CHAPTER 9

Risk Management

The point of departure for management of the central government's risk is a low interest-rate risk due to the long duration of the government debt portfolio. During the financial crisis an inappropriate distribution of the central government's interest-rate fixing has been built up. By concluding interest-rate swaps, the central government can achieve expected reductions of interest costs without increasing the risk of higher interest costs. Consequently, interest-rate swaps will continue to be transacted, provided that the swap markets are well-functioning.

The central government holds foreign debt in order to maintain an adequate foreign-exchange reserve. To minimise the exchange-rate risk, the central government's foreign debt portfolio is exposed solely in euro.

2009 saw an expansion of collateral pledged in connection with the central government's swap agreements. This can be attributed to general ly lower ratings of the central government's swap counterparties. Overall, the higher volume of collateral contributed to reducing the central government's credit exposure. However, this should be viewed in the light of the central government's exposure to more counterparties with lower credit ratings.

Interest-Rate Risk 9.1

The overall objective for Government Debt Management is to achieve the lowest possible long-term borrowing costs, while taking the degree of risk into account. A major risk factor with regard to Danish government debt is the interest-rate risk, i.e. the risk of higher borrowing costs as a result of the development in interest rates.

Management of interest-rate risk in 2009
The financial crisis has led to significant change of the central govern ment's portfolio of assets and liabilities. In response to strong investor interest from the insurance and pension sector, a new 30-year govern ment bond was opened in November 2008. The proceeds of DKK 90 bil lion were deposited in the central government's account at Danmarks Nation albank. Moreover, foreign borrowing was increased in order to raise the foreign-exchange reserve, and the proceeds were deposited in the central government's account. This led to build-up of the central gov ern ment's gross portfolios, a longer duration of liabilities and a shorter duration of assets, whereby the duration of the total central-government debt port folio rose considerably, cf. Chart 9.1.1.

Development in Duration during 2008 and 2009	Chart 9.1.1

At the beginning of 2009, the intention was to smooth out the interest-rate fixing by concluding 10-year interest-rate swaps for up to DKK 20 bil lion, provided that the swap markets normalise. In the 1st half of 2009, the swap markets were still strongly influenced by the financial crisis, so the central government did not transact interest-rate swaps. As the mar kets gradually normalised in the 2nd half of the year, the use of interest-rate swaps was resumed. 10-year portfolio interest-rate swaps for a total amount of approximately DKK 6 billion were concluded.

Management of interest-rate risk in 2010
The management of the central government's interest-rate risk in 2010 should be viewed in the light of the prospects of rising government debt in the coming years, greater uncertainty than usual concerning govern ment finances and gradual normalisation of the financial markets.

The point of departure for management of the central government's risk is a low interest-rate risk. The duration of the government's liabilities is long after a period of issuance focused on the 10-year maturity segment and issuance of the 30-year government bond. At the same time, the duration of the central government's assets has declined due to the large balance of the central government's account and short-term re-lending to the Financial Stability Company. In view of the continued low net govern ment debt, fluctuations in the overall duration are thus considerable.

Interest-rate fixing
Interest-rate fixing is the amount in kroner on which a new, unknown rate of interest is to be fixed within one year. Interest-rate fixing is calculated as interest-rate fixing for liabilities less interest-rate fixing for assets.

Basically, an even distribution of interest-rate fixing over time and across maturity segments is expedient, and interest-rate fixing should be positive in each maturity segment. Thus the central government has di versified its interest-rate exposure across the yield curve and does not take speculative positions in relation to the future shape of the yield curve.

Since the liabilities in the government debt portfolio exceed the assets, interest-rate fixing will be positive overall, cf. Chart 9.1.2. The balance of the central government's account at Danmarks Nationalbank is large. Interest-rate fixing in 2010 will thus comprise more short-term assets than short-term liabilities, i.e. negative short-term interest-rate fixing.

Interest-rate fixing on maturity segments without conclusion of interest-rate swaps	Chart 9.1.2

The central government can obtain a more appropriate interest-rate ex pos ure by concluding interest-rate swaps, whereby the central govern ment pays interest at a floating rate and receives interest at a fixed rate. This increases short-term interest-rate fixing and reduces long-term interest-rate fixing, which smoothes interest-rate fixing, both in terms of maturity segment and over time.

Analyses in the Cost-at-Risk model
The interest-rate fixing of the debt portfolio describes the sensitivity to changes in interest rates, i.e. the central government's interest-rate expos ure. In order to assess the interest-rate risk, the probability of interest-rate changes needs to be taken into account.

The interest-rate risk is analysed in Government Debt Management's Cost-at-Risk (CaR) model, based on the strategy for future issuance, buy-backs and re-lending to ensure that the expected financing requirement is met. Projections using the CaR model show that conclusion of interest-rate swaps entail savings without increasing the risk of higher interest costs in future. Moreover, by concluding interest-rate swaps the central government can still benefit from lower interest costs in future, cf. Chart 9.1.3.

Expected interest cost and interest-rate risk	Chart 9.1.3
Note: Annual conclusion of 10-year interest-rate swaps for DKK 0, 10, 20 and 30 billion. Risk bands are the 5th and 95th percentiles, respectively.

The analyses of interest-rate fixing and the trade-off between interest costs and interest-rate risk in the CaR model show that it would be ap propriate to conclude interest-rate swaps in the coming years. Against this back ground, Government Debt Management has chosen to continue to use interest-rate swaps in risk management, conditional on well-func tioning swap markets. Moreover, the use of interest-rate swaps should be seen in the light of the reduction of the government's holdings of portfolio interest-rate swaps by DKK 22 billion since 2007 and the expiry of interest-rate swaps for a further DKK 16 billion in 2010.

Exchange-Rate Risk 9.2

The central government raises foreign debt in order to maintain an adequate foreign-exchange reserve. Exchange-rate risk is the risk that the value of the central-government debt in kroner increases as a result of changes in exchange rates. To minimise the exchange-rate risk, the central gov ernment's foreign debt portfolio is exposed solely in euro. The exchange-rate risk is low due to Denmark's fixed-exchange-rate policy vis-à-vis the euro. In addition, Danmarks Nationalbank's foreign-exchange reserve is predominantly exposed in euro.

In connection with foreign loans in dollars, Swedish kronor and Nor weg ian kroner, the central government has concluded interest-rate swaps so that the foreign debt is ultimately exposed in euro. Concurrently, the cen tral government has issued Commercial Paper in dollar, also with ul tim ate exposure in euro via forward contracts with Danmarks Nation albank.

Re-lending to Danish Ship Finance in dollars is financed in kroner and swapped to dollars, thereby hedging the exchange-rate risk.

Credit Risk 9.3

Credit risk is the risk of incurring a financial loss as a consequence of a counterparty's default on its payment obligations.

The central government's swap portfolio is subject to credit risk. When a swap is transacted, its market value is zero, but over time the market value may become either positive or negative for the central government, depending on the development in interest and exchange rates. A swap with a positive market value is an asset for the central government and therefore subject to credit risk since the central government is exposed to the swap counterparty's ability to pay.

The central government's credit risk is minimised by observing a number of credit management principles. Credit risk is spread on a number of counterparties with high credit ratings that have concluded agreements on unilateral pledging of collateral. The central government's credit management is described in more detail in the Appendix Principles for Management of Credit Risk on Government Swaps.

Foreign borrowing has increased the swap portfolio
At end-2009, the swap portfolio consisted of 324 swaps with 19 counterparties, with a principal totalling DKK 226 billion, cf. Table 9.3.1. In 2009, the central government transacted 21 swaps with a principal totalling DKK 76 billion. In connection with foreign borrowing, currency swaps into euro were transacted for DKK 59 billion.

The dollar significantly affects the market value of the swap portfolio
The development in the market value of the central government's swaps reflects fluctuations in interest and exchange rates.

The market value of the central government's currency swap portfolio is primarily influenced by the dollar rate. As a result of the issuance of dollar loans, the currency swap portfolio consists chiefly of dollar-to-euro swaps. Hence, the market value of the swap portfolio tends to decline when the dollar weakens. As a result of the fixed-exchange-rate policy, the central government's portfolio of currency swaps between kroner and euro does not give rise to major fluctuations in market value.

Interest-rate swaps are typically used to restructure debt from long to short duration, which means that the central government primarily pays interest at a floating rate and receives interest at a fixed rate. The market value of the government's portfolio of interest-rate swaps thus increases when interest rates decline.

In 2009, the market value of the central government's swap portfolio fell by DKK 1.1 billion, cf. Table 9.3.2, primarily due to the depreciation of the dollar.

Lower credit exposure
The total market value of the swap portfolio cannot be directly applied as a measure of the central government's credit exposure. The credit exposure is calculated on the basis of the market values of the individual counterparties' swap portfolios with the central government. The central government's maximum credit loss without adjustment for the collateral pledged (current exposure) is the sum of the positive market values for the individual counterparties. A counterparty's swap portfolio is not in cluded in the current exposure if the market value is negative. The current exposure rose by DKK 2.5 billion in 2009, primarily reflecting a higher market value of the central government's interest-rate swaps. In the same period, volume of collateral pledged rose by DKK 3.3 billion, resulting in a decrease in the central government's overall credit exposure by DKK 0.8 billion in 2009, cf. Chart 9.3.1.

Credit exposure on the Central-government swap portfolio	Chart 9.3.1

Downgrading of swap counterparties
In 2009, the increase in pledged collateral mainly reflected downgrading of the central government's swap counterparties. The counterparties' thresh old values for pledging of collateral have thus been reduced, so the counterparties must pledge more collateral when the market values of their swap portfolios are positive for the central government. Viewed in isol ation, downgrading of counterparties thus reduces the central gov ern ment's credit exposure. Conversely, the quality of the credit exposure has declined since the exposure to counterparties with lower ratings has grown since the end of 2008, cf. Chart 9.3.2.

Credit exposure broken down by counterparty rating	Chart 9.3.2

Swap counterparty diversification
The central government reduces the risk of substantial credit losses by using a large number of swap counterparties. At end-2009, the central govern ment's outstanding swaps were distributed on 19 counterparties, cf. Chart 9.3.3.

SWAP PORTFOLIO broken down BY COUNTERPARTIES	Chart 9.3.3

In previous years, the central government had outstanding swaps with several counterparties with the highest rating (AAA), typically special pur pose vehicles (SPVs) that had this rating as a result of their financial structure. An SPV is legally separated from all other companies in the same group, which means that its capital cannot be claimed by the parent company or other group companies if they encounter financial difficulties. An SPV hedges its entire market risk via the parent company, and the SPV's capital base is adjusted on an ongoing basis to ensure sufficient cover for the SPV's financial obligations at all times. Traditionally, the rating agencies have therefore considered the risk of the SPV defaulting on its financial obligations to be limited.

Experience with SPVs during the financial crisis, particularly the SPVs associated with Lehman Brothers, caused the rating agencies to adopt a more critical approach to SPVs in 2009. Consequently, a number of SPVs were downgraded, including those that are counterparties of the central government. At the end of 2009, the central government had outstanding swaps with a principal totalling DKK 34 billion with two SPVs rated AA+ and AA, respectively.