This paper was written while the author worked in the Research Division, Funds Management and Banking Department, Bank of Canada.
Special Issue Paper
Liquidity, risk, and return: specifying an objective function for the management of foreign reserves†
Article first published online: 16 MAY 2012
Copyright © 2012 John Wiley & Sons, Ltd.
Applied Stochastic Models in Business and Industry
Special Issue: Special issue on ISBIS 2010
Volume 28, Issue 3, pages 175–193, May/June 2012
How to Cite
Romanyuk, Y. (2012), Liquidity, risk, and return: specifying an objective function for the management of foreign reserves. Appl. Stochastic Models Bus. Ind., 28: 175–193. doi: 10.1002/asmb.1921
- Issue published online: 18 JUN 2012
- Article first published online: 16 MAY 2012
- Manuscript Accepted: 20 FEB 2012
- Manuscript Revised: 18 JAN 2012
- Manuscript Received: 11 AUG 2010
- foreign reserves management;
- asset allocation;
- stochastic programming
Countries hold foreign reserves for various reasons, which include foreign-exchange intervention and liquidity provision. To ensure that reserves can meet their objectives, reserve managers employ strategic models to determine the optimal allocations of assets and, possibly, their associated liabilities over some investment horizon. An objective function is a key component of such models, and its specification is challenging in view of the specialized function of foreign reserves as insurance in crises. To this end, the author investigates how to translate the three common policy objectives for foreign reserves (liquidity, safety, and return) into objective functions for strategic reserves management. A strategic reserves management model is illustrated that trades off expected net returns with costs and liquidity issues related to a potential liquidation of a portion of the portfolio. The model is cast in a stochastic programming framework. Results indicate that liquidity preference affects both the initial asset allocation and the composition of the reserves being sold. An important policy implication is that if a portion of reserves has to be liquidated during a crisis, it may be optimal to sell assets with higher liquidation costs so as to remain with a more liquid portfolio in an environment of great market uncertainty. Copyright © 2012 John Wiley & Sons, Ltd.