is subject to constant development, Government Debt Management in 2008 began to update the government's credit-risk management. This is done with a view to reducing the credit exposure on the government debt and introducing simpler, more up-to-date credit-risk handling.

The first updates were implemented in the spring with a switch to daily, rather than monthly, adjustment of the collateral. This limits the credit exposure and simplifies credit-risk management as it is no longer relevant to take into account developments in the potential credit exposure.

Towards the end of 2008, Government Debt Management began to renegotiate all existing collateral agreements (CSA). Under the current agreements, the counterparty must pledge securities as collateral when the market value of the swap portfolio exceeds a threshold value. The threshold value depends on the rating of the counterparty. In the renegotiations, importance is attached to limiting the overall credit exposure by reducing the threshold values to zero. A lower threshold means that the central government's counterparties must pledge more collateral when the market value of the swaps concluded develops in favour of the government.

A lower threshold implies higher administration costs due to more frequent pledging of collateral. This issue can be addressed by raising the minimum amount to be transferred when adjusting the collateral (the minimum transfer amount). The new CSA envisages raising the minimum transfer amount and linking it to the counterparty's rating.

Operational risk 9.4

Government Debt Management is divided into front, middle and back offices. A clear division of functions reduces operational risk and facilitates internal control. Moreover, only standardised, well-known financial instruments are used, and legal risk is minimised by exclusively using standardised contracts.

Procedures have been defined for the individual tasks, and all procedures are maintained on an ongoing basis and approved by the manager in charge.