IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Market Variables,Shocks to the Baseline

Joint Vienna Institute, Vienna, Austria

February 23 – 27, 2015

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Forecasting market variables is difficult

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IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

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Agenda

• What is needed for step 6?

• Baseline scenario defined in step 4

• What are risk/shock scenarios – and how can we determine them?

– Risk/shock scenarios versus stress test

• The reason for a specific shock scenario – tell at story

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Step 6

• Objective

– Identify and analyze possible debt management strategies, assess their performance, and choose a small number of candidates debt management strategies

• Alternative strategies

• Cost and risk measures

• Exogenous shocks to market rates with broadly equal probability

• Selection criteria to choose the best among the options

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

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The baseline scenario

• The debt charges generated by the baseline scenariofor a given financing 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 from the baseline scenario are termed risk or shock scenarios

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

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Defining shock scenarios

• Risk scenarios are deviations from the baseline scenarios

– What are the cost and risk implications of adverse scenarios?

• Objective risk scenarios?

– If there is access to good market data• Historical interest and exchange rates

– Standard deviations from historical rates

– Worst case/best case scenarios

• However, historical rates may not be:

– Good predictors of future rates, or

– Normally distributed

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

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Shock Scenarios

• Shocks are exogenous– Risk is exogenous, beyond control of the debt manager

• Implicit assumption that shocks are broadly equal probability – Difficult – sound judgment is needed

• Step 4 provides information on risks to– To macro variables (growth/primary balance/funding

options)– To market variables (exchange and interest rate)

• When and for how long? Mean reversion?

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

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Examples of shocks

• FX shock– 15%, 30% - 1 and 2 standard deviations

• Domestic interest shock – X% of the entire yield curve– A shift in the shape of the yield curve

• Higher short term rates

• Foreign interest shock– X% of the entire yield curve– A shift in the shape of the yield curve

• Some aid in judging size– Plot past rates/difference 1-10 years– Eye-ball the frequency of large shocks

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Shocks to Interest Rates - FX

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Interest rates for FX borrowing: EMBI spread

– history of credit spreads may provide some information of their volatility which in turn help determining the size of the shocks

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Looking at historical exchange rates (1)IDR/USD

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1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Looking at historical exchange rates (2)

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Looking at historical exchange rates (3)

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Looking at historical exchange rates (4)

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Looking at historical exchange rates (5)

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Looking at historical exchange rates (6)

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Looking at historical exchange rates (7)

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Market Forecasts

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Choosing Shocks• Most rely on historical data to generate risk

scenarios but should also consider stress scenarios -events with low probability but high impact

• Possible approaches

– Define possible risk scenarios through discussions

– Look as past extreme events (financial crises)

– Talk to central bank, planning ministry etc.

– Talk to the market (banks, primary dealers)

– Talk to colleagues in neighboring countries

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

What happens when you have identified the shocks?

• Develop a set of alternative scenarios to the baseline

– You will need to provide (a good) explanation for each of the scenarios – you need to be able to tell a story that provides the background for your choice

• Good historical data is helpful – but you will still have to make choices (and be able to explain why you made those choices)

– An absence of historical data makes the choice more difficult

IMF-WB Workshop on Medium Term Debt Management Strategy (MTDS)

Summary

• Identify the relevant history to test strategies under periods of high interest rates and depreciation of the exchange rate

• Standard deviation is a useful concept only when data is available and the history is relevant

• Risk analysis should include both shocks reflecting the historical volatility of market rates as well as stress tests designed to capture events with a low probability of occurrence but that can cause major damage to the stability of government finances

• Build a story around each of the shocks