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MODELLING COST AT RISK

A PREMILINARY APPROACH FOR BEGINNERS

Sanga Sangarabalan and Per-Olof Jönsson

All queries should be addressed to the authors at sanga@newmalden00.freeserve.co.uk perolofjonsson@yahoo.com

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COST AT RISK MODELLING
This is an introductory article for those who are at the initial stage of developing a Cost at Risk (CaR) model. Since it is intended to encouragethe application of this approach we have avoided the heavy quantitative aspects of modelling. This is to keep the discussion simple and readable. For those who are interested in knowing more, some basic references are given at the end of this paper, which can then be followed up with more references. The article is divided in to two sections, the first highlighting the general preliminary approachto Cost at Risk modelling (Sections 1 and 2) and the second (Section 3) on the application to a Middle Income Country (MIC) where the authors have developed a simple model.

1. General Overview 1.1 Objective: The objectives in the IMF and World Bank Guidelines for Public Debt Management ─first published in 1999─ state that debt managers should seek to minimise the cost of debt at a prudent levelof risk in the medium term. Many developing and newly emerging market countries have begun to follow this objective and formulate their debt strategy in terms of financing the gap at minimum cost and prudent level of risk. In applying this objective a country must clearly define the main terms, financing gap, costs, risks and the time frame in which the application is carried out. For manycountries this is a new experience and therefore may require assistance in understanding CaR, the methodology to be employed, the scope of such applications and the likely constraints to be faced. In this paper we have provided a list of issues and discussed a preliminary approach in building a CaR model. 1.2 Strategy: A strategy will examine many combinations of costs and risks but finally the countrywould choose a particular cost and risk combination. The various costs and risks are the result of testing various strategy combinations. In other words financing gap can be filled by various combinations of debt in terms of structure (external, domestic) maturity (short term, medium term), currency combinations (US dollar, Euro, Local currency) and interest rate structure (variable rate, fixedrate). It is worth pointing out that in general, there is no strategy that would generate a scenario which will have a unique solution of minimum cost and minimum risk. Therefore what will result from various strategy combinations is a trade-off between cost and risk. Some countries might prefer -in comparative terms - to have higher cost than lower risk and others might prefer lower cost andhigher risk.

1.3 CaR and Debt Sustainability Analysis (DSA): Many of the staff from low income countries
(LICs) are familiar today with DSA. In the recent past, the Heavily Indebted Poor Countries (HIPCs) have carried out this type of exercise to determine their entitlement, the magnitude (if eligible) and timing of debt relief. The non-HIPC low income countries and the newly emerging countries doalso carry out DSA exercises some times jointly with the IMF and World Bank. In fact, almost all Article IV missions include a DSA which is usually carried out by the IMF with assistance provided by the country. Unfortunately, many of the staff involved in DSA exercises believe or are led to believe that debt strategies can be formulated using a DSA only. We on the contrary, believe that DSA isonly the first step in looking at external or fiscal sustainability of debt and to carry out a comprehensive debt strategy more work in terms of various tradeoffs between costs and risks is needed. DSA looks at debt burden (stock levels) and liquidity (flows) indicators. CaR, on the other hand, is confined to flow measures in terms of interest and exchange rate costs. It is an appropriate...