Money market portfolio
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1 1 Money market portfolio April 11 Management of Norges Bank s money market portfolio Report for the fourth quarter 1
2 Contents 1 Key figures Market value and return 3 3 Market risk and management guidelines 5 Developments in the fixed income market 7 5 Operational risk 8
3 th quarter 1 April 11 Management of Norges Bank s money market portfolio in 1 Norges Bank s foreign exchange reserves shall be available for interventions in the foreign exchange market as part of the conduct of monetary policy or in the interest of promoting financial stability. The reserves are divided into a money market portfolio and an investment portfolio. At Norges Bank, Norges Bank Investment Management manages the investment portfolio (reported separately), while the money market portfolio is managed by Norges Bank Monetary Policy (NBMP). The money market portfolio is the most liquid portion of the Bank s foreign exchange reserves. This is the primary response mechanism in Norges Bank s foreign exchange contingency arrangement. On 3 February 1, the Executive Board approved new guidelines for the money market portfolio. The size of the money market portfolio shall be between SDR bn and SDR 3bn. Under the new guidelines, the portfolio is invested in such a way that within a single trading day it may be used for foreign exchange market transactions without having to realise significant losses. In addition, the money market portfolio is used to meet Norges Bank s international commitments, including transactions with the IMF and loans to individual countries. Under the liquidity requirements, the portfolio must be invested in short-term, low-risk instruments such as US and German government bonds with residual maturity of less than one year. In addition, portfolio management shall seek a reasonable return within the constraints set by liquidity requirements and risk limits. The benchmark portfolio is composed of overnight USD and EUR money market indices and Treasury bill indices for the same currencies. 1
4 th quarter 1 April 11 1 Key figures At end-1 the money market portfolio was NOK.3bn, or SDR.7bn (see Chart 1-1). This was a decrease of NOK 7.3bn (equivalent to SDR 3bn) since end-9. Chart 1-1. Portfolio size. Bn NOK (l.a.) and bn SDR (r.a.) end of month. Bn NOK Bn SDR Jan 1 Apr 1 Jul 1 Oct 1 NOK SDR SDR Limits Source: Norges Bank The return on the portfolio in 1 was.7 % measured in terms of the benchmark currency basket, a return of.7 percentage point above the benchmark. The low return of.7 % must be seen in the context of the liquidity and risk requirements for the money market portfolio (Section 1 and Section 3.5 of the Executive Board s guidelines). Through 1, US and euro area short-term interest rates were at a historically low level. Table 1-1. Key figures in percent as of 31 st December 1. Annualised. Measured in the benchmark currency allocation. 1 Portfolio return.7 Benchmark return.3 Excess return.7 Standard deviation*.5 Realised relative volatility (percentage points).8 Information rate (IR**).9 * The standard deviation here is a measure of fluctuations in the money market portfolio at 31 December 1. The return for each month is compared with the average for the period. The higher the standard deviation is, the wider the fluctuations in relation to the average and the higher the risk. ** IR is a risk-adjusted return measure and is used to measure performance in investment management. IR is the ratio between excess return and the portfolio s actual relative market risk (measured by relative volatility). IR shows the level of excess return achieved for each unit of risk.
5 th quarter 1 April 11 Market value and return In connection with the new strategy for the Bank s foreign exchange reserves approved by the Executive Board, capital in the amount of NOK 31bn was transferred from the money market portfolio to the investment portfolio on 31 March 1. Following this, the money market portfolio has consisted of shortterm money market instruments and government securities denominated in EUR and USD with residual maturity of less than one year. Norges Bank replicated the euro portion of the benchmark with the aid of EURIBOR money market futures through 1. This replication did not negatively impact the liquidity in the money market portfolio. The market value of the money market portfolio fell by NOK 1.bn from the end of 1 Q3 (see Table -1). Net outflow related to Norges Bank s international commitments, including transactions with the IMF and loans to individual countries, amounted to NOK 1.bn in Q. Appreciation of the krone against the USD and EUR reduced the value by NOK.3bn in this quarter. The return on the portfolio in 1 Q was.13 % measured in international currency and negative 1. % measured in NOK. The return was measured against the benchmark portfolio defined by the Executive Board. The actual return in Q was equal to the return on the benchmark portfolio. Overall, the return on the money market portfolio in 1 was.7 % measured in terms of the benchmark currency basket, an excess return of.7 percentage point in relation to the benchmark portfolio. The return of.7 percentage point above the benchmark is largely due to the currency composition of the actual portfolio, which was different from that of the benchmark portfolio in 1 Q1. Chart -1. Portfolio return in basis points. Chart -. points. Excess return in basis 8 7 Excess return last quarter Excess return per month Cummulative excess return Excess return last quarter Excess return per month Cummulative excess return Jan 1 Apr 1 Jul 1 Oct 1 Source: Norges Bank - - Jan 1 Apr 1 Jul 1 Oct 1 Source: Norges Bank 3
6 th quarter 1 April 11 Table -1. Key figures as of 31 st December 1. Quarterly observations. Q1 Q Q3 Q Sum Market value (mill. NOK) Market value of portfolio In flow during the quarter - 81* Quarterly return** Return attributed to currency movements*** Portfolio total return Return measured in international currency basket (percent) Portfolio Benchmark Excess return (percentage points) Return measured in NOK (percent) Portfolio Benchmark * The executive board approved new guidelines for the money market portfolio on 3 rd February 1. ** Measured in the benchmark currency basket. *** The volatility of the NOK exchange rate does not influence the international purchasing power of the money market portfolio. Table -. Market value per instrument in the money market portfolio. Mill NOK Q1 Q Q3 Q Tri-party contracts and cash Money market instruments Futures 3-5 Sum NOK Sum SDR
7 th quarter 1 April 11 3 Market risk and management guidelines Market risk in the money market portfolio is measured in terms of expected absolute and relative volatility. Relative volatility (tracking error) is a statistically defined risk measure that indicates the size of the expected deviation that can normally be expected between the return on the benchmark portfolio and the return on the actual portfolio. The limit for expected relative market volatility has been set at 1. %. The Bank uses a model based on historical market fluctuations. Under normal market conditions, the annual return on the actual portfolio is therefore expected to deviate from the return on the benchmark portfolio by more than 1. % in one out of three years. In line with the purpose of the management of the money market portfolio, several buffers have been implemented to ensure that the limit for expected volatility is not exceeded. In addition to a buffer of.5 % of the relative volatility limit set by the head of NBMP-MOA, limits have been set for maximum monthly loss and the maximum number of futures contracts for the active management mandates. Average expected relative volatility was measured at.11 % in 1 and fell somewhat through Q (see Chart 3-1). Chart 3-1. Relative volatility. Annualised, basis points. Chart 3-. Daily currency allocation (EUR and USD) in the portfolio Relative volatility Jan 1 Apr 1 Jul 1 Oct 1 Source: Norges Bank Evolution of EURUSD (percent, monthly) % 1 % % -1 % Evolution of EURUSD (l.a.) Share USD (r.a.) Share EUR (r.a.) 55 % 53 % 5 % 8 % - % 5 % Jan 1 Apr 1 Jul 1 Oct 1 Source: Norges Bank and Thomson Reuters Ecowin Currency allocation in the portfolio (percent) Chart 3- shows developments in the percentage of the portfolio allocated to USD and EUR respectively. Although the distribution has at times been uneven, the difference between the shares of the two currencies has remained well within the limit of ±5 percentage points. The benchmark portfolio s currency weights are rebalanced each month to a currency allocation equivalent to 5 % USD and 5 % EUR. In Chart 3- the exchange rate is re-indexed at each rebalancing date. Charts 3-3 and 3- show the MOVE Index, which is an estimated measure of volatility on one-month Treasury options. Under normal market conditions, the sample space for the MOVE Index would be 8 to 15, which implies a daily volatility on Treasury options of between 5 and 8 basis points. At end-december 1, the index stood at 11. This indicates that the market has normalised. 5
8 th quarter 1 April 11 Chart 3-3. MOVE-index. Since 7 Chart 3-. MOVE-index. Year MOVE-index Average (1999-8) Normal interval MOVE-index Average (1999-8) Normal interval Index points Index points Index points 5 5 Index points Source: Norges Bank and Bloomberg Jan 1 Apr 1 Jul 1 Oct 1 Source: Norges Bank and Bloomberg Table 3-1. Key figures for risk and exposure. End of quarter 1. Risk Limits Actual 31 st Mar 3 th Jun 3 th Sep 31 st Dec Market risk Maximum 1. percent relative volatility* Alternative method**..5 Asset allocation Cash (Minimum 1%) Securities Currency allocation US dollars (5 % - 55 %) Euro (5 % - 55 %) Duration benchmark * Norges Bank uses daily observations to calculate expected relative volatility where recent observations are given greater weight than older observations. With this method, in the event of abrupt increases in market volatility, relative volatility will promptly indicate that risk exposure should be reduced. Exponentially weighted daily observations have a half-life of 33 days. Regulation of market risk in the money market portfolio comprises several levels/buffers that ensure than the limit for expected volatility is not exceeded. The head of NBMP-MOA withholds buffer of.5 percent of the relative volatility limit. In addition, limits have been set for maximum monthly loss and the maximum number of futures contracts for the active management mandates. ** In addition to the calculation using weighted daily observations, Norges Bank also calculates historical relative volatility based on unweighted monthly observations. This measure expresses volatility in the portfolio as it would be if market volatility were at its long-term normal level. Table 3-. Tri-party agreements, investment universe and collateral as of 31 st December 1. Mill. NOK. Rating S & P EUR USD Sum Market value tri-party agreements Collateral AAA Sovereign AA AA A Supernational organisations Sum collateral
9 th quarter 1 April 11 Developments in the fixed income market In the period to summer, the expansionary liquidity policy pursued by the ECB and a high level of surplus liquidity contributed to keeping euro area money market rates low. When long-term loans matured in July, surplus liquidity fell considerably, with an attendant rise in short-term money market rates (see Chart -1). Surplus liquidity fell further in late autumn. The combination of lower surplus liquidity and the ECB s focus on inflation contributed to a further rise in European money market rates towards the end of the year. Better-than-expected key economic figures for the euro area also pulled up money market rates. The spread between interest rates on interbank loans and short-term government debt widened towards the end of the year as a consequence of renewed turbulence owing to high government debt in Europe. In the US, the decline in money market rates since May was driven by weak key figures, then amplified in July by the decision to purchase government debt (quantitative easing). Expectations that interest rates would remain low for a long period began to turn towards the end of the latter half of 1 as key figures proved to be more favourable than expected (see Chart -). Chart -1. German LIBOR interest rates. 3 and 1 months. Chart -. US LIBOR interest rates. 3 and 1 months.. % 1.8 % Germany 3M Germany 1M. % 1.8 %. % 1.8 % USA 3M USA 1M. % 1.8 % 1.3 % 1.3 % 1.3 % 1.3 % 1. %.8 % 1. %.8 % 1. %.8 % 1. %.8 %.5 %.5 %.5 %.5 %.3 %.3 %.3 %.3 %. %. % Jan 1 Apr 1 Jul 1 Oct 1 Source: Bloomberg. %. % Jan 1 Apr 1 Jul 1 Oct 1 Source: Bloomberg Chart -3 shows changes in the TED spread. The TED spread is the difference between interbank rates and interest rates on short-term government debt. The US TED spread rose by about 5 basis points in Q, while the European TED spread rose by about basis points. Since the euro portion of government benchmark bonds are replicated by Euribor money market futures, the money market portfolio is exposed to the European TED spread. The widening of the spread in 1 Q had a negative impact on returns. Chart - shows changes in the slope of the yield curve (1 years minus years) in the US and the euro area. 7
10 th quarter 1 April 11 Chart -3. TED-spread * in EUR and USD.. Chart -. Yield rate curve slope in USA and the Euro-area. 1 - year. 8 7 USD EUR % 3. % 1- yr EUR 1- yr USD 3.5 % 3. %.5 %.5 % %. % 1. % 1. % %.5 % Jan 1 Apr 1 Jul 1 Oct 1 Source: Norges Bank and Bloomberg. %. % Jan 1 Apr 1 Jul 1 Oct 1 Source: Thomson Reuters EcoWin * The TED-spread measures the difference between interbank rates and government bills. 5 Operational risk In line with Norges Bank s strategy, a framework for management of operational risk was established and operationalised in NBMP in 1. The most important processes and key controls were documented, and risk at gross and net level was identified. Gross risk is defined as operational risk before control measures. Net risk is defined as residual risk after the implementation of control measures. Risk assessment is an integral part of line management reporting and is monitored on an ongoing basis by the executive management. 8
11 th quarter 1 April 11 Annex A: Government bonds Table A-1. Holdings (securities) as of 31 st December 1. Name Maturity Holding Market value USD USD NOK Treasury Bill Treasury Note/Bond Treasury Bill Treasury Note/Bond Treasury Note/Bond SUM Securities
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