New financial model projects future interest costs for dynamic debt portfolios
Banque de France researchers have developed a financial model to project future interest expenses for dynamic debt portfolios. The model simulates the impact of interest rate changes on rolling debt instruments, with applications for sovereign and corporate debt.
Unpacking debt's interest rate sensitivity
Banque de France researchers have developed a financial model to project the future interest expenses of dynamic debt portfolios.
This model simulates the progressive repayment of borrowed amounts, which are then refinanced by issuing new debt at prevailing market conditions.
It accounts for variable-rate interests and inflation indexing, offering a forward-looking approach that does not rely on past econometric estimations.
This makes the model particularly suited for scenario analysis, including stress-testing, and capable of accommodating diverse scenarios for market interest rates and debt amounts.
Starting from detailed data on current debt's maturity structure and interest rates, combined with a given future path for market rates, the model provides precise estimates of financial consequences for borrowing entities.
The model focuses on the interest rate risk inherent in a debt portfolio, covering nominal interest payments and specific costs attached to index debt products.
Sovereign and corporate debt in focus
The model is applied to French government marketable debt and aggregated euro area non-financial corporate (NFC) debt.
For the French sovereign, back-testing shows the model accounts for the cost of debt with an an average relative projection error of 3 percent.
A scenario projects the French state's average cost of debt to increase from 1.7 percent to 2.9 percent by 2029, reflecting refinancing at higher rates.
For euro area NFCs, the model reveals significant heterogeneity in cost of debt sensitivities across countries.
This divergence stems from differences in debt structure, like varying shares of fixed-rate long-term debt versus short-term and variable-rate debt.
The model quantifies these differences, highlighting how debt structure dictates interest expense trajectories.
A powerful tool, with caveats
This model offers a robust, forward-looking tool for anticipating debt cost dynamics, crucial for financial stability monitoring.
Its exclusion of mitigation strategies like derivatives or remunerated deposits, however, represents a notable limitation for comprehensive risk assessment.
For agents actively managing their debt portfolios, its practical utility is somewhat constrained without these broader considerations.