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.
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