MARKET VARIABLES: SHOCK TO THE BASELINE UNCTAD, World Bank and IMF Workshop Geneva, February 06-10 2017

Shock (RISK) scenarios Risk scenarios are deviations from the baseline scenario What are the cost and risk implications of adverse scenarios Risk is exogenous, beyond control of the debt manager Shocks are exogenous

Shock (RISK) scenarios Examples FX shock Foreign interest shock 15%, 30% - 1 and 2 standard deviations Shift in the yield curve Shape of the yield curve Domestic interest shock Changes in base rates/spreads A shift in the entire yield curve Some aid in judging size A change in the shape of the yield curve Plot past rates/difference 1-10 years Higher short term rates Eye-ball the frequency of large shocks

The Shock (Risk) Scenarios Some Alternative Approaches Expert scenarios Different paths of evolution / Scenario Trees What-if Analysis / Stress tests Historical observations Historical volatility Extracted from the market Implied volatility Using derivative prices if they exist

The Shock (Risk) Scenarios Significant departure of debt servicing costs from the baseline projections may result from: Abrupt tightening of monetary policy Changes in investors’ risk preference Many changes in the fundamentals of the economy These may result in abrupt increases in interest rates or falls in the value of the local currency Most DMs rely on historical data to generate risk scenarios but one should also consider stress scenarios events with low probability

Shocks to FX Rates

Shocks to FX Rates

Shocks to FX Rates Quiz: Which Exhange rate is this? (Local Currency per USD)

Shocks to FX Rates Quiz: Which Exhange rate is this?

Indonesian Rupiah vs. US Dollar, January 1, 1992=100 Shocks to FX Rates Collapses in exchange rate pegs: Impossible to predict Indonesian Rupiah vs. US Dollar, January 1, 1992=100

Shocks to FX Rates Forecasts available for hard currencies

The Shocks to Interest rates: Art or Science

The Shocks Interest rates - FX FX risk free rates: With long and stable time series Credit Spreads: Time series (of the country or peer countries) provide information on the volatility Historical data might give good idea of shock size Stress tests: from debt crises in the last two decades

Shocks to Interest Rates - FX

Shocks to Interest Rates - FX

Shocks to Interest Rates - FX

Shocks to Interest Rates - LC Central Bank Monetary Policy Rates (%)

Shocks to Interest Rates - LC Treasury Bill Rates (%)

Shocks to Interest Rates - LC Treasury Bill vs Bond Rates (%)

Shocks to Interest Rates - LC Treasury Bill vs Bond Rates (%)

The Shocks Interest rates – Local Currency (LC) Use of mean and standard deviation for LC interest rates might be questionable: Lack of fully developed yield curves Lack of sufficient historical data Structural change(s) Risk scenario could be constructed based on real interest rate and inflation. Real interest rates have “economic meaning”, nominal rates are behind the “monetary veil” In high-inflation countries it is easier to first model the real return and then add the inflation expectation

Shocks to Interest Rates – FX/LC looking at past crises

The Shocks Interest rates – Local Currency (LC) Scenario Trees Identify certain events that might affect market variables: Elections Structural changes Political/Social turbulence etc. Analyze/discuss possible consequences

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) Check web for projections of rates by investment banks, think tanks, etc Talk to colleagues in neighboring countries

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

Concluding Remarks We are NOT trying to “forecast” market variables Future is hard to predict!

Concluding Remarks We are looking for a reasonable way to understand the cost-risk tradeoffs and their sensitivity to changes in the market rates i.e. to understand the degree of risk exposure of the debt portfolio