Market Variables, Shocks to the Baseline

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)

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

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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)

The baseline scenario • The debt charges generated by the baseline scenario for 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 5

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

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 6

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

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? 7

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

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 8

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 800

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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