Risk Management for Central Bank Foreign Reserves by Carlos, Pierre Cardon, Joachim Coche, Francis X. Diebold

By Carlos, Pierre Cardon, Joachim Coche, Francis X. Diebold and Simone Mangan Elli Bernadell

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This view should however be reconsidered. Modern portfolio management techniques and portfolio risk monitoring systems have made leverage a meaningless concept because leverage can no longer be defined without significant controversy. The intent of leverage constraints was always to put a cap or upper boundary on 11 See Kealhofer, 1999. Thoughts on investment guidelines 41 the risk level of the whole portfolio. This made a lot of sense when methods of risk measurement were in their infancy or when theoretical measures of risk were impossible to implement owing to technological or information constraints.

Credit quality restrictions have a potentially negative impact on portfolio performance, however, because they are often viewed a substitute for liquidity concerns and for capital preservation concerns. As discussed earlier, a high credit rating implies absolutely nothing about market liquidity, and can give the investor an totally unwarranted comfort level about future expected returns if the security contains embedded options. Thus, the problem with constraining portfolios to contain only investment-grade credit quality is that it does not address liquidity or the predictability of returns associated with embedded options.

A common investment restriction in currency overlay programmes allows only for the decision whether to hedge, partially hedge, or not hedge at all the currency exposure from a given foreign currency-denominated bond. This is too restrictive and violates many of the concepts of modern portfolio risk management. A better approach is to set a risk target or upper bound estimated risk limit for the total risk of the currency portfolio based on some measure of VaR or a standard-deviation method of assessing risk.

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