|
The all-important risk on Danish government debt is interest-rate risk, i.e. the risk of higher interest costs due to the development in interest rates.
Consolidated risk managenemt
The interest-rate risk on the central-government debt is managed on a consolidated basis according to the Asset Liability Management (ALM) principle. This entails that the interest costs on liabilities and interest income from assets are viewed together.
Separation of issuance strategy and interest-rate risk
In Denmark, the issuance strategy is separated from the management of the duration of the central-government debt by means of interest-rate swaps. The advantage of this separation is that the issuance strategy can be targeted at building up large, liquid government bonds in the 10-year to maturity segment.
Choice of interest rate risk
The decision of the interest-rate risk on the central government debt (duration) is revised each year and taken on the basis of long-term analyses of the development of interest rate costs, the central government debt's yearly interest rate exposure (interest-rate fixing) and the trade-off between costs and risks based on the Cost-at-Risk (CaR) model.
Duration
The key measure for the central government's interest-rate risk is the duration of the total debt portfolio. Duration increases with the fixed-interest period, which makes it a summary measure of the trade-off between costs and risks. The shorter the duration, the higher the interest-rate risk on the central-government debt.
Interest rate fixing
Duration is a measure of the portfolio's average fixed-interest period. As an average measure, duration does not shed light on the dispersion of the interest-rate exposure over time. The duration is therefore supplemented with the interest-rate fixing. The interest-rate fixing is the share of the debt for which a new interest rate is to be fixed in a given year. A parallel shift to the yield curve of 1 percentage point will increase interest costs in the given year by approximately 1 per cent of the interest-rate fixing.
Cost-at-Risk (CaR)
CaR models provide a systematic approach to quantificaton of the trade-off between costs and risks. The models are based on a number of simplified assumptions, including the development in budget surplus, debt structure and the development in interest rates.
The CaR model simulates future interest costs on the central government debt portfolio based on 2,500 interest-rate scenarios, modelled with a 2 factor CIR model. The CaR model calculates expected future interest costs, as well as the maximum interest costs that can be expected with a probability of 95 per cent, subject to varying assumptions concerning e.g. duration. |
