Risk Management

OPERATIONAL RISK

As described in the media, banknote material was found at Amagerforbrændingen waste incineration plant in July 2007. Danmarks Nationalbank was summoned in connection with the incident and all material was collected. It was ascertained that the banknotes were pre-printed pink banknotes from Danmarks Nationalbank's Banknote Printing Works which had accidentally been mixed with other waste and sent to Amagerforbrændingen in connection with an ordinary delivery of waste from Danmarks Nationalbank. This led to a review of procedures at the Banknote Printing Works. The review was concluded in December 2007 and has resulted in a general admonition and adjustment of procedures and work routines.

Insurance strategy
Danmarks Nationalbank's insurance strategy provides overall guidelines for what Danmarks Nationalbank has decided to insure, based on the principles governing its risk profile and the chosen level of retention for own account. In addition, the strategy lays down the organisational division of insurance responsibilities. The insurance strategy covers areas that are necessary for the general operation of Danmarks Nationalbank, including buildings and staff. However, the insurance strategy does not cover losses resulting from market operations, position-taking, etc.

Danmarks Nationalbank's insurance policies are reviewed on an annual basis in collaboration with an external insurance agent. No major changes were made to the insurance strategy in 2007.

FINANCIAL RISK

Danmarks Nationalbank is exposed to a number of financial risks. Some of them arise from its role as monetary authority and are thus unavoidable, while others reflect how Danmarks Nationalbank, in its capacity as a financial enterprise, weighs risk and reward.

Danmarks Nationalbank is primarily exposed to market risks such as interest-rate, gold and foreign-exchange risks. In addition, it is to a lesser extent exposed to liquidity and credit risk. Danmarks Nationalbank opts for a very prudent level of risk-taking and seeks to completely avoid losses resulting from the failure of counterparties.^[1]

Market risk
Market risk is the risk of losses as a result of fluctuations in interest and exchange rates in the financial markets.

Interest-rate exposure
Part of Danmarks Nationalbank's portfolio is invested in bonds, which entails exposure to changes in interest rates.

In 2007, Danmarks Nationalbank reduced its interest-rate exposure by lowering the krone duration of the overall portfolio from kr. 1.9 billion to kr. 1.6 billion, cf. Table 3.

Gold exposure
Pursuant to the Danmarks Nationalbank Act, Danmarks Nationalbank is obliged to hold a stock of gold. Throughout 2007 the gold stock was constant at 66.6 tonnes.

Higher gold prices meant that the market value of the gold stock rose from kr. 7.7 billion to kr. 9.1 billion during 2007. This increased Danmarks Nationalbank's exposure to fluctuations in the gold price.

Foreign-exchange exposure
As part of its fixed-exchange-rate policy, Danmarks Nationalbank holds a foreign-exchange reserve comprising investments in euro, US dollars, pounds sterling and Swedish kronor.

Using currency swaps, Danmarks Nationalbank has converted most of its foreign-exchange exposure in non-euro currencies to euro. On account of the fixed-exchange-rate policy this significantly reduces the foreign-exchange risk so that the risk stemming from the foreign-exchange exposure is relatively small in relation to the size of the foreign-exchange reserve.

At the close of 2007, Danmarks Nationalbank's foreign-exchange exposure was kr. 173 billion. Danmarks Nationalbank will thus incur a loss of kr. 1.7 billion if the krone strengthens by 1 per cent. This is in line with the exposure in 2006.

Quantification of market risk
One measure of Danmarks Nationalbank's aggregate market risk is Value-at-Risk (VaR). VaR combines the exposure to various market conditions with an estimate of the volatility in these market conditions.

At the close of 2007, Danmarks Nationalbank's VaR was calculated at kr. 3.3 billion, which is kr. 0.9 billion higher than at the beginning of the year, cf. Chart 2. The result indicates that in 2008, with a probability of 95 per cent, Danmarks Nationalbank will not incur a capital loss exceeding kr. 3.3 billion. Conversely, the result indicates that with a probability of 5 per cent Danmarks Nationalbank will experience a capital loss exceeding kr. 3.3 billion. VaR does not indicate the size of any such potential loss.

The increase in VaR was attributable to higher risk contributions from gold and interest rates in 2007, cf. Chart 2, as a result of higher gold prices and greater interest-rate volatility.

Stress test
VaR indicates the maximum loss under normal market conditions, but not the potential loss under extreme market conditions. Consequently, it is useful to supplement VaR with stress tests. These reflect how extreme, but realistic, scenarios for market developments affect the value of Danmarks Nationalbank's current portfolio.

The stress tests show that in the most pessimistic scenario the loss to Danmarks Nationalbank will be almost kr. 15 billion, corresponding to the 2006 level. Such a loss, which is equivalent to almost 30 per cent of Danmarks Nationalbank's net capital, will typically be related to a substantial strengthening of the Danish krone against the euro, as well as significant rises in interest rates in the US and European markets.

Liquidity risk
For Danmarks Nationalbank, liquidity risk is the risk that it is not possible to release funds for intervention to support the krone, even though the funds are held in reserve.

In the management of the foreign-exchange reserve it is important to ensure that a large part of the reserve can be converted quickly into liquid funds. Consequently, a large proportion of the foreign-exchange reserve is placed in the money market or in gilt-edged bonds that can easily be realised or used as collateral in various liquid markets. Danmarks Nationalbank can also raise funds for intervention purposes by drawing on various standby credit facilities.

Danmarks Nationalbank's liquidity risk was thus very modest in 2007, as was also the case in 2006.

Credit risk
Credit risk is the risk of loss due to a counterparty defaulting on its obligations. Credit risk also comprises the risk that the credit rating of a counterparty drops, resulting in a capital loss.

Danmarks Nationalbank seeks to reduce its credit risk by spreading its assets over many counterparties with a high credit standing. For deposits with foreign banks, repo agreements using government bonds as collateral are also applied. Should a repo counterparty be subject to compulsory liquidation, Danmarks Nationalbank's deposit is covered by the collateral provided. Danmarks Nationalbank's credit risk is thus relatively small, cf. Table 4.

Turmoil in the credit markets
Danmarks Nationalbank's portfolio has not been significantly affected by the turmoil in the credit markets. Thanks to the prudent investment strategy, Danmarks Nationalbank has not incurred losses as a result of counterparties' inability to meet their payment obligations. Moreover, only few of its counterparties have been downgraded.

Overall it must, however, be assumed that the credit risk on investment increased in 2007. Danmarks Nationalbank has therefore revised its investment policy for money-market deposits by raising the minimum requirement for the credit rating of counterparty banks.