Decomposing exchange rate risk of Chinese foreign exchange reserves

Abstract

Exchange rate risk is one of the most important risks that Chinese government must face when dealing with foreign exchange reserves (also called Forex reserves). In order to meet the requirement of Forex reserves management, Forex reserves decomposition is required because it can offer the way each asset and its marginal change influence the whole exchange rate risk of Forex reserves. So this paper presents global ordinary least squares method, asymmetric response model and adjusted conditional mean model to decompose the exchange rate risk of Forex reserves. Empirical study shows that under extreme market circumstance the marginal changes of assets add more exchange risk to Chinese Forex reserves than normal market circumstance; all assets increase the exchange rate risk to the Chinese Forex reserves; and the new added asset doesnpsilat obviously diversify the exchange rate risk of Chinese Forex reserves.