Tài liệu RISK MANAGEMENT FOR CENTRAL BANK FOREIGN RESERVES pdf

RISK MANAGEMENT FOR CENTRAL BANK

FOREIGN RESERVES

RISK MANAGEMENT FOR CENTRAL BANK FOREIGN RESERVES EUROPEAN CENTRAL BANK

EDITORS:

CARLOS BERNADELL,

PIERRE CARDON,

JOACHIM COCHE,

FRANCIS X. DIEBOLD AND

SIMONE MANGANELLI

RISK MANAGEMENT FOR CENTRAL BANK

FOREIGN RESERVES

EDITORS:

CARLOS BERNADELL,

PIERRE CARDON,

JOACHIM COCHE,

FRANCIS X. DIEBOLD AND

SIMONE MANGANELLI

Published by:

© European Central Bank, May 2004

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The views expressed in this publication do not necessarily reflect those of the European Central Bank.

No responsibility for them should be attributed to the ECB or to any of the other institutions with which

the authors are affiliated.

All rights reserved by the authors.

Editors:

Carlos Bernadell (ECB), Pierre Cardon (BIS), Joachim Coche (ECB),

Francis X. Diebold (University of Pennsylvania) and Simone Manganelli (ECB)

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ISBN 92-9181-497-0 (print)

ISBN 92-9181-498-9 (online)

Table of Contents

Foreword by Gertrude Tumpel-Gugerell....................................................................... 5

Introduction by Carlos Bernadell (ECB), Pierre Cardon (BIS), Joachim Coche (ECB),

Francis X. Diebold (University of Pennsylvania) and Simone Manganelli (ECB) ........ 7

1 GENERAL FRAMEWORK AND STRATEGIES

1 Strategic asset allocation for foreign exchange reserves

by Pierre Cardon (BIS) and Joachim Coche (ECB) ............................................... 13

2 Thoughts on investment guidelines for institutions with special liquidity

and capital preservation requirements

by Bluford H. Putnam (Bayesian Edge Technology & Solutions, Ltd.) ................ 29

3 A framework for strategic foreign reserves risk management

by Stijn Claessens (University of Amsterdam) and Jerome Kreuser

(The RisKontrol Group GmbH) ............................................................................. 47

4 Asset allocation for central banks: optimally combining liquidity, duration,

currency and non-government risk

by Stephen J. Fisher and Min C. Lie (JP Morgan Fleming Asset Management) ... 75

5 Reaching for yield: selected issues for reserves managers

by Eli M. Remolona (BIS) and Martijn A. Schriijvers (De Nederlandsche Bank) 97

6 The risk of diversification

by Peter Ferket and Machiel Zwanenburg (Robeco Asset Management) .............. 107

7 Currency reserve management by dual benchmark optimisation

by Andreas Gintschel and Bernd Scherer (Deutsche Asset Management) ............. 137

2 SPECIFICS OF RISK MEASUREMENT AND MANAGEMENT

8 Risk systems in central bank reserves management

by Mark Dwyer (DST International) and John Nugée (State Street Global Advisors) 151

9 Corporate bonds in central bank reserves portfolios: a strategic asset

allocation perspective

by Roberts L. Grava (Latvijas Banka) .................................................................... 167

10 Setting counterparty credit limits for the reserves portfolio

by Srichander Ramaswamy (BIS) .......................................................................... 181

11 Multi-factor risk analysis of bond portfolios

by Lev Dynkin and Jay Hyman (Lehman Brothers) .............................................. 201

12 Managing market risks: a balance sheet approach

by Bert Boertje and Han van der Hoorn (De Nederlandsche Bank) ...................... 223

13 Ex post risk attribution in a value-at-risk framework

by Eugen Puschkarski (Oesterreichische Nationalbank)........................................ 233

14 Ruin theory revisited: stochastic models for operational risks

by Paul Embrechts (ETHZ), Roger Kaufmann (ETHZ) and

Gennady Samorodnitsky (Cornell University) ....................................................... 243

4 Contents

3 CASE STUDIES

15 Risk management practices at the ECB

by Ciarán Rogers (ECB) ......................................................................................... 265

16 Management of currency distribution and duration

by Karel Bauer, Michal Koblas, Ladislav Mochan and Jan Schmidt

(C

v

eská národní banka) ............................................................................................ 275

17 Foreign reserves risk management in Hong Kong

by Clement Ho (Hong Kong Monetary Authority) ................................................ 291

18 Performance attribution analysis – a homemade solution

by Alojz Simicak and Michal Zajac (Národná banka Slovenska) ......................... 305

19 Performance attribution for fixed income portfolios in Central Bank of Brazil

international reserves management

by Antonio Francisco de Almeida da Silva Junior (Central Bank of Brazil) ......... 315

20 Management of the international reserve liquidity portfolio

by David Delgado Ruiz, Pedro Martínez Somoza, Eneira Osorio Yánez and

Reinaldo Pabón Chwoschtschinsky (Central Bank of Venezuela) ......................... 331

21 Determining neutral duration in the Bank of Israel’s dollar portfolio

by Janet Assouline (Bank of Israel) ........................................................................ 343

List of contributors ......................................................................................................... 361

Foreword

Risk management is a key element of sound corporate governance in any financial institution,

including central banks. In particular, central banks, in performing their policy tasks, are

exposed to a variety of financial and non-financial risks, which they may want to manage.

One such key risk concerns foreign reserves, because central banks’ main activity, namely

ensuring price stability, needs to be backed by an adequate financial position.

Efficient management of foreign exchange reserves is vital if a central bank’s credibility is

to be maintained. For many central banks, a significant part of the financial risks inherent in

their balance sheet arises from foreign reserve assets. Successful foreign reserves

management ensures that the capacity to intervene in the foreign exchange markets exists

when needed, while simultaneously minimising the costs of holding reserves. Risk

management of foreign reserves contributes to these objectives by strategically managing and

controlling the exposure to financial and operational risks.

Undoubtedly, foreign reserves risk management can benefit from methodologies and tools

applied in the private asset management industry, as well as from developments of leading firms

in competitive markets. However, the motivation for a volume addressing risk management from

a central bank’s point of view is that not all private sector concepts are directly applicable to

foreign reserves management. Central banks are idiosyncratic investors, because policy

objectives induce specific portfolio management objectives and constraints and prescribe a

generally prudent attitude towards market, credit and liquidity risk. Foreign reserves

management deviates in terms of the investment universe, available risk budgets, investment

horizons, management of liquidity risk, and the role and scope of active portfolio management.

This volume gathers valuable contributions by academics and practitioners that reflect the

specific nature of central bank reserves management. The contributions highlight the

important role risk management plays in the continuous validation and improvement of

central banks’ investment processes.

Traditionally, reserves were mainly invested in liquid sovereign bonds. A changing

investment universe makes it possible or even requires holdings to be more diversified. While

observing liquidity and other policy requirements, highly-rated non-government instruments are

added to the investment universe. These developments change the role of risk management:

beyond a pure risk control perspective, proactive risk management must on a strategic level be

involved when transforming policy requirements into strategic investment decisions.

Despite a broadened investment universe, holding foreign reserves implies opportunity

costs, as investments must necessarily deviate from a broadly diversified market portfolio. In

recent years, many central banks have started using active management to further minimise

these costs. Strategies and methods applied in the private asset management industry have

therefore found their way into reserves management. These developments should go hand-in￾hand with a further strengthening of risk management functions.

This volume contributes to the development of methodologies and best practices in a

changing environment for reserves management. In so doing, it strengthens the belief that risk

management functions in central banks need comprehensive mandates to assure an efficient

allocation of resources, development of sound governance structures, improved

accountability, and a culture of risk awareness across all operational activities.

Gertrude Tumpel-Gugerell

Member of the Executive Board of the European Central Bank

6 Introduction

Introduction

Carlos Bernadell (ECB), Pierre Cardon (BIS), Joachim Coche (ECB),

Francis X. Diebold (University of Pennsylvania), and Simone Manganelli (ECB)

The management of foreign exchange reserves is an important task undertaken by central

banks. Depending on the design of exchange rate arrangements and the requirements of

monetary policy, foreign reserve assets may serve a variety of purposes, ranging from

exchange rate management to external debt management. Hence central banks’ efficient

management of foreign reserves is vital if they are to fulfil their mandates comprehensively.

In particular, efficient allocation and management of foreign reserves will promote the

liquidity needed to fulfil policy mandates while at the same time minimising the costs of

holding reserves. Central bank foreign reserves risk management can contribute to these

objectives by managing and controlling the exposure to financial and operational risks.

In recent years, many central banks have expanded their risk control units into

comprehensive risk management functions, beneficially independent to some extent from the

bank’s risk-taking activities, and supporting decisions at all stages of the foreign reserves

investment process. In addition to supporting traditional control functions such as compliance

monitoring, foreign reserves risk management can contribute to the translation of policy goals

into specific and efficient strategic asset allocations that focus not only on risk, but also on

return.

Indeed, it is precisely the risk-return interface, and the tension that arises for central banks

navigating that interface, that motivate this volume. On the one hand, it is probably socially

wasteful for a central bank to hold only sovereign bonds, accepting their relatively low risk￾free return, which suggests the desirability of more aggressive central bank investment

strategies. On the other hand, central banks are unique institutions with very particular

mandates, which suggests that naively importing private sector asset management strategies

may be misguided. So, then, what should a central bank do? In this volume, we attempt to

progress toward an answer.

Our approach contains three components, corresponding to the volume’s three parts: (I)

General Framework and Strategies, (II) Specifics of Risk Measurement and Management,

and (III) Case Studies. Part I sets the stage in broad terms, suggesting and evaluating various

alternatives, and making it clear that an appropriate framework must respect the unique

aspects of central banking environments, characterised by a high degree of risk aversion and

institutional constraints. Part II contains a variety of rather more technical contributions

focusing on risk measurement and optimisation of the risk-return trade-off as appropriate for

central banks. Finally, Part III contains descriptions of current practice at a variety of central

banks worldwide, which are designed to provide context and perspective.

Part I, General Framework and Strategies, begins with Cardon and Coche, who stress the

importance of good corporate governance and a sound organisational design. Their paper

views strategic asset allocation as a three-step process. First, an appropriate organisational

design should be developed to ensure a smooth implementation of daily reserves risk

management. The paper argues for a three-tier governance structure, with clearly

distinguished and segregated strategic asset allocation, tactical asset allocation, and actual

portfolio management responsibilities. Second, the general policy and institutional

requirements should be translated into specific, precise and quantifiable investment

guidelines. Finally, these investment guidelines should be transformed into an optimal long￾term risk-return profile.

8 Introduction

Putnam dwells on the second step of the process described by Cardon and Coche. He

argues that for central bank foreign risk management, it is crucial to understand the interplay

between investment objectives and investment guidelines. A thorough examination of the

commonly-employed investment guidelines may uncover the existence of strategies that

actually work against the complex long-term investment objectives of central banks. In

concrete terms, he suggests addressing the trade-off between short-term and long-term needs

by dividing the foreign reserves portfolio into two sections: “liquid” and “liquidity￾challenged”. This would permit the central bank to withstand sudden shocks to the market

environment, while at the same time earning liquidity, complexity and volatility premia

which are typically only available to long-term investors.

The remaining five contributions in Part I provide different examples of how central banks’

investment guidelines can be embedded in a well-structured mathematical framework.

Claessens and Kreuser suggest a numerical approach in order to solve a dynamic stochastic

optimisation model that incorporates both macro aspects of policy objectives (e.g. monetary

policy needs and foreign exchange management) and micro elements (e.g. the definition of

portfolio benchmarks and the evaluation of investment managers).

Fisher and Lie criticise risk management strategies based on exogenous ad hoc restrictions

of the investment universe. This typical asset allocation process generally leads to

overconstrained portfolios and to significant efficiency losses. They suggest an asset

allocation framework that maximises portfolio returns, given a risk target and subject to

constraints on liquidity, credit quality and currency allocations.

Remolona and Schrijvers examine three alternative strategies. The first focuses on

duration, the second on default risk and corporate bonds, and the third on higher-yielding

currencies. They find that the trade-off between risk and return as measured by the Sharpe

ratio points to a recommended duration of not longer than two years. In the case of corporate

bonds, the key issue is how to achieve a proper diversification, given the significant

asymmetries that characterise the distribution of these portfolio returns. For higher-yielding

currencies, empirical evidence suggests that yield differentials are generally not offset, but

rather reinforced, by currency movements.

Ferket and Zwanenburg quantify the risk and return characteristics of some of the most

popular asset classes in the private asset management industry (long-term and global

government bonds, investment-grade credits, high-yield bonds and equities), which they then

compare to those of a cash benchmark – the lowest risk portfolio. Their empirical results

suggest several diversification strategies that may have attractive risk-return trade-offs for

central banks.

Scherer and Gintschel look at currency allocation. The literature focuses on two problems

– wealth preservation and liquidity preservation – that are typically solved separately. Rather

than following each approach in isolation, the authors model the currency allocation decision

as a multi-objective optimisation problem, making explicit the trade-off between the two

objectives, and incorporating political constraints into the decision-making process.

Part II of the volume, Specifics of Risk Measurement and Management, contains

contributions that deal with more technical aspects of the risk management process. Nugee

and Dwyer introduce the concept of “whole enterprise” risk management. They first describe

risk management from a narrow financial risk control perspective. Then, they examine the

typical financial risks faced by a central bank, and critically review the traditional risk

methodologies in use. In the second part of the paper, they argue in favour of a wider

framework of risk management and corporate governance for the entire central bank,

Introduction 9

incorporating aspects of legal, operational and reputational risks in addition to the common

financial risks.

The papers by Grava and by Ramaswamy discuss issues related to diversification towards

corporate bonds and measurement of credit risk. Given the current environment –

characterised by low- yield, highly-rated government bonds – managers of official foreign

exchange reserves have started to consider higher-yielding alternative instruments. The

overall message is that the potential inclusion of higher-yielding securities in a central bank

reserves portfolio should not be discarded a priori, provided that the related risks are properly

measured and managed.

Grava studies the effects of adding corporate securities to reserves portfolios. He considers

only highly-rated investment-grade bonds, on the grounds that investment in lower-rated

securities might require specialised skills and resources not typically available at a central

bank. The main finding is that adding spread risk leads to better risk-return profiles than

increasing portfolio duration. Moreover, a long-term passive allocation to credit sectors,

coupled with the ability to tolerate short-term underperformance, generates significantly

higher returns in the long run.

Ramaswamy provides a framework to implement an internal credit risk model for reserves

management in a central bank. The model uses as input only publicly available information,

thereby providing a good compromise between accuracy and simplicity. The paper also

provides indicative values for the credit risk model parameters required for quantifying credit

risk.

The next three papers deal with market risk. Dynkin and Hyman describe the Lehman

Brothers market risk model. This is a multi-factor model, with the factor loadings rather than

the factors viewed as observables. The paper illustrates the advantages of such a methodology

and provides a good overview of its usefulness for risk management.

Bortje and van der Hoorn present a balance sheet approach to managing market risk. The

paper distinguishes two dimensions along which the financial strength of a central bank can

be measured: its profit-generating capacity, and its ability to absorb losses. A central bank’s

profitability can be gauged from the profit and loss account. Under simplifying assumptions

about exchange rates and yield curves, the paper argues that profitability is largely driven by

the size of the monetary base, the interest rate level, and operating costs. On the other hand,

the ability to absorb losses is found by comparing the potential loss (as measured by the

Value-at-Risk of the portfolio) with the total amount of reserves. The composition of the

balance sheet is subsequently optimised within a constrained maximisation framework.

Puschkarski develops a general procedure for decomposing time variation in portfolio

Value-at-Risk from one reporting period to the next. This decomposition occurs across three

main dimensions: time, market developments, and changes in portfolio allocation. A fourth

element, taking into account the interaction between these three dimensions, is also described.

Such analysis will help managers to set and monitor risk limits, and to understand how and

why they are occasionally breached.

Finally, we conclude Part II with a very general contribution on operational risk as relevant

to central banks. Embrechts, Kaufmann and Samorodnitsky note that operational risk

arises from inadequate internal processes and/or unanticipated external events, both of which

are highly relevant for central banks. Hence proper quantification of operational risk may

affect central bank reserve management, because the bank will generally want to react when

confronted with unanticipated catastrophic events. The paper first discusses issues related to

the availability and characteristics of operational risk data, and then, exploiting analogies

10 Introduction

between the nature of operational risk data and insurance losses, argues that statistical tools

from extreme value theory can be successfully applied to the modelling of operational risk.

Part III of the volume, Case Studies, contains contributions by risk managers from a

selected sample of central banks around the world. Rogers gives a broad non-technical

overview of the implementation of risk management at the ECB. The paper describes the

ECB’s financial position by examining a stylised balance sheet, illustrating the monitoring

and management of the main risks related to currency and interest rate movements.

Schmidt, Bauer, Koblas and Mochan describe how Cv

eská národní banka (CNB)

manages its foreign exchange reserves. CNB has the explicit objective of maximising returns

on its foreign reserves, subject to liquidity, market risk and credit risk constraints. The paper

describes the strategies adopted to achieve this objective, with special attention given to the

currency composition and the duration of the portfolio.

Ho illustrates the framework and the application of risk management to Hong Kong’s

foreign reserves portfolio. The paper starts with a brief historical overview of the Exchange

Fund – the body in charge of safeguarding the value of the Hong Kong dollar. It then moves

on to describe the risk management framework, the implementation of the strategic asset

allocation, and measurement of performance attribution.

The issue of performance attribution is taken up by the two subsequent papers. Zajac and

Simicak, from Národná banka Slovenska, and de Almeida, from the Central Bank of Brazil,

discuss in detail the methods used in their respective central banks to identify the sources of

differential returns in a portfolio with many assets and currencies. As these contributions

clearly point out, performance attribution is a key element in the risk management process. It

enhances the transparency of the investment process and ultimately leads to portfolios that

more closely reflect the general investment guidelines.

The volume ends with two contributions from the Central Bank of Venezuela (CBV) and

the Bank of Israel. Delgado, Martínez, Osorio and Pabón discuss the methodology in place

at the CBV for the risk, return and liquidity management of CBV international reserves.

Liquidity management is particularly challenging in Venezuela since the country’s

international reserves are mainly determined by oil exports, which represent a significant

source of volatility. Assouline presents a method to determine the target duration of the Bank

of Israel’s dollar portfolio using a shortfall approach. The method requires the portfolio

manager to set three preference parameters, which reflect the bank’s risk aversion, and

calculates the optimal portfolio duration implied by these parameters.

In closing, we would like to thank all of the authors who contributed to this volume. In

compiling it, we have attempted to convey a sense of the excitement presently associated with

risk management in central bank foreign reserves contexts, as cutting-edge techniques from

private sector asset management are adapted to central bank environments. Indeed, the

contributions make it clear that best practice central bank reserves management is already in a

state of flux, owing to improvements in asset management techniques and decreasing supplies

of government bonds. To minimise the costs of holding reserves while observing liquidity

and other constraints, central banks are now adding non-government bonds to their

investment universe, and are increasingly using active asset management strategies,

employing modern performance attribution and risk decomposition methods to evaluate

performance. We hope that the volume stimulates additional discussion and provides a

blueprint for additional improvements.

1 GENERAL FRAMEWORK AND STRATEGIES

12 Cardon and Coche

Strategic asset allocation for foreign exchange reserves1

Pierre Cardon and Joachim Coche

Abstract

This paper discusses a possible blueprint for the management of the foreign reserves’

strategic asset allocation. At the outset we address the importance of a sound organisational

set-up. A three-tier governance structure comprising an oversight committee, investment

committee and actual portfolio management is one approach whereby asset allocation

decisions can be efficiently implemented. In a second step, we focus on the design of

investment philosophies, which translate general policy requirements into concrete

objectives and constraints required when establishing the long-term risk return profile.

Finally, a quantitative framework for deriving the actual asset allocation is developed.

1 Introduction

Central banks hold foreign exchange reserves for a variety of reasons, one of which is to

maintain the capacity to intervene in exceptional circumstances in currency markets. Another

is to provide liquidity to support currency boards and fixed exchange rate regimes. With the

aim of reducing external vulnerability, foreign reserves holdings also take into consideration

the country’s external debt. Furthermore, reserves serve as a store of national wealth. Central

banks have to choose an appropriate strategic asset allocation of the foreign reserves in

agreement with these general policy objectives. An important consequence of the chosen

asset allocation is its impact on overall performance and risk over time, as shown by many

empirical studies.2

Strategic asset allocation can be defined as the long-term allocation of capital (wealth) to

different asset classes such as bonds, equity and real estate. The aim is to optimise the risk/

return trade-off given the specific preferences and goals of an individual or an organisation.

For central banks’ foreign reserves portfolios, the asset allocation process typically comprises

decisions on the currency composition and, within each currency, on the allocation to various

fixed income asset classes, mainly government bonds and other highly liquid, highly secure

instrument types.

Although it is to be expected that a strategic asset allocation decision will be effective over

the medium to long term, the allocation might be reviewed and revised in the light of

changing investment opportunities. Despite these revisions, strategic asset allocation does not

aim to generate superior returns compared to a market index by moving in and out of asset

classes at the most beneficial time.3

Rather, the strategic asset allocation process transforms

1 The views expressed in this article are those of the authors (Pierre Cardon (BIS) and Joachim Coche (ECB), and do not

necessarily reflect those of the Bank for International Settlements or the European Central Bank. 2 For example, Ibbotson and Kaplan (2000) show that asset allocation decisions explain about 90% of the variability of

returns over time. 3 Such a market timing strategy may be implemented by using a tactical asset allocation over a short to medium-term

horizon.

1

14 Cardon and Coche

goals and risk return preferences into the long-term optimal proportions of individual asset

classes.4

In the context of reserves management, strategic asset allocation may be seen as a

three-step process.

In the first step, we will show the importance of a sound organisational set-up for managing

reserves efficiently. In terms of an active investment style, we will argue for a three-tier

governance structure where the responsibilities for strategic, tactical asset allocation and

actual portfolio management are clearly segregated. Once in place, this framework will

facilitate a disciplined implementation of the asset allocation decision and should help in

clarifying accountability, managing risks and promoting a risk awareness culture across the

organisation.

In the second step, we will discuss three alternative investment philosophies for central

banks whereby policy requirements can be translated into investment principles. We will first

look at the individual currency approach, where the primary objective for reserves

management is to ensure efficient risk-return combinations on the level of individual

currency sub-portfolios. Alternatively, the base currency approach explores diversification

effects on the level of aggregated reserves as measured in the central bank’s domestic

currency or another base currency such as Special Drawing Rights (SDRs) issued by the IMF.

In contrast to these first two asset-only approaches, the asset and liability perspective seeks to

derive objectives by taking into consideration central banks’ ability to bear financial risks and

or the country’s external debt.

In the third step, the reserves’ long-term risk-return profile is derived from the previously

established investment principles. To this end, we discuss a model-based approach in order to

establish a strategic asset allocation and risk budgets for active management. Such a

quantitative process, in our example essentially a basic one-period mean-variance

optimisation, would be the most objective, long-term estimate for fulfilling the investment

principles. It also offers the advantage of disburdening decision-makers, who are responsible

for the design of monetary policy, from having to make concrete investment decisions beyond

specifying preferences and policy requirements. However, we will argue that such a

quantitative investment process should not be followed mechanically. Instead, all results

should be subject to an extensive validation process before a strategic asset allocation is

finally decided.

The paper is organised as follows. Section 2 describes an organisational set-up which

ensures effective governance and implementation of day-to-day reserves management.

Section 3 discusses how policy requirements can be transformed into concrete objectives and

how constraints for strategic asset allocation can be codified in the Statement of Investment

Principles. Based on this, Section 4 outlines a quantitative process for strategic asset

allocation. Finally, Section 5 concludes this paper.

4 In recent years, discussions have focused on broadening the strategic asset allocation towards a more comprehensive

risk budgeting approach. When establishing asset class weights, the risk budget approach simultaneously determines the

optimal leeway for active management, and thereby explicitly accounts for diversification effects between benchmark risk

and active management risk (Chow and Kritzman, 2001). Risk budgeting could also be seen as a technique for tracking the

risk per unit of return.