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Sovereign Wealth and Risk Management. A New Framework for Optimal Asset Allocation of Sovereign Wealth

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  • Bodie, Zvi
  • Brière, Marie
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    Abstract

    This paper sets out a new analytical framework for optimal asset allocation of sovereign wealth, based on the theory of contingent claim ana lysis (CCA) applied to the sovereign’s economic balance sheet. A country solves an asset-l iability management (ALM) problem between its sources of income and its expenditures. We derive analytically the optimal asset allocation of sovereign wealth, taking explic it account of all sources of risks affecting the sovereign’s balance sheet. The optima l composition of sovereign wealth should involve a performance-seeking portfolio and three hedging demand terms for the variability of the fiscal surplus, and external and domestic debt. Our results provide guidance for sovereign wealth management, particula rly with respect to sovereign wealth funds and foreign exchange reserves. A real-life ap plication of our model in the case of Chile shows that at least 60% of the Chilean asset allocation should be dedicated to emerging bonds, developed and emerging equities. Ch ile’s current sovereign investment is under-diversified.

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    Bibliographic Info

    Paper provided by Paris Dauphine University in its series Economics Papers from University Paris Dauphine with number 123456789/7874.

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    Date of creation: May 2013
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    Handle: RePEc:dau:papers:123456789/7874

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    Keywords: Central Bank Reserves; Sovereign Wealth Funds; Asset-Liability Management; Contingent Claim Analysis; Balance Sheet;

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    1. Serkan Arslanalp & Yin Liao, 2013. "Contingent Liabilities and Sovereign Risk: Evidence from Banking Sectors," CAMA Working Papers 2013-43, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
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    3. Beck, Roland & Rahbari, Ebrahim, 2011. "Optimal reserve composition in the presence of sudden stops," Journal of International Money and Finance, Elsevier, vol. 30(6), pages 1107-1127, October.
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    19. Kavonius, Ilja Kristian & Castrén, Olli, 2009. "Balance Sheet Interlinkages and Macro-Financial Risk Analysis in the Euro Area," Working Paper Series 1124, European Central Bank.
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