Foreign Exchange Reserves – Protection Connected with Financial Risks

Foreign exchange reserves are indispensable for fulfilling the central banks’ statutory mandates. For some central banks their investment is in addition a major source of profit. However, holding the foreign exchange reserves exposes central banks to financial risks. Some of these risks are unavoidable and can be challenging to manage. Such risks may increase when central banks decide to invest part of their foreign reserves on the markets beyond the traditional scope of assets that hitherto have been perceived as safe and highly liquid. The increasing awareness of financial risks explains the popularity of dividing the reserves assets into sub-portfolios, i.e. tranching and a risk budgeting concept. Such frameworks are not a panacea for avoiding potential financial losses but could support well-structured financial risk management processes and assure more stable risk profile. But this framework works only with efficient decision-making process, adequate risk measures, and proper IT support—these are the classic challenges that central banks’ risk managers have to address.