9 Glossary of terms used in the report

Active management

So-called active management involves the manager selecting a composition of the actual portfolio that deviates from the benchmark portfolio. The purpose of such deviation is to achieve an excess return vis-à-vis the benchmark portfolio. In financial literature this excess return is termed alpha return .

Duration

Duration is a widely used risk measure within fixed-income management. The issuer of the bond pays interest on an ongoing basis, and the loan is redeemed upon maturity. If the bond matures in ten years, the investor will normally receive interest payments semi-annually or annually, whereas the nominal value is repaid after ten years. Duration is a different measure of the bond’s tenor than the term to maturity, taking into account the fact that interest on the loan is paid throughout the term. Somewhat simplified, one may say that the duration of a bond expresses how many years it takes for half of the loan to be repaid. Modified duration is a measure of sensitivity that is used to calculate by how much the price of a bond changes if the interest rate is marginally adjusted. This concept is an approximate expression of the percentage change in the market value of a bond given a one percentage point change in the market interest rate. If the interest rate changes significantly, duration is not a good measure of interest rate risk associated with a bond or a fixed-income portfolio.

Index management

Index management aims for the return on the actual portfolio to closely match the return on the benchmark portfolio. If the indices making up the benchmark portfolio encompass the majority of the market-traded securities, index management will yield approximately the same return (before costs) as the overall market. In financial literature, return achieved through broad exposure to the securities market is often referred to as beta return .

Correlation coefficient

The return on the benchmark portfolio is arrived at through a weighted sum of the return on the benchmark portfolio for equities and the benchmark portfolio for fixed-income securities respectively. However, the risk associated with the benchmark portfolio is normally lower than a weighted sum of the risk associated with the equity benchmark and fixed-income benchmark. The reason for this is that the returns in the equity and fixed-income markets do not keep in step with each other. A measure of the degree of (linear) covariation between the return rates is the correlation coefficient . This is a statistical measure ranging between -1 and +1, where -1 denotes perfect negative correlation and +1 denotes perfect positive correlation. Only in the case of perfect positive correlation will the risk associated with the Fund’s overall benchmark portfolio be equal to the weighted sum of the risks of the equity and fixed-income benchmarks. In all other cases, the risk will be lower. The risk reduction achieved by spreading investments across different assets in this way is known as a diversification benefit .

Credit risk

Credit risk is the risk of incurring a loss as a result of default on the part of the issuer of a security or the counterparty in a securities transaction.

Credit risk and market risk are partly overlapping concepts (see below). Credit risk normally refers to the risk that a bond issuer or counterparty in a securities transaction will be declared bankrupt. However, if a bond issuer’s creditworthiness is impaired, this will normally lead to a reduction in the bond price and an ensuing increase in the expected return (interest) on the bond. The difference between the interest rate that an enterprise has to pay and the interest rate a state pays when issuing bonds is often called “credit spread”. These variations reflect variations in the market’s assessment of the creditworthiness of the enterprise in question. The risk relating to potential changes in the credit spread is normally included under the concept of market risk.

Market risk

Market risk is the risk that the value of a securities portfolio will change as the result of fluctuations in equity prices, exchange rates, and interest rates. It is normally assumed that one must accept higher market risk in order to achieve a higher expected return.

Operational risk

Operational risk is the risk of financial loss or loss of reputation as a result of breakdown of internal processes, human error, systems failure, or other losses caused by external factors that are not a consequence of the market risk of the portfolio. There is no expected return associated with operational risk. However, in managing operational risk one must balance the objective of keeping the probability of such losses low against the costs incurred as a result of increased control, monitoring, etc.

Benchmark portfolio

In order to evaluate the operative management of the Government Pension Fund, the actual return on a portfolio must be compared with what results could alternatively be achieved through a somewhat similar investment of the funds. It is common to express an alternative investment in the form of a benchmark portfolio . The composition of a benchmark portfolio may be said to reflect the owner’s primary choice of investment strategy.

Relative volatility (tracking error)

The benchmark portfolio acts as a risk management tool for operational management purposes by defining a limit as to what deviation is accepted between the actual investments and the benchmark portfolio. The difference between the actual portfolio and the benchmark portfolio may be defined as a difference portfolio. The standard deviations of the return on this difference portfolio are referred to as relative volatility , indicating the market risk involved in the operative management. As far as the Government Pension Fund is concerned, the Ministry has established a limit of 1.5 pct. for relative expected volatility. Somewhat simplified, this means that over time the difference between the return on the Fund and the benchmark portfolio will not exceed 1.5 pct. in two out of three years. With regard to the management of the Government Pension Fund – Norway, the Executive Board of the National Insurance Fund has fixed an upper limit for 2007 of 3.5 pct. on relative volatility.

Risk

A frequently used risk measure, the standard deviation is a measure of the fluctuations in returns over a period. The higher the standard deviation is, the more volatility (fluctuations) or risk relative to the average return there will be. By linking the standard deviation to a probability distribution, one may say something about the probability that a portfolio will decrease in value by x per cent or increase in value by y per cent during a given period.

Through the fiscal rule for budget policy, government petroleum revenues are phased into the economy more or less in step with the developments in expected real return. This facilitates the adoption of a long time horizon for the Fund’s investments, and annual variations in returns therefore play a lesser role. It is more relevant to assess the risk over time and the probability of a negative aggregate return over a number of years than possible losses from one year to the next.

The probability of a negative portfolio return decreases proportionately with the time horizon, as one expects positive returns over time in the financial market. On the other hand, the potential fall in the value of the portfolio increases proportionately with the time horizon, since one cannot rule out the possibility that one year of negative returns may be followed by more of the kind. The extent to which the time horizon increases the potential loss of value depends on whether or not the returns tend to revert to normal long-term levels.