Risk-based public-sector debt management

Friday, 18 March 2016: 4:50 PM
Stefan Mittnik, Ph.D. , University of Munich, 80799 Munich, Germany
Objectives: The paper presents methods for designing optimal public-debt management strategies when future refinancing risks are subjected to Value-at-Risk constraints

Data/Method: Using time series data on interest rates faced by the German Bundesländer, we assess refinancing risks based on projections of the term structure interest rates. We then demonstrate how to derive optimal financing schedules and mixes of instruments, when risk budgets are specified in terms of annual Value-at-Risk (VaR) limits.

Debt financing is a most common strategy in fiscal policy making. Being virtually permanent debtors, governments continually roll over debt. Thus, any financing decision today triggers refinancing risks in the future, due to uncertainties in future interest rate developments. Moreover, present financing costs are typically inversely related to future financing risks as short-term rates tend to be lower but more volatile than long-term rates. Thus, a major challenge in public-debt management is to balance financing costs and refinancing risks by choosing an appropriate funding schedule.

The dynamics of the term structure of interest rates is the driver of refinancing risk. Using time series data on interest rates faced by the German Bundesländer, we empirically assess the nature of refinancing risks. We compare alternative strategies for term structure prediction. Furthermore, assuming that budget plans detail future financing needs, expected financing costs as well as annual buffers for cost overruns – i.e., annual Value-at-Risk limits –, we show how to derive optimal, feasible annual financing schedules in terms of future duration mixes given projected interest rate risks.

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