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Interest Rate Benchmark Review

Interest Rate Benchmark Review. Background. Outcome of CGS Review Consider cost/risk outcomes Manage to an interest rate benchmark Current benchmark introduced in 1996 Substantial savings to the Commonwealth to date Review of benchmark recently completed

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Interest Rate Benchmark Review

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  1. Interest RateBenchmark Review

  2. Background • Outcome of CGS Review • Consider cost/risk outcomes • Manage to an interest rate benchmark • Current benchmark introduced in 1996 • Substantial savings to the Commonwealth to date • Review of benchmark recently completed • Benchmark explicitly determines cost/risk trade-off. • Low debt environment very important • Managing to new benchmark means re-entry into IR swap market • AOFM announced suspension of IR swap program in February 2002

  3. Agenda – September 29th • Measurement issues • Within-year variability in financing requirement • Modified Duration as a single risk measure • Nominal vs Inflation-linked debt • The New Interest Rate Benchmark • Two tiered limit framework • Portfolio Profiles • Current vs Benchmark • Swap Activity

  4. Within-year variability • Large swings in short-term assets make duration volatile • Short-term assets defease short-term liabilities • Previous approach focused on duration of total portfolio • (Mod) Duration target range of 3.0 to 3.5 • Have been outside target range for sustained periods • Nature of target range requires greater clarity

  5. Within-year variability

  6. Solution: Portfolio Split • Split the portfolio for interest rate risk management purposes • Long-Term Debt Portfolio (LTDP) • Include long-term debt and any long-term asset holding • Cash Management Portfolio (CMP) • Manage the within-year financing requirement • Average duration less than 0.5 • Transfers between portfolios are made on the basis of public information • See Operational Notices section of AOFM website for rules • Transfer data will not be made available on a real-time basis • Transfers should be verifiable

  7. Solution: Portfolio Split

  8. Duration as single risk measure • Duration is a single summary measure of interest rate risk / proxy for average term to repricing • Good measure for some interest rate shocks • May be misleading for some shocks • Detailed maturity/repricing profile of the portfolio is important

  9. Solution: A second risk measure • Use two measures of interest rate risk: • Modified Duration • Short-dated exposure • A measure of the proportion of the portfolio subject to immediate repricing when interest rates change • We will not specify the precise portfolio • Too prescriptive • Too difficult to build a compliance and reporting framework

  10. Nominal vs Inflation-linked debt • Previous duration measure did not distinguish between inflation-indexed and nominal debt • Distinction is more important as indexed debt becomes a larger proportion of the portfolio • Different interest rate changes affect indexed and nominal debt differently…

  11. Nominal vs Inflation-linked debt • Real interest rates change with no change in inflation: • inflation-indexed payments are stable • indexed debt’s cost resembles nominal debt’s cost • Inflation changes: • inflation-indexed payments change • indexed debt’s cost resembles floating rate debt’s cost

  12. Solution: Focus on nominal portfolio • Focus on the nominal debt portfolio • Express limit framework in terms of the nominal portfolio • No direct control instruments available for indexed debt • Report modified duration and short-dated exposure measures for both types of shocks for the LTDP • Note that these measures converge on the nominal portfolio measures as TIBs mature

  13. The New Interest Rate Benchmark Benchmark AUD Long-Term Debt Portfolio • Two-tiered limit framework • Operational Limits: Approved by Secretary to the Treasury • Policy Limits: Approved by Treasurer • Transition period of up to three years may be required

  14. Portfolio profiles contrasted Current A$ LTDP New Benchmark Portfolio Duration = 2.5 Duration = 2.0

  15. Portfolio profiles contrasted Current A$ LTDP New Benchmark Portfolio Duration = 2.5 Duration = 2.0

  16. Swap Activity 2003-04 • The swap program for 2003-04 is $6 billion to $10 billion. • Long-end receiving of $2 billion to $4 billion • Short-end paying of $4 billion to $6 billion • This will: • reduce modified duration; and • reduce short-dated exposure • Transition to the new benchmark will take up to 3 years • Expected commencement: Next week

  17. Questions?

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