The allimportant risk on Danish government debt is interestrate risk, i.e. the risk of higher interest costs due to the development in interest rates.
Consolidated risk managenemt
The interestrate risk on the centralgovernment 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.
Choice of interest rate risk
The decision of the interestrate risk on the central government debt (duration) is based on longterm projectionss of the development of interest rate costs, the central government debt's yearly interest rate exposure (interestrate fixing) and the tradeoff between costs and risks based on the CostatRisk (CaR) model.
Duration
The key measure for the central government's interestrate risk is the duration of the total debt portfolio. Duration increases with the time to refixing of the debt, which makes it a summary measure of the tradeoff between costs and risks. The shorter the duration, the higher the interestrate risk on the centralgovernment debt.
Interest rate fixing
Duration is a measure of the portfolio's average time to refixing. As an average measure, duration does not shed light on the dispersion of the interestrate exposure over time. Therefore, duration is supplemented with the interestrate fixing. The interestrate fixing is the size 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 interestrate fixing.
CostatRisk (CaR)
CaR models provide a systematic approach to quantificaton of the tradeoff between costs and risks. The models are based on a number of simplified assumptions, including the development in budget deficits, debt structure and the development in interest rates.
The CaR model simulates future interest costs on the central government debt portfolio based on 5,000 interestrate scenarios, modelled with a 3 factor AFNS model. The CaR model calculates expected future interest costs, as well as the maximum interest costs that can be expected with a certain probability (say 95 per cent), subject to varying assumptions concerning e.g. duration.
