Future Market Rates for Scenario Analysis

Transcription

1 Future Market Rates for Scenario Analysis MTDS: Step 4 1

2 Step 4 (Market variables) Objective Identify baseline projections for market variables and the main risks to these Outcome A clearly defined baseline scenario Risk scenarios 2

3 Agenda Why do we need future market variables to analyze cost and risk? Baseline and risk scenarios How can future market variables be generated Summary 3

4 What is a risk model? A specific representation of something more general and usually more complex Allows quantification of cost and risk Requires clear definition of cost and risk Simplified representation of the debt process Computation tool what-if scenarios Basic tool for assessment, monitoring and review of risk support the identification and choice of indicators/targets 4

5 The structure of a simple scenario analysis model INPUT Existing debt cash flows Macro Variables -Primary fiscal balance Structure of new debt -Borrowing strategy Financial variables - Exchange rates - Interest rates ENGINE Cash-flow Simulation OUTPUT Cost Risk 5

6 Why do we need future market rates The debt portfolio is exposed to changes in market rates in the future Our focus is how market rates affect cost to the government s budget For example, an increase in interest rates will lead to an immediate reduction in the market value of the debt, however, as we are interested in the budget effect, we want to know how the increase affects our payments over the next budget-cycle and longer We want to be able to compare how various strategies performs under alternative, albeit reasonable scenarios for future market rates 6

7 Measurement of risk Cost Risk Scenario 1 Risk 1,X Baseline Scenario Cost 1,X Time 7

8 The baseline scenario Interest and exchange rates for each period within the projection-horizon The debt service flows generated by the baseline scenario for a given new debt issuance strategy will be defined as the expected cost The baseline scenario for interest and exchange rates is the most likely future scenario Neutral/objective The baseline for interest rates and exchange rates will provide a reference point Deviations are termed risk scenarios 8

9 Possibilities Defining a baseline scenario Assume interest and exchange rates remain at their current level Ask a number of analysts to prepare forecast, and take an average Extract market s expectations of future interest and exchange rates In the end, the choice of a method to generate the base-case scenario will depend on preferences and an access to data 9

10 Extracting information from market rates Enter into a contract today for settlement at some future point in time forward contracts A forward contract is an agreement, transacted at the current date, to buy or sell an asset at a certain future date for a given price Prices of forward contracts contain some information about what the market expects to happen in the future Where forward contracts are not traded implicit forward rates can be derived from current market rates 10

11 Forward interest rates A forward interest rate can be denoted f(t,τ,t) Where t is the current time, τ is the starting point of the forward contract, and T is the maturity of the contract Time f(0,1,2) For example, f(0; 1; 2), represents a contract today to borrow money for one (2 minus 1) year in one year time 11

12 Implicit forward rates can be derived from the zero coupon interest rates z(0,1) z(0,2) f(0,1,2) Time Borrow 100 today for 2 years, and invest 100 for 1 year, i.e. on a net basis we are borrowing 100 in year 1 for repayment in year 2 f(0,1,2) = [(1+z(0,2)) 2 / (1+z(0,1)) 1 ]

13 13 General formula for calculating forward interest rates Implication: The zero-coupon term structure can be transformed into a forward term structure of interest rates Require calculation (modeling or forecasting) of zero-coupon rates 1 ), ( 1 ), ( 1 ),, ( 1 T t t T t z T t z T t f

14 Implied forward yield curves 16% 16% 14% 14% 12% 12% 10% 10% 8% 8% 6% 6% 4% 2% Zero Curve Implied 2F's Implied 4F's Implied 1F's Implied 3F's Implied 5F's 4% 2% Zero Curve Implied 2F's Implied 4F's Implied 1F's Implied 3F's Implied 5F's 0% % % 16% 12% 14% 10% 12% 8% 6% 10% 8% 6% 4% 2% Zero Curve Implied 2F's Implied 4F's Implied 1F's Implied 3F's Implied 5F's 4% 2% Zero Curve Implied 2F's Implied 4F's Implied 1F's Implied 3F's Implied 5F's 0% %

15 Forward exchange rates A forward exchange rate can be denoted F T (HC/FC) where T denotes the date the future foreign exchange transaction will take place, HC represents the home currency, and FC is the foreign currency For example, F 2 (GBP/USD) represents a contract today to buy or sell sterling pounds in exchange for US dollars in two years from now Again, these forward rates are available in the market or they can be derived from spot exchange and interest rates 15

16 Deriving forward rates from spot exchange and interest rates A similar derivation of forward interest rates can be applied to exchange rates High relative interest rates in the home country lead through arbitrage to a lower future value of HC relative to FC, and vice versa If we know the spot rate and the zero coupon rates, we can calculate the forward exchange rate Covered interest rate parity F T HC FC S t HC FC Where F T is the forward exchange rate at time T, S t is the spot exchange rate at time t, HC denotes the home currency, FC the foreign currency, and z h and z f are the respective zero coupon rates 1 1 z z h f t, T t, T T t T t 16

17 The arbitrage argument behind the covered interest rate parity 1,000 pesos Local market rate 10% 1,100 pesos 1,000 pesos 1,100 pesos Spot market Exchange rate 1,000 per USD Forward market Exchange rate 1,068 per USD 1 USD Local market rate 3% 1,03 USD 17

18 Will implicit forward rates be realized? If forward rates represent the expected future spot rates E E t z(, T) f ( t,, T) S HC / FC F HC FC t T T / Expectations hypothesis However, many empirical tests have rejected these hypothesis. The revised version includes a risk premium that could be time variant But forward rates are still useful when designing the basecase scenario for market rates Risk premia are generally modest and difficult to estimate 18

19 Is this the best approach? For many countries access to market data is limited The domestic market for government securities is thin and short Interest rates are not market determined Fixed exchange rate policy Macroeconomic projections provide a reasonable alternative MoF, CB, IFIs or investment banks If real interest rates and exchange rates are more stable they might be easier to project Nominal interest rates require projecting inflation Nominal exchange rates require projections of inflation differentials with trade partner countries 19

20 FX interest rates, example Project risk free rates e.g. US Treasuries US Treasury Curves Average Yield Curve for US Treasuries Project the spreads to the risk free rates Use historical spreads, or countries with similar credit rating (Bloomberg, Reuters, Dealogic, etc) y US Treasury Credit Spread in USD y USD rate Ukraine

21 The example of Moldova 25% % % Moldova, Domestic Yield Curve 20% Moldova, Domestic Yield Curve 15% Moldova Yield Curve for USD 15% 10% 10% Moldova Yield Curve for USD 5% US Treasuries, Average % US Treasuries, Forward Yield Curve, Based on Average US Dollar Yield Curve = US Treasury bp Domestic yield curve: US dollar curve + inflation differential IDA 0.75 percent interest rate, 40 year tenor and 10 year grace Bilateral 3 percent interest rate, 10 year tenor and 5 year grace 21

22 Summary: Baseline scenario The baseline scenario provides the reference point for comparing cost and risk of alternative strategies Forward prices offer a market based alternative when data is available i.e. yield curve Projecting nominal rates as a function of real rates and inflation has several advantages Projections of real rates and inflation are available Supported by economic theory Real rates tend to be more stable in the long term Constant rates and average of analysts forecasts are a last resort 22

23 Risk scenarios Risk scenarios are deviations from the baseline scenario What are the cost and risk implications of adverse scenarios? Objective scenarios? If there is an access to good market data Historical interest and exchange rates Standard deviations of historical rates Worst case/best case scenarios However, historical rates may not be Good predictors of future rates, or Normally distributed 23

24 800 Collapses in exchange rate pegs: Impossible to predict Indonesian Rupiah vs. US Dollar, January 1, 1992=

25 Scenarios Considered for MTDS in Moldova Scenario 1-Domestic yield curve positive shock. 400 basis points decrease in the interest rate on domestic debt Scenario 2-Domestic yield curve negative shock. 400 basis points increase in the interest rate on domestic debt Scenario 3-Exchange rate shock. A standard oneperiod exchange rate shock of 30 percent depreciation of the leu to occur in 2010 Scenario 4-Fiscal shock. A two-period worsening (i.e. the shock occurs in 2010 and 2011) in the primary deficit equivalent to 5 percent of nominal 25 GDP

26 Use all information sources Define possible risk scenarios through discussions Look at past extreme events (financial crises) Stress scenarios Talk to the central bank, planning ministry etc. Colleagues in neighboring countries 26

27 Summary: Risk scenarios Identify the relevant history to test strategies under periods of high interest rates and devaluation of the exchange rate Standard deviation is a useful concept only when data is available and the history is relevant Conduct stress tests: a typical 30% devaluation run for DSA may not be enough. Past (and current) crisis provide good database for stress tests 27

28 Summary Base and risk scenarios for market rates are substantial pieces of input to cost-risk analysis Defining these is art rather than science Use all relevant information available Output from Step 4 (Market rates) A clearly defined baseline scenario Risk scenarios 28