Risk Management
Risk management is distinctly at the Ministry of Finance as an integral part of the drafts of alternative debt strategies, and as a core of modern debt management. The identification of the main risks relevant to Czech debt management is determined above all by the deepening of primary budget deficits leading to the acceleration of the growth in borrowing requirements of the central government.
Refinancing Risk
The typical sign of the recent years has been a considerable overhang of the debt volume that has to be refinanced every year, over the volume of the state debt due in the given year. Therefore, the minimization of the refinance risk constitutes at present the principal basis in drafting the issuance and debt strategies of the Ministry of Finance. Refinancing risk is managed by a system of four indicators: share of short-term state debt (due in one year), share of medium-term state debt, average time to maturity and the maturity profile. These four indicators must be considered as a self-contained system, whereas focussing attention on only one of them is dangerous.
The share of short-term state debt is a key indicator of refinancing risk in the short-term horizon. The Ministry has been focusing on managing short-term refinancing risk since 2004 and since 2006 it applies limits which have not been exceeded in any year of their existence. In 2006 to 2012, the limit for this indicator was defined at 20.0%. For 2012 and 2013, the limit was increased by 5 p.p. to 25.0% in relation to introducing a limit on the share of medium-term state debt. The system of limits for the share of short-term and medium-term state debt allows the distribution of the refinancing risk of the debt portfolio over the short-term and medium-term horizon. For 2014, the Ministry reduces the limit of short-term state debt by 5 p.p. to 20.0% of the total gross state debt. The Ministry has undertaken this step due to the increased available liquidity of the treasury single accounts and the subsequent reduction of the cash reserve, which consists entirely of money market instruments.
The debt due within five years is managed using the share of medium-term debt in total state debt indicator, for which the Ministry has set explicit limits since 2012. For 2012 and 2013, this limit was set at 70.0%. For 2014, the Ministry will leave the limit for the share of medium-term state debt in total state debt at 70.0%. The setting of this limit is related to the Ministry’s long-term strategy, and therefore it is unlikely to change even in coming years.
Another indicator used in managing of the refinancing risk is the average time to maturity of state debt. The goal for this indicator was first explicitly declared for 2005. The span of the target band was 1 year for the years 2005 to 2008, and in 2005 it amounted to 5.5 to 6.5 years and for 2006 to 2008 it was increased by 0.5 year to 6.0 to 7.0 years. For 2009 and 2010, the Ministry widened the target band by half a year, setting it down to 5.5 to 7.0 years. For 2011, the Ministry narrowed the target band and moved it down to 5.25 to 6.25 years. For 2012 and 2013, the Ministry adjusted the target band down by 0.25 years to 5.0 to 6.0 years. The declared goals were fulfilled in all years. The downward adjustment of the target band in recent years was the result of the increased uncertainty related to the future development of the Eurozone and the related preference of investors to purchase short-term government bonds. For 2014, the Ministry has preserved the target band of average time to maturity of state debt on the level of 5.0 to 6.0 years with an outlook in the upper part of the interval.
Maintaining the average time to maturity within the target band and smooth redemption profile of the debt portfolio determine the term and volume structure of the issues of government bonds on the domestic and foreign market and the setting of repayment of loans drawn from the European Investment Bank.
The Ministry of Finance puts intensified effort into the harmonization of the minimization of the refinance risk with another strategic objective lying in the liquidity enhancement of the individual issues of Treasury bonds. The promotion of liquidity on secondary market through an increase in the total nominal amount of issues should contribute, in addition to the drop in interest costs, to the decrease in the liquidity risk in the sense that the auction bid of governemnt bonds shall not find the corresponding demand exclusively because of non-liquid secondary market in general, or will only find it under the conditions of a high premium asked for non-liquidity. It is necessary to stress that in the case that the mentioned two aims get into conflict in the preparation of issuance calendars, the management of the redemption profile shall be clearly preferred.
For the assessment of the overall refinancing risk of the debt portfolio it is important to take into account the condition of assets available within one year. Assets available within one year are made of cash reserve, short-term government bonds in the nuclear and pension investment portfolios, in special purpose accounts of state financial assets and short-term lending and on-lending. These liquid funds are part of the treasury single account with a positive impact on the immediate liquidity and state debt.
Interest Rate Risk
Interest rate risk remains the most important market risk affecting the state debt management. The Ministry manages interest rate risk using the strategic indicator - average time to re-fixing of state debt. Another indicator monitored is the interest re-fixing within 1 year. To express the state debt service costs the sophisticated model framework of Cost-at-Risk is used, which is based on the Value-at-Risk methodology and simulates future expected and maximum interest costs for a particular degree of risk, which is derived from the volatility of the time structure of interest rates.
The average time to re-fixing is the key indicator of refinancing risk in short term. Starting in 2011, the Ministry has set an explicit target band for this indicator to value of 4.0 to 5.0 years. The goal was set in line with international practice, taking into consideration optimization of costs on state debt and risks stemming from the re-fixing of interest rates. The primary tool for fulfilling this is the issuance of fixed- and floating-rate government bonds and drawing of loans from the European Investment Bank. The Ministry expects the target band to be achieved using only the primary tool. However, in case the investors’ interest shifts towards the instruments with a rate at the shorter end of the yield curve, the Ministry will consider reaching the target band using derivate operations.
Another indicator monitored by the Ministry in connection with interest rate risk management, for which the Ministry has also been setting the strategic goal for each year since 2006, is the interest re-fixing of the debt portfolio within 1 year, referring to the share of debt which is sensitive to interest rate fluctuations on the financial market the following year. For 2014, the Ministry keeps the target band at the level of 30.0 to 40.0% of total state debt with an outlook close to the middle of the interval. This goal is in line with the average time to re-fixing in the target band of 4.0 to 5.0 years. The structure of interest re-fixing of the debt portfolio within 1 year is important not only for the expression of short-term interest rate risk, but also affects long-term interest rate risk expressed by the indicator average time to re-fixing. The Ministry manages the debt portfolio consisting of the government bonds and other liabilities of the state forming the national debt by time to maturity, interest rate, type and frequency of interest of individual debt instruments. This detailed debt portfolio allows understand of the structure of interest costs on state debt and subsequent management of these costs.
The Ministry has been applying a sophisticated model framework known as Cost-at-risk (CaR) for measuring and managing interest risk, which is based on Value-at-Risk methodology and simulates future expected and maximum interest costs for a particular degree of risk, which is derived from the volatility of the time structure of interest rates. The stochastic element of the CaR model is the yield curve, and the deterministic element is the dynamic structure of the portfolio of state debt, which is based on the planned method of funding the government’s gross borrowing requirement while respecting the set strategic goals for managing financial risks.
The primary goal of the model is to determine the maximum costs on state debt, which with 95% or 99% probability will not be exceeded (CaR 95% and CaR 99%). The secondary goal of the model is to estimate the actual interest costs on state debt. The simulation framework operates separately with the interest costs and interest income. The outcome of aggregation of interest costs and interest income are the net interest costs on state debt. At present, the Ministry operates with the three-year simulation horizon, due to the correspondence of the prediction of revenue and expenditure of budget chapter 396 – State Debt as a part of the Medium-term Outlook of the State Budget of the Czech Republic, which is designed for three years. The three-year simulation horizon is used to conduct analyses of the efficient frontier, which provides better comparability of the individual strategies through the gradual accumulation of expected interest costs and relative risk of individual issuance strategies.
The interest rate model used to construe the CaR indicator for the period of 2014 to 2016 is based on the modelling of the entire yield curve. Another very important feature of the model is the non-undervalued estimate of the volatility of the long curve end. The model was defined for the first time ever and applied in Yacine-Ait Sahalia: Testing Continuous Time Models of the Spot Interest Rate, The Review of Financial Studies, 9, 2, 385-426, 1996. The model is characteristic for its “mean reversion” feature, i.e. convergence of expected rates to its balanced value and has been modified by the Ministry so as to comply with Czech market specifics. The model parameters are estimated based on historical daily observations of the Czech yield curve starting on 25 August 2000. 10 000 simulations of interest rates are conducted daily for each of the required maturities. The model outcome includes simulations of money market yield curves, according to which, however, only a small portion of the state debt bears interest. Therefore, it is important to model the risk premium of government bonds, defined as a difference between the government bonds yield curve and money market yield curve. Given the conditions on government bond market, Ministry chooses a less conservative approach to modelling the risk premium. As from 2012, the Ministry has switched from the CaR 95% indicator to the CaR 99% indicator when evaluating the risk of interest costs on state debt. One of the reasons for this transition is compliance with the risk management practices in developed financial institutions. The CaR 95% indicator is still constructed along with the whole probability distribution of future interest costs.
The Ministry is also concerned with the problem of interest rates hikes, which could occur e.g. via a sharp increase in the Czech National Bank basic rate, sudden deterioration of the economic situation in the Eurozone, a sharp increase of the risk premium for Czech government bonds, etc. Therefore, it is crucial for the Ministry to monitor separately the shifts in individual parts of the yield curves and to quantify the impact of these circumstances on interest expenditure and revenue of budget chapter 396 - State debt.
Currency risk
Currency risk is another market risk to which the state debt portfolio is exposed. As from 2011, the Ministry has been actively managing this risk. Starting in 2014, the Ministry manages the net foreign-currency exposure of the state debt. By changing the methodology, the Ministry will take into account the foreign-currency exposure of state financial assets, which reduces foreign-currency exposure of the debt portfolio and provides a more realistic picture of real currency risk. In this respect, the Ministry distinguishes between net foreign-currency exposure of state debt and foreign-currency state debt. Foreign-currency state debt represents the total nominal value of the debt portfolio denominated in foreign currency. Net foreign-currency exposure represents the difference between the foreign-currency exposure of state debt and the foreign-currency exposure of state financial assets, and reflects the real market risk to which the foreign-currency debt is exposed as a result of fluctuating exchange rates. Net foreign-currency exposure of state debt is mainly affected by derivative transactions which hedge a part of foreign-currency debt against the unfavourable development of exchange rates.
The share of net foreign-currency exposure in the total state debt is the key indicator introduced relating the currency risk. The limit for this indicator in medium term is set on 15% + 2 p.p. The Ministry also monitors the share of net foreign-currency exposure denominated in EUR in the total net foreign-currency exposure of state debt. The dominance of EUR in the net foreign-currency exposure has been evident since 2008.