The choice of a multicurrency portfolio for a central bank: Bonds, eurodeposits, and forward contracts

Abstract

This study describes a Mean-Vkiunce framework to analyze the risk/reward tradeoffs involved in the selection of a multicurrency benchmark portfolio for a Central Bank. Standard portfolio selection techniques a la Markowitz [9] can be, to some extent, applied to the management of Central Bank reserves. There are, however, important additional considerations that have to be incorporated in view of the special role played by Central Bank reserves. The framework presented in this paper is a particular application of the traditional Mean-Variance analysis.1 Based on estimates of risk and return for each of the assets considered individually and in a portfolio context, this method allows to explicitly quantify the tradeoff between risk and return. This approach has also the flexibility to incorporate policy constraints as stated by a Central Bank. The efficient portfolios are the ones which provide the maximum return available at a given level of risk consistent with policy constraints on currency composition, limits on maturity, liquidity requirements created by the potential need for immediate action in the foreign exchange market when intervention is required, and other explicitly stated criteria. This study introduces the concept of a trade-based numeruire in which returns are defined and measured, and uses as an illustration a real-life situation where the numeraire used to deflate all returns is a basket of three currencies with the following weights: 40% U.S. dollar, 51% Japanese Yen, and 9% Deutsche Mark. The currency weights capture the importance of each currency in the structure of import flows. Within each local market, the menu of assets includes Govemment bonds of various maturities as well as short-term Eurodeposits to conform to traditional Central Bank portfolio management practices.2 When expressed in the numeraire, the returns on Government bonds are the result of the combined impact of both local interest-rate risk and exchange-rate