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Appendix 2: Description of risks in debt and asset management

The Government faces a number of risks when conducting debt and asset management:

Funding risk refers to the borrower's ability to raise funds in an orderly manner, as required and without penalty. To manage funding risk, the debt manager must be cognisant of the various markets that can be accessed, the instruments available, the mechanisms under which debt can be raised and their changing relative cost effectiveness. Moreover, it involves promoting the Commonwealth's stock in the markets and establishing a diverse investor base. Funding risk is intrinsic to any borrower, including the Commonwealth.

Interest rate risk refers to the risk of adverse movements in interest rates reducing the portfolio's value. For example, if the Commonwealth undertakes borrowing at a fixed rate and interest rates subsequently decline, the Commonwealth may be left with debt that has relatively expensive interest service costs compared with the prevailing market interest rate. In this circumstance, whilst the interest service cost of debt (that is, budget public debt interest cost) has not changed, significant opportunity costs are associated with not being able to benefit from the lower interest rates.

Liquidity risk refers to the ability of borrowers and investors to buy or sell securities in reasonable quantities in a timely manner without having a significant impact on market prices. The degree of liquidity depends on the depth of the secondary market for that security. Borrowers also face another form of liquidity risk. This is the difficulty they face having funds available to meet their obligations. Borrowers such as the Commonwealth manage this risk by accessing a range of funding instruments that enable them to raise cash at short notice and ensure they can liquidate surplus funds at short notice.

Credit risk refers to the loss that may occur if a counterparty to a transaction fails to meet its obligations. In the Commonwealth's case, this arises in the context of derivative transactions it undertakes to achieve portfolio management objectives. Managing credit risk involves monitoring and setting limits to exposures to counterparties, pricing and incorporating credit risk into decisions about debt management transactions.

Operational risk refers to the potential for loss arising from normal operations. This refers to events including system failures, natural disasters, fraud and human error. Managing this risk involves the management of personnel, IT hardware and software systems, internal controls, reputation and legal issues. Operational risk is difficult to quantify, but when failures do occur, the costs can be very high. Managing operational risk depends on staff being appropriately skilled and experienced, flexibility to retain or recruit new staff with the requisite skills, appropriate process controls and adequate computer hardware/software systems to support debt management activities.

Country risk involves all risks (sovereign and private) arising from economic, social as well as political developments in a country, which may adversely affect the interests of cross-border investors. For example, a large economy-wide shock may lead to a foreign government defaulting on its own obligations and/or limiting/preventing resident borrowers from repaying the capital they owe.

Exchange rate risk occurs for two reasons. First, the assets held in a foreign currency devalue when that currency depreciates against the investor's domestic currency. Second, default may arise when the depreciation in local currency increases the foreign debt burdens of the issuers, increasing their risk of default. Derivatives may be used to hedge foreign exchange risk.