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Sovereign Asset and Liability Management: An E-Learning Training Course
I. Balance Sheet Risks
I.i. Currency Matching
I.ii. Interest Rate Matching
I.iii. Maturity Matching
I.iv.Derivatives
II. Methodologies
II.i. Initial Methodologies
II.ii. Advanced Methodologies
Conclusion
Bibliography
Glossary
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Derivatives

“The most flexible financial tools for aligning the actual sovereign portfolio with the [strategic] benchmark, and for hedging the portfolio from risks are derivative instruments (e.g.) currency and interest rate swaps, forward contracts, futures, and options).  Derivatives enable the portfolio manager to move the actual sovereign portfolio to the benchmark portfolio without selling large amounts of securities, which could disrupt financial markets, and to unbundle various risks inherent to an underlying security and manage them separately.  All the derivative positions of the portfolio manager need to be carried out within the guidelines of the policymaker, and should only be taken on the underlying debt or reserves portfolio, without any net or leveraged position” (Cassard and Landau, 1997). 

“Governments should look for natural hedges in their asset and liability portfolios which enable them to reduce risk on the government’s balance sheet and lower transaction costs.  Natural hedges occur when the portfolio exposures can be structured to offset one another without recourse to purchasing financial derivatives…After natural hedges have been established, governments who have access to financial derivatives then need to decide whether to purchase them in order to construct financial hedges and reduce market risk...Where transaction costs and credit risks are acceptable, governments generally prefer to hedge their exposures given their preferences for greater certainty and less cash flow volatility” (Wheeler, 2004).

While derivatives can be an effective tool in mitigating risk, caution must be exercised in the use of derivatives.  As derivatives are off-balance sheet items, the risk associated with them must be accounted for.  Just as other off-balance sheet items should be measured and quantified within the SALM framework, derivatives should be as well; derivatives can and should be understood in the same context as off-balance sheet contingent liabilities.  Lack of proper quantification and measurement of derivatives played a significant role in the financial crisis of 2008 as they were not appropriately accounted for.

Just as the complexity of the SALM framework for a sovereign will be determined by available resources, the use of derivatives will be as well.  As the primary objective of the sovereign is to remain solvent, it is vital that all risks associated with the use of derivatives is fully understood and considered by the sovereign.  “Instruments (loans and swaps) used in the management of the government debt must be simple, standardized and well known in the market.  These features support transparency of government debt management and reduce operational risks” (OECD, 2005).  An advanced risk management framework will support the use of sophisticated derivatives but requires the same caution and understanding of risk in the decision making process.  The sovereign must closely examine if the derivative will appropriately mitigate risk or put the government-wide balance sheet at greater risk and potentially threaten solvency.

For additional information on the use of derivatives, please see the report of the International Securities Market Association (ISMA) entitled “Derivatives and Public Debt Management”.

 

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