Effectiveness of the New Zealand Debt Management Office.

Asset and liability management (ALM): In the context of this report, the management of the risk that losses may be incurred as a result of exposure to foreign exchange, interest rate, or possibly other price movements. This is the practice whereby the potential effect of foreign exchange or interest rate fluctuations is eliminated or controlled.

Backtesting: This is the process of gauging the accuracy and quality of a VaR model by comparing the model-generated VaR measures that it produces over time against actual observed gains and losses. Backtesting is typically performed by comparing 1-day profit and loss against modelled 1-day VaR to avoid the effect of changes in the portfolio within longer time periods aff ecting the observed profit or loss. The Bank of International Settlements Backtesting Framework ranks backtesting results into three levels:

  • Green – backtesting results do not suggest a problem with the quality or accuracy of the model.
  • Yellow – backtesting results do raise questions in this regard, but a conclusion is not definitive.
  • Red – backtesting indicates that there is almost certainly a problem with the VaR model.

Basis point: One-hundredth of one percent – that is, 1% equals 100 basis points (bps).

Cap or floor: A cap is an interest rate option to protect against rising interest rates. In exchange for the cap premium, the buyer is protected from higher rates (above the cap strike price) for the period of time covered by the cap. At the expiry of the option, the cap seller reimburses the cap buyer if the reference rate is above the cap strike rate. If rates are below the cap rate, the option is left to expire and funding can be obtained at lower interest rates. Although the cost of the cap increases the effective cost of funds for a borrower, it also provides protection and flexibility without locking in an interest rate. A floor is similar to a cap except that it provides protection against falling rates below the floor strike rate. A floor provides the floor buyer with reimbursement if the reference rate falls below the floor strike rate.

Carry trade: A strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a diff erent currency yielding a higher interest rate.

Clean P&L: The validation of 1-day VaR measures can be aff ected by intra-day trading, fee income, and new or closed deals. The profits and losses from these are not derived from the original portfolio that VaR was calculated from. Therefore, a hypothetical clean P&L that removes these and reflects the profit or loss that would have been earned from the portfolio as a result of market movements if it had been unchanged for the day. This clean P&L is then compared to the 1-day VaR that was calculated for this portfolio.

Collateral: Assets pledged or provided as security.

Commodity: A generic term for any item or product (including indices) that can be traded by investors on a market. More specifically, it refers to natural materials and their derived products such as metals, agricultural products and energy products.

Concentration risk: The risk of loss because of the concentration of exposure to a specific instrument, individual transaction, industry, or country.

Confirmation: A document through which a market participant notifies its counterparties of the details of a transaction and, typically, allows them time to affirm or question the transaction.

Counterparty: One of the opposing parties involved in a transaction.

Credit default swap: A contract allowing for the transfer of credit risk through a derivative instrument. The party transferring credit risk is obligated to pay a fee to the transferee.

Credit rating agencies/Rating agencies (for example, Standard & Poor’s and Moody’s Investor Service): Independent institutions that assess the creditworthiness or the credit risk of issuers, and provide credit ratings that are publicly available and used by investors as well as analysts as a guide for investment decisions in regard to relative credit standing or strength.

Credit risk or exposure: Credit risk refers to the risk of financial loss as a result of a credit rating downgrade or default of an institution or security issuer.

Derivative or derivative security: An instrument, such as an option, futures contract, or swap, of which the criteria and value are determined by those of an underlying asset such as a stock, currency, or commodity. Derivatives are used extensively in the hedging of financial and treasury risks.

Duration: The measure of the price sensitivity of a fixed-income security to an interest rate change of 100 basis points. Calculation is based on the weighted average of the present values for all cash flows. However, duration is measured in years, and should not be confused with the maturity of the security.

Exchange rate: The value of a particular currency denominated in terms of another currency.

Exchange traded options: Exchange traded options may have a futures contract as the underlying interest. Options on interest rates or options on interest rate futures can be used to construct an interest rate cap or floor. Options may be settled in cash or with the underlying asset or futures contract, depending on exchange rules. When the underlying interest is a futures contract, the purchase of a put option permits the option buyer to sell the futures contract at the strike price, which provides protection against falling interest rates. The purchase of a call option on a futures contract allows the option buyer to buy the futures contract at the strike price, providing protection against rising (futures) prices.

Fixed to floating interest rate debt profile (fixed/floating or fixed and floating ratio): Refers to the ratio of debt in a portfolio that is at a fixed rate and the debt that is subject to periodic interest rate repricing.

Foreign exchange contract/Foreign exchange forward contract (FEC): A contractual obligation to buy or sell a specified foreign currency amount at the exchange rate agreed on the day the contract is entered into for delivery at a specific future date. The exchange rate used is the forward rate for those two currencies at the time that the contract is entered into.

Forward rate agreement (FRA): Bilateral forward contract that fixes the interest rate on the day of the agreement for payment at a future settlement date. Typically, this can be up to two years later. FRAs are used to hedge against interest rate exposure in the sense that one of the parties pays a fixed rate and the other a variable rate.

Funding risk: Funding risk refers to the risk of loss caused by the inability to raise funds at an acceptable cost or to access markets in a timely manner.

Futures (futures contracts): Contracts stipulating the purchase or sale of currencies or securities of a specified quantity, at a specified price and on a predetermined date in the future. Futures are traded on exchanges. In contrast to forward contracts, futures contracts are not usually intended for the actual delivery of the underlying financial instruments, but for trading and hedging purposes. Also, in contrast to forward contracts, futures are not tailored contracts but are standardised in terms of quantity, price, and maturity periods.

Government curve: The equivalent of the yield curve, using the yields of various government bond maturities charted by yield and time to maturity of the bond.

Hedging: The implementation of a set of strategies and processes used by an organisation with the explicit aim of limiting or eliminating, through the use of hedging instruments, the effect of fluctuations in the price of credit, foreign exchange or commodities on an organisation’s profits, corporate value, investments, or liabilities.

Hedging instruments: Types of derivative instruments or assets/liabilities the cash flows or fair market value of which can be used to fully or partially off set the changes in those of the hedged items. They include forward contracts, FRAs, swaps, futures, and options.

Historical simulation VaR: This methodology or approach involves revaluing the portfolio using the observed market data for each day over a period of time, ranking the gains and losses, and taking the desired percentile worst loss as the VaR number. This method makes no assumptions about the distribution or correlation of market price movements. The key assumption is that past market movements will be reflective of future movements.

Interest rate swap (IRS): A swap agreement where interest payments on a certain amount of principal are exchanged between two parties on a specified date. One of the payment streams involved is usually based on a fixed interest rate, while the other is based on a floating rate.

Liquidity: The ability to turn an asset into cash at short notice and/or raise cash by issuing debt or by having ready access to funding (for example, borrowing facilities). Liquidity also refers to an organisation’s ability to pay its obligations when they become due.

Liquidity risk: Liquidity risk refers to the risk of loss as a result of a lack of market liquidity, preventing quick or cost-effective liquidation of products, positions, or portfolios.

Market price: The current or most recent price of a security or financial instrument in the market.

Market risk: Market risk refers to the risk of financial loss as a result of adverse market movements. NZDMO specifically measures market risk with regard to movements in interest rates and foreign exchange rates.

Mark-to-market: The practice of revaluing securities and financial instruments using current market prices.

Middle office: The basic responsibilities of this area include treasury reporting, management information, treasury accounting, and determining and monitoring the internal treasury control framework. Many organisations may not have operations sizeable enough to require a middle Office or, alternatively, some of these activities may be performed by other areas.

Operational risk: Operational risk is the risk that failures in computer systems, internal supervision and control, or events such as natural disasters will impose unexpected losses on an organisation. Problems tend to arise because inadequate attention was paid to some process or system or because personnel either fail to perform their duties or have ill-specified responsibilities or procedures. People tend to be the root cause of most operational risks, which inevitably arise from someone making a questionable decision, either by mistake or on purpose.

Options: A financial option provides the option buyer with the right, but not the obligation, to buy or sell a specified financial product at the strike or exercise price. In exchange for this right, the option buyer pays an option premium to the option seller. The writer (seller) of the option has the obligation to deliver the underlying product or pay monies, or accept delivery of the underlying product or receive monies, if the option buyer exercises it. Options trade between institutions directly and in the exchange traded market. Exchange traded or listed options are transacted through a broker and have standardised expiry dates, contract amounts, and strike prices. Interest rate options may be cash-settled contracts on interest rates, fixed-income instruments such as government bonds, or options on futures contracts.

Potential credit exposure: Potential credit exposure seeks to take account of possible future movements in the mark-to-market value of outstanding derivatives and investments from the date the analysis is undertaken to the maturity date of the transactions. As a result, even if the current mark-to-market of a particular derivative is zero, or even negative, the assessment of potential exposure will be greater than zero, reflecting the possibility of the transaction acquiring a positive value between that time and maturity.

Repurchase agreement/Repo: A sale and repurchase agreement. An arrangement by which an investor holding a security sells the security to a counterparty while simultaneously obtaining the right and obligation to repurchase it at a specific price on a future date or on demand. Government repos are issued by several central banks to help banks meet short-term shortfalls in their reserve requirements and as a means of creating liquidity in their national government debt market.

Segregation of duties: An internal control mechanism used when undertaking financial operations that prevents one person from having overall control from initiation to settlement of a financial transaction. It ensures that diff erent people are involved in the diff erent stages of a transaction, consisting mainly of the initiation, confirmation, recording, and settlement processes.

Settlement: The exchange of securities between buyer and seller and the corresponding transfer of money between the two contractual parties. Settlement is usually preceded by confirmations on, among other things, the date and method of exchange and payment.

Spot price: The price of a financial instrument for immediate delivery.

Spot transaction: A transaction where both parties agree to pay each other a specific amount in a foreign currency (or currencies or foreign and local currency) either on the same day or within a maximum of two days.

Stop loss: A risk management technique where thresholds are set up to trigger an automatic sale or purchase or elimination of an exposure in the event of a negative price movement.

Straight through processing: The end-to-end processing of automated data without manual intervention.

Swap: An agreement between two parties to exchange (or swap), under specified conditions, a set of cash flows (either the same or diff erent currencies) at a future point in time.

Swap curve: The equivalent of the yield curve, using the fixed yields of various swap maturities charted by yield and time to maturity of the swap.

Swap rate: The fixed interest rate (or yield) required to be exchanged for a series of cash flow payments, based on floating interest rates, for a particular length of time (term to maturity of the swap).

Swap spread: The diff erence between the fixed interest rate of a swap and the interest rate of a government bond of the same maturity, expressed in basis points.

Swaptions: Swaptions are options on interest rate swaps. They give the swaption buyer the right, but not the obligation, to enter into an interest rate swap with predetermined characteristics at or before the option’s expiry. Swaption premium is paid by the swaption buyer to the swaption seller, typically as a percentage of the notional amount of the swap.

Trading: The purchasing or selling of currencies, interest rate products, securities and derivatives.

Translation exposure or risk: The potential negative effects on an organisation’s reported profits or balance sheet from exchange rate fluctuations.

Treasury management system (TMS): A configuration of hardware and software that is linked to internal and external information sources that allow an organisation’s treasury function to collect all the necessary financial information regarding the organisation in a uniform format. The TMS allows the automation of a variety of treasury tasks from routine calculations to transaction initiation. It also greatly facilitates analysis, forecasting of treasury results, and risk management. It facilitates straight through processing, particularly if it is linked to various front and back Office applications or integrated into an “enterprise resource planning” solution.

Value at Risk (VaR): VaR is expressed as the worst case loss that could be expected to be incurred from a given portfolio as a result of movements in identified risk parameters, over a nominated time period within a specified level of probability. VaR is calculated for a specific portfolio at a specific point in time. NZDMO’s VaR measure reflects its exposure to interest rate and foreign exchange (FX) risks over 1-day, 1-month, and 1-year periods with a 95% level of confidence. That is, it would expect to incur a loss on its portfolio, from movements in interest and FX rates, greater than the calculated VaR over these periods just 1 day in 20.

Variance-covariance VaR/VCV VaR: This methodology or approach involves using observed price volatilities and correlations of price movements across a historical period to derive the market risk inherent in a portfolio. The approach assumes that volatilities are distributed normally, and takes an appropriate multiple of the standard deviation of observed volatilities as the loss at the desired confidence level for a position. Losses on individual positions are then correlated based on observations to arrive at a portfolio VaR measure. Following industry practice, NZDMO calculates the 1-month and 1-year VaR calculations by taking the 1-day VaR number and multiplying it by the square root of time (for example, 1-day VaR x √365 = 1-year VaR).

Volatility: The level or extent of fluctuation in the rate or price of financial instruments and assets.

Yield curve: The line that results from plotting, at a certain time, the market interest rates of a financial instrument (for instance a bond) over a range of maturity dates.

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