Should governments minimize debt service cost and risk? A closer look at the debt strategy. Simulation approach

Massimo Bernaschi (), Alessandro Missale and Davide Vergni ()

Departmental Working Papers from Department of Economics, Management and Quantitative Methods at Università degli Studi di Milano

Abstract: Simulation-based cost-risk analysis of the interest expenditure is increasingly used for policy evaluation of public debt strategies by governments around the world. This paper is a first attempt to empirically evaluate this approach by comparing its implications for the maturity structure of public debt with those derived from the optimal taxation theory of debt management. To this end, we simulate the time path of the distribution of the interest expenditure for stylized portfolios of different maturities using simple stochastic models of the evolution of the term structure of interest rates, and examine the performance of such portfolios with standard cost-risk indicators. We find that: i) the ranking of debt portfolios by expenditure risk may depend on the length of the simulation period; to obtain the same policy conclusions as the optimal taxation theory, the time horizon must extend up to the redemption date of the longest maturity bond issued over the simulation period; ii) in sharp contrast with optimal taxation theory, a cost-risk trade off naturally emerges when a risk premium on long term bonds is considered, but this may not be sufficient to identify the optimal maturity structure. Our analysis points to the danger of assuming the cost-risk minimization of the interest expenditure as the main objective of debt management. A policy that either aims to minimize the interest expenditure over a too short horizon or does not consider that risk premiums may reflect a fair price for insurance may lead to sub-optimal debt strategies.

Keywords: debt management; maturity structure; interest costs; interest rate risk; optimal taxation; simulation models; term structure (search for similar items in EconPapers)
JEL-codes: E61 G12 H63 (search for similar items in EconPapers)
Date: 2009-12-15
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Citations: View citations in EconPapers (5)

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