Assessing Sovereign Debt Strategies Under Alternative Term Structure Models

Abstract

This paper examines the theoretical restrictions on alternative term structure models in assessing sovereign borrowing strategies. Our approach draws upon Hahm & Kim's (2003) cost-risk analytic model of sovereign debt management within a mean-variance framework. To explore the effects of different interest rate modeling strategies on government debt portfolio selection, two models are considered; namely, the time series-based dynamic Nelson-Siegel (DNS) model proposed by Diebold & Li (2006) and the DNS model with arbitrage-free restrictions proposed by Christensen et al. (2008a). Using monthly spot rates for 12 maturities of nominal Korea Treasury Bonds (KTB) from September 2000 to November 2008, the present paper finds that a more generic term structure model, such as the DNS model, performs better in terms of smaller out-of-sample root mean squared errors at different forecast horizons. However, looking at the goodness-of-fit, the size of pricing errors and the magnitude of the root mean squared errors suggests that both models are reasonable representations of KTB spot curves. For the actual KTB position as of December 2007, the present paper shows that the 95% cost-at-risk level might be able to trim as much as 5-6% by rebalancing the portfolio. Furthermore, DNS models, both with and without no-arbitrage restrictions, produce a consistent assessment of different strategies. This paper also shows that introducing new short-term domestic debt instruments, such as 1-year zero coupon KTB, would benefit government in terms of lowering both the average debt-service cost and the 95% cost-at-risk. However, it is found that such benefits might dissipate if the issuance weights for such instruments exceed a certain level, which is approximately 4% of the position in the case of Korea.