2. The Use of Derivatives in Public Debt Management: The Brazilian Proposal Luiz Fernando Figueiredo April 2002 1

3. 2 I. Background II. The New Derivative Instrument Use of Derivatives in Public Debt Management

4. 3 I. Background Use of Derivatives in Public Debt Management

5. 4 FBrazilian economy hit by several external and domestic shocks in 2001; FAdverse shocks led to:  Exchange rate depreciation of 40% from January to September;  Increase of inflation from 6% in 2000 to 7.7% in 2001;  Deceleration of GDP growth from 4.4% in 2000 to 1.5% in 2001;  Fall in FDI from US$ 32.8 billion in 2000 to US$ 22.6 billion in 2001; Use of Derivatives in Public Debt Management

6. 5 F Main outcome of shocks was the sharp FX depreciation up to mid-October; April 3 rd, 2002 updated. 2.30 1.20 1.40 1.60 1.80 2.00 2.20 2.40 2.60 2.80 3.00 Jan 99 Apr 99 Jul 99 Oct 99 Jan 00 Apr 00 Jul 00 Oct 00 Jan 01 Apr 01 Jul 01 Oct 01 Jan 02 Apr 02 2.80 R$/US$

7. 6 Use of Derivatives in Public Debt Management F Demand for hedge by companies increased from US$ 28 billion in January to US$ 45 billion at the end of the year. 25 30 35 40 45 50 Jan-01Jan-01 Mar-01Mar-01 Apr-01 May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Demand for Hedge - Open FX Swap Contracts at CETIP - (Central for Custody and Financial Settlement of Securities) US$ billion

8. 7 Use of Derivatives in Public Debt Management F Demand for hedge by companies increased from US$ 28 billion in January to US$ 45 billion at the end of the year. 25 30 35 40 45 50 Jan-01Jan-01 Mar-01Mar-01 Apr-01 May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Demand for Hedge - Open FX Swap Contracts at CETIP - (Central for Custody and Financial Settlement of Securities) US$ billion

9. 8 Use of Derivatives in Public Debt Management FMonetary response to shocks included:  Increase of the Selic rate (overnight rate) from 15.25% in March to 19% from July to February;  Intervention on the FX spot market to foster liquidity, with sales of US$ 50 million/day in the second semester;  Net issuance of US$ 11.1 billion in dollar-linked debt, especially in September-October period (net issuance of US$ 7.7 billion in the period);

10. 9 Use of Derivatives in Public Debt Management F Demand for hedge and FX depreciation led to rising share of dollar-indexed debt in total outstanding, peaking in October (32.8%) from 22.3% in December/2000. 15% 20% 25% 30% 35% Dec-99 Feb-00 Apr-00 Jun-00 Aug-00 Oct-00 Dec-00 Feb-01 Apr-01 Jun-01 Aug-01 Oct-01 Dec-01 Feb-02 32.8% FX indexed bonds - share in total outstanding - 28.7% %

11. 10 Use of Derivatives in Public Debt Management F C oncentration of maturities of dollar-indexed bonds in 2002 (36.8% of total), triggering the “elections risk”; 0 2 4 6 8 10 Apr-02 May-02 Jun-02 Jul-02 Aug-02 Sep-02 Oct-02 Nov-02 Dec-02 Jan-03 Feb-03 Mar-03 US$ billion Structure of Maturities Dollar-indexed bonds – position in March

12. 11 II. The New Derivative Instrument Use of Derivatives in Public Debt Management

13. 12 Use of Derivatives in Public Debt Management FCentral Bank/Treasury initiated in March joint auctions of currency vs. interest rate swaps with LFT (Selic-indexed bond) to rollover dollar-indexed debt. FMain aim is to replicate a dollar-indexed bond, supplying hedge to the market, but offering two instruments instead of only one, allowing the market to negotiate both separately. ÜThe intermediation cost will diminish and market will price risks more appropriately. ÜRegistration of swap contract at BM&F (monthly adjustment of margin) will boost liquidity and stimulate migration from OTC trading.

14. 13 Use of Derivatives in Public Debt Management FX bond Swap US$ CDI Step 1 Step 2 FX bond- Swap US$ “Package” (FX bond + Swap US$) = CDI + Premium- CDI Step 3 Central Bank / Treasury Financial Intermediaries Corporates Mutual Funds F Previous Framework: CDI = Interbank CD LFT = Selic-indexed bond

15. 14 Use of Derivatives in Public Debt Management LFT Step 1 SWAP US$ CDI Step 1` Step2 Central Bank / Treasury Mutual Funds Financial Intermediaries Financial Intermediaries Corporates LFT F New Proposal: CDI = Interbank CD LFT = Selic-indexed bond

16. 15 F Announcement of new instrument had an immediate impact on market rates. Use of Derivatives in Public Debt Management 0 50 100 150 200 250 300 350 7-Feb 18-Feb28-Feb28-Feb 6-Mar8-Mar 12-Mar21-Mar27-Mar28-Mar 3-Apr4-Apr8-Apr FX bonds and swaps yield Basis Point Auctions Day Disclosure of new strategy to roll over FX debt Start of swap auctions

17. 16 F Open Interest Swap, Futures and Forward Contracts on Dec 28, 2001 Use of Derivatives in Public Debt Management R$ million Bm&f* Cetip** Fx Swap 151.441,154,937 DI Futures 85,159 - Fx Futures 29,432 - Adjusted DI Forward - 26,403 * Notional Value ** Updated Value DI Swap 187,470 167,130

18. 17 F Also affecting the yield curve Use of Derivatives in Public Debt Management April 3 rd, 2002 updated. 15 20 25 30 Jan-00Apr-00 Jul-00 Oct-00 Jan-01Apr-01 Jul-01 Oct-01 Jan-02Apr-02 Over Selic Swap pre 360 days % per year

19. 18  Weaken market focus on “elections risk”;  Since February, reductions of Selic rate;  FX consistent appreciation from October-level peak;  Trade balance recovery and lesser-than-expected fall in FDI;  Drop in inflation expectations;  Moody´s revised outlook and fall in sovereign-risk premium;  Evidence of slight recovery in economic activity; F2002: Beginning of a new virtuous cycle ? Use of Derivatives in Public Debt Management