Foreign reserves´ strategic asset allocation

Despite foreign reserves´ strategic asset allocation relies mainly on Modern Portfolio Theory (MPT), the unique characteristics of central banks obliges them to articulate and reconcile typical optimization procedures with reserves´ management objectives such as providing confidence regarding the ability to meet the country´s external commitments. Moreover, further involvedness come from broad economic factors as diverse as the openness of capital and current accounts, external debt´s maturity and currency composition, and exchange rate regime. Therefore, in order to alleviate the divergence from theory and practice regarding foreign reserves´ strategic asset allocation, this paper describes the methodologies and procedures developed and employed by the Foreign Reserves Department of Banco de la República. The mainstay of the paper is a long-term-dependence-adjusted and non-loss-constrained version of the Black-Litterman model for obtaining the efficient frontier from a set of investments complying with safety, liquidity and return criteria, where the choice of the portfolio which maximizes utility makes use of an estimation of the Board of Directors´ risk aversion. Results exhibit the effects of the unique nature of foreign reserves management for emerging markets. Typical features of foreign reserves management by central banks, such as non-loss restrictions due to capital preservation objectives, result in increased complexity in the optimization process and in asset allocations significantly distant from standard MPT´s optimality.