Risk Management for Central Bank Foreign Reserves

RISK MANAGEMENT FOR CENTRAL BANK FOREIGN RESERVES, April 2004......Page 1
Table of Contents......Page 4
Foreword......Page 6
Introduction......Page 8
1 GENERAL FRAMEWORK AND STRATEGIES......Page 12
1 Introduction......Page 14
2 Organisational set-up......Page 16
3 Policy objectives and investment principles......Page 20
4 Deriving a strategic asset allocation process......Page 23
5 Conclusions......Page 27
References......Page 28
1 Introduction......Page 30
2 The interplay of objectives and guidelines......Page 31
2.1 Liquidity management challenges......Page 32
2.2 Value-at-risk and capital preservation......Page 35
3 Guidelines in practice......Page 40
3.2 Leverage......Page 41
3.4 Currency management......Page 43
4 Central bank investment guidelines......Page 45
References......Page 47
1 Introduction......Page 48
2 Typical approaches to foreign exchange reserves risk management......Page 49
3 A general analytical framework for ALM......Page 52
4 Specific reserves management problems......Page 61
5 Application of the framework to foreign exchange reserves management......Page 66
6 Conclusions......Page 71
References......Page 72
1 Introduction......Page 76
2 Current central bank asset allocation practice......Page 78
3 A strategic asset allocation framework for central banks......Page 81
3.1 Description of the asset allocation framework......Page 82
3.2 Base case: the typical central bank approach......Page 83
3.3 Relaxing the currency and bond constraints......Page 85
3.4 Relaxing the country duration constraints......Page 87
3.5 Allowing non-government securities......Page 89
4 Conclusion......Page 92
A.1 Optimisation framework......Page 93
A.2 Calibrating the model......Page 94
References......Page 96
1 Introduction......Page 98
2 Duration and volatility: have lower yields changed the trade-off?......Page 99
3 Credit risk and skewness: the challenge of diversification......Page 101
4 Instruments in other currencies: do higher yields mean higher returns?......Page 103
5 Conclusion......Page 105
References......Page 106
1 Introduction......Page 108
2.1 Data......Page 109
2.2 Empirical set-up......Page 110
Risk/return characteristics......Page 111
3.1 The risk of government bond investing......Page 112
3.2 Empirical results......Page 114
4.1 The risk of international bond investing......Page 116
4.2 Empirical results......Page 120
5.1 Introduction......Page 122
5.2 Example of an active duration management strategy......Page 124
5.3 Empirical results for active management......Page 125
6.1 Investment-grade credits, high-yield bonds and equities......Page 128
6.2 Empirical results for investment grade credits......Page 131
6.3 Empirical results for high yield and equities......Page 132
7 Conclusion......Page 134
References......Page 135
1 Currency allocation and central banks......Page 138
2 Data......Page 139
3 Multiple benchmarks and risk regimes......Page 141
4 State-dependent preferences......Page 144
5 Pareto optimality and non-normality......Page 146
References......Page 148
2 SPECIFICS OF RISK MEASUREMENT AND MANAGEMENT......Page 150
1 Introduction......Page 152
2 Financial risk in reserves management......Page 153
3 Using risk......Page 154
4 Traditional risk control in reserves management......Page 155
5 Consequences of complexity......Page 156
6 The rise of value-at-risk techniques......Page 158
7 The control of risk and the use of value-at-risk in practice......Page 159
8 Weaknesses and dangers in using VaR techniques......Page 160
9 Calculating VaR in practice: different VaR methodologies......Page 163
10 Reserves management within the wider central bank context......Page 164
11 Conclusion......Page 165
References......Page 166
1 Introduction......Page 168
2 Underlying assumptions......Page 169
3 Compensation for assumed risk......Page 170
4 Active or passive management?......Page 174
5 Portfolio construction......Page 176
6 Portfolio performance simulations......Page 178
7 Conclusions......Page 179
References......Page 180
1 Background......Page 182
2 Motivation and outline......Page 183
3 Credit risk terminology......Page 184
4 Counterparty credit risk......Page 185
4.1 Probability of default......Page 186
4.2 Recovery rate statistics......Page 187
4.4 Expected and unexpected losses......Page 188
5.1 Quantifying portfolio credit risk......Page 190
5.2 Estimating default correlation......Page 191
5.3 Estimating asset return correlation......Page 192
6 Managing credit risk......Page 193
6.2 Disaggregating unexpected loss across maturities......Page 194
6.4 Setting up exposure limits......Page 195
7 An optimisation framework......Page 197
8 Credit loss simulation......Page 198
References......Page 200
1 Introduction......Page 202
2 Basic risk model mathematics......Page 205
3 Overview of risk model applications......Page 206
4 Risk reports......Page 209
5 A detailed look at one application: proxy portfolios......Page 214
6 Calibration and extensions......Page 217
7 Conclusion......Page 220
References......Page 221
2 Central Bank responsibilities......Page 224
3.1 Expected return and structural profit......Page 226
3.2 Value-at-risk and potential loss......Page 227
3.3 Managing market risk......Page 229
4 Impact of exogenous influences......Page 230
5 Concluding remarks......Page 231
References......Page 232
1 Introduction......Page 234
2 Risk attribution model (RAM)......Page 235
3 Risk attribution in practice......Page 237
4 Relevance of using an RAM for Central Banks......Page 240
6 Conclusion......Page 241
References......Page 242
1 Introduction......Page 244
2 Data and preliminary stylised facts......Page 246
3 The problem......Page 248
4.1 Extreme value theory (EVT)......Page 250
4.2. Ruin theory revisited......Page 254
4.3 Further tools......Page 258
5 Final comments......Page 259
References......Page 260
3 CASE STUDIES......Page 264
1 Introduction......Page 266
2 The ECB’s financial position......Page 267
3 The role of risk management at the ECB......Page 268
3.1 Responsibilities of the ECB’s risk management division......Page 269
4 Organisational set-up......Page 271
5 Risk management support......Page 272
6 Conclusion......Page 273
2 Currency composition......Page 276
2.1 Optimisation of the currency allocation with regard to the koruna value of the foreign exchange reserves......Page 277
2.2 Liabilities match......Page 280
3.1 The static approach......Page 284
3.2 The dynamic approach......Page 285
4.2 Benchmark duration......Page 290
1 Introduction......Page 292
2 Developing a sound governance and institutional framework for reserves management in Hong Kong......Page 293
3 Risk management framework......Page 295
4 Strategic allocation of assets......Page 299
5 Performance measurement framework......Page 302
6 Conclusion......Page 303
References......Page 304
Appendix A Measures to increase transparency of disclosure......Page 305
1 Introduction......Page 306
3 Description of the attributes......Page 307
4 Calculating performance attribution......Page 310
5 How can data be transformed into information?......Page 314
7 Conclusion......Page 315
1 Introduction......Page 316
2 Investment process oriented by a benchmark portfolio in the Central Bank of Brazil......Page 317
3 The role of performance attribution......Page 318
4 The building block approach for performance attribution......Page 319
5 Specific issues in performance attribution......Page 324
6 Conclusions......Page 329
References......Page 330
1 Introduction......Page 332
2.1 Theoretical background......Page 333
2.2. Liquidity risk model......Page 335
3.1 Estimation of the probability of a liquidity crisis......Page 338
3.2 Liquidity crisis histogram......Page 340
4 Conclusions......Page 341
References......Page 342
1 Introduction......Page 344
3 The model......Page 345
4 Determining the minimum threshold......Page 347
5 Results......Page 348
6 Retroactive examination of meeting the shortfall duration......Page 349
8 Examination of the model over the long term (out of sample)......Page 351
9 Choosing the minimum threshold level for the Bank of Israel’ dollar portfolio......Page 353
10 Practical experience......Page 355
11 Conclusion......Page 358
References......Page 359
Appendix Determining the range of historical observations according to which the distribution of annual holding period returns are measured......Page 360
List of contributors......Page 362