Petroleum Fund of Timor-Leste Notes to the financial statements
for the year ended 31 December 2013
12. Financial risk and management objectives and policies continued
b Credit risk
Credit risk is the risk that a counterparty to a financial instrument will fail to discharge an obligation or commitment that it has entered into with the Petroleum Fund, resulting in a loss to the Fund. It arises principally from debt securities held, and also from derivative financial
instruments, cash and cash equivalents, balances due from brokers and receivables from reverse repurchase agreements. For risk management reporting purposes the Fund considers and consolidates all elements of credit risk exposure, reflecting the fact that the main concentration to
which the Fund is exposed arises from the Fund’s investments in debt securities.
i Credit risk management
Articles 14 and 15 of the Petroleum Fund law provide broad constraints on the extent of credit risk that can be taken by the Petroleum Fund. The law specifies that not less than 50 of the Petroleum Fund may be invested in investment grade fixed income investments while not
more than 50 of the Petroleum Fund may be invested in listed equities. Up to 5 of the Fund may be invested in other types of securities. The Investment Advisory Board advised the Minister of Finance in June 2012 that in view of the long-term investment horizon of the Fund,
the strategic asset allocation to listed equities should be 40 while the allocation to investment grade fixed interest securities should be 60. The Board recommended implementing this strategic asset allocation by gradually increasing the public equity exposure by 0.83 a month
from the then 20 exposure to equities over a period of two years to 30 June 2014. This strategy was in the process of being implemented during the reporting period.
The mandate in the Operational Management Agreement prescribes that the performance of the Petroleum Fund shall be measured against benchmark indexes for a series of mandates, restricts the permissible investment universe to highly rated financial instruments, and
establishes tracking error limits restricting the permissible deviation of the portfolio investments from the benchmark for each mandate. The maximum loss that the Petroleum Fund would suffer from the default of a single issuer is the amount disclosed below with respect to
investments in Treasury Notes issued by the United States Government and Equity Securities traded on developed market exchanges.
ii Concentration of credit exposure
Concentrations of credit risk arise when a number of financial instruments or contracts are entered into with the same counterparty, or when a number of counterparties are engaged in similar business activities, or activities in the same geographical region, or have similar economic
features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic, political or other conditions.
In order to avoid excessive concentrations of risk, the Petroleum Fund’s policy is to develop over time a well diversified portfolio within limits set by the Petroleum Fund law.
The Petroleum Fund’s significant end-of-year concentrations of credit exposure by the industry or country of the issuer were as follows:
As at 31122013
As at 31122012
USD USD
Fixed interest securities and money market securities Sovereign issuers:
United States Government 8,112,364,538
8,676,319,344 Australia Government
145,008,543 -
Japan Government 136,010,191
- United Kingdom Government
146,555,355 -
European Governments 444,651,310
- Governments of other countries
586,562,474 -
9,571,152,411 8,676,319,344
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Petroleum Fund of Timor-Leste Notes to the financial statements
for the year ended 31 December 2013
12. Financial risk and management objectives and policies continued
iii Credit exposure by credit rating
The following table presents an analysis of the Petroleum Funds debt securities classified according to the Standard and Poors credit rating of the issuer. AAA is the highest rating possible and indicates that the entity has an extremely strong capacity to pay interest and principal.
AA is a high grade rating, indicating a very strong capacity, and A is an upper medium grade, indicating a strong capacity to pay interest and principal. BBB is the lowest investment grade rating, indicating a medium capacity to pay interest and principal. Ratings lower than AAA can
be modified by + or – signs to indicate relative standing within the major categories.
As at 31122013
As at 31122012
USD USD
International fixed interest securities and money market securities
AA+ 9,571,152,411
8,676,319,344
Total 9,571,152,411
8,676,319,344 iv Credit exposure by counterparty as a percentage of the Petroleum Fund’s capital
No more than 1 2012 – Nil of assets of the Petroleum Fund is exposed to a single sovereign issuer, other than the United States Government, all of which sovereigns are developed nations.The assets exposed to the United States Government amounted to 54 2012:
74 of the Petroleum Funds capital. A change in the credit ratings of the Petroleum Funds counterparties may have an impact on the future financial performance of the Petroleum Fund.
v Settlement risk
The financial activities of the Petroleum Fund may give rise to risk at the time of settlement of transactions. Settlement risk is the risk of loss due to the failure of an entity to honour its obligations to deliver cash, securities or other assets as contractually agreed.
For the majority of transactions, the Petroleum Fund mitigates this risk by requiring the custodian to conduct settlements on a Delivery versus Payment basis, whereby a trade is settled only when both parties have fulfilled their contractual settlement obligations by delivering the
agreed amounts of cash or financial assets. The settlement will fail if either party fails to meet its obligation.
c Market risk
Market risk is the risk that changes in market prices, such as interest rates, equity prices, foreign exchange rates and credit spreads not relating to changes in the obligor’sissuer’s credit standing will affect the Petroleum Fund’s income or fair value of its holdings of financial
instruments. The objective of market risk management is to manage and control market risk exposures within acceptable parameters, while optimising the return.
The maximum risk resulting from financial instruments equals their fair value. The Petroleum Fund’s strategy for the management of market risks is driven by the Fund’s investment objectives, including diversification of
its investment portfolio, by specifying benchmarks in individual investment mandates with risk limits defined by maximum tracking errors. The Petroleum Fund’s market risk is thus managed on a regular basis by the investment managers in accordance with these investment
mandates.
i Equity price risk
Equity price risk is the risk of unfavourable changes in the fair values of equities or equity-linked derivatives as the result of changes in the levels of equity indices and the value of individual shares. The equity price risk exposure arises from the Fund’s investments in equity
securities and from equity-linked derivatives. The Fund manages this risk by investing in a variety of stock exchanges and by limiting exposure to any one company or issuing entity, excluding sovereign states to 3 of net assets consistent with Article 15.5a of the Petroleum
Fund Law. The Fund’s law limits equity investments to no more than 5 of the share capital of a particular issuer consistent with Article 15.3b of the Petroleum Fund Law.
Management’s best estimate of the effect on the profit or loss for a year due to a reasonably possible change in equity indices, with all other variables held constant is indicated in the table below. There is no effect on ‘other comprehensive income’ as the Fund has no assets
classified as ‘available-for-sale’ or designated hedging instruments. In practice, the actual trading results may differ from the sensitivity analysis below and the difference could be material. An equivalent decrease in each of the indices shown below would have resulted in an
equivalent, but opposite, impact.
The Petroleum Fund manages its exposure to equity price risk by analysing the portfolio by industrial sector and country each month, and benchmarking the performance of each sectorcountry to the MSCI World Index, by considering the performance of the Fund attributable to
stock allocation, security selection and the interaction effect.
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