Balancing Volatility and Returns in the Czech National Bank's Foreign Exchange Portfolio

This paper discusses the implications of possible changes in the composition of the Czech National Bank's foreign exchange reserves, which are large by international standards and account for about 98% of the CNB's assets and are thus crucial for its earnings. Starting from the allocation as of October 31, 2022, we test how the risk-return characteristics change under the following three hypotheses: (i) increasing the share of equities from about 18% to, for example, 20%, (ii) increasing the amount of gold to, for example, 100 tons (from about 0.5% to 4.5% of the reserves), (iii) reducing the share of euro-denominated assets from 46% to, for example, 40%. The results suggest that if asset prices followed the pattern of the last 20 years, increasing the share of equities to 20% would increase the expected return on the portfolio, while the volatility would increase only slightly. Next, increasing the amount of gold to 100 tons could increase the expected return on the portfolio, while its volatility, measured in Czech koruna, would decrease. Reducing the share of euro-denominated assets, on the other hand, could slightly increase the expected return on the portfolio but could also significantly increase the volatility of the returns measured in Czech koruna, and is therefore not appropriate.