Central Bank of Lithuania: Asset Allocation in a Risk Parity Framework

Abstract

This chapter reviews the Strategic Asset Allocation (SAA) at the Bank of Lithuania (BoL) and presents its transformation from a capital preservation approach based on historical data to a new framework which rests on three pillars: a forward-looking regime aware asset return simulation procedure, a risk budget, and a risk parity concept. A comprehensive review of the theoretical and practical aspects of the new framework is presented, paying special attention to the analysis of advantages and disadvantages based on practical experience in a central bank context. The potential of the current SAA framework at the BoL to strike the balance between the diversification, search for yield and the risk-on and risk-off nature of the markets is demonstrated. The analysis explores potential directions for further development of risk parity-based asset allocation. The considerations are given to merits of moving from an asset-based risk parity toward one that is founded in risk factors or in a hierarchical clustering. The possibility of replacing the volatility diversification with a tail risk diversification approach is emphasized as a way of alignment of asset allocation with the fact that central bank’s investment portfolio is, in its essence, a portfolio for “rainy days”.