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.
Choice of interest rate risk
The decision of the interest-rate risk on the central government debt (duration) is based on long-term projectionss 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.
The key measure for the central government's interest-rate 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 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 time to refixing. As an average measure, duration does not shed light on the dispersion of the interest-rate exposure over time. Therefore, duration is supplemented with the interest-rate fixing. The interest-rate 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 interest-rate fixing.
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 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 interest-rate 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.