BIS Papers No 58

Portfolio and risk management for central banks and sovereign wealth funds Proceedings of a joint conference organised by the BIS, the ECB and the World Bank in Basel, 23 November 2010

Banking

October 2011

JEL classification: E58, F33, G11

Papers in this volume were prepared for a conference organised by the Bank for International Settlements, the European Central Bank and the World Bank in Basel on 23 November 2010. The views expressed are those of the authors and do not necessarily reflect the views of the BIS or the institutions represented at the meeting. Individual papers (or excerpts thereof) may be reproduced or translated with the authorisation of the authors concerned.

This publication is available on the BIS website (www.bis.org).

Bank for International Settlements 2011. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated.

ISSN 1609-0381 (print) ISBN 92-9131-888-4 (print)

ISSN 1682-7651 (online) ISBN 92-9197-888-4 (online)

BIS Papers No 58 iii

Programme

Tuesday 2 November

09:00 Welcoming remarks by the organizers Bank for International Settlements (BIS), European Central Bank (ECB) and World Bank

09:15 Keynote address: Financial turbulence and international investment Robert Z Aliber, University of Chicago

Reserve management

Chair: Roberts Grava, World Bank

10:15 Managing foreign exchange reserves in the crisis and after Robert N McCauley and Jean-Franois Rigaudy, BIS

Discussant: Han van der Hoorn, IMF

11:30 Diversifying market and default risk in high grade sovereign bond portfolios Myles Brennan, Adam Kobor and Vidhya Rustaman, World Bank

Discussant: Fernando Monar, ECB

12:15 Sovereign credit scorecard Martin Hohensee, Deutsche Bank, Singapore

Discussant: Antonio Scalia, Bank of Italy

Break-out sessions

Active management Chair: Pierre Cardon, BIS

Portfolio construction Chair: Gabriel Petre, World Bank

14:30 Simple and optimal alpha strategy selection and risk budgeting Robert Scott, Schroder Investment Management, London

Including linkers in a sovereign bond portfolio: an HJM approach Ricardo Selves and Marcin Stamirowski, European Commission

15:00 Active portfolio management in the public sector Vahe Sahakyan, BIS

Hedging inflation risk with domestic investment and foreign currency in a developing economy Marie Brire and Ombretta Signori, Amundi, Paris

15:30 Explaining the returns of active currency managers Sam Nasypbek, World Bank, and Scheherazade S Rehman, George Washington University

Fundamental allocation for government bond portfolios Cyril Caillault, Lombard Odier Darier Hentsch Investment Managers, Geneva

iv BIS Papers No 58

Tuesday 2 November (cont)

Quantitative techniques Chair: Jean-Pierre Matt, BIS

Risk management Chair: Ken Nyholm, ECB

16:30 Optimal active portfolio management and relative performance drivers: theory and evidence Roberto Violi, Bank of Italy

An option theoretic model for ultimate loss-given-default with systematic recovery risk and stochastic returns on defaulted debt Michael Jacobs, Jr, Office of the Comptroller of the Currency, Washington DC

17:00 Portfolio optimization and long-term dependence Carlos Len, Central Bank of Colombia, and Alejandro Reveiz, World Bank

Securitization rating performance and agency incentives Daniel Rsch, University of Hanover, and Harald Scheule, University of Melbourne

17:30 Combining equilibrium, resampling, and analysts views in portfolio optimization Jos Luiz Barros Fernandes and Jos Renato Haas Ornelas, Central Bank of Brazil, and Oscar Augusto Martnez Cusicanqui, Central Bank of Bolivia

Stress testing central banks and sovereign wealth funds Himadri Bhattacharya, Tata Capital Limited, Mumbai; Jerome Kreuser, The RisKontrol Group, Berne; and Sivaprakasam Sivakumar, Argonaut Capital Partners LLC, Boston

Wednesday 3 November

Sovereign wealth management Chair: Evangelos Tabakis, ECB

09:00 Rethinking asset allocation for institutional investors Arjan B Berkelaar and Ali AlMansour, KAUST Investment Management Co, Arlington

Discussant: David Bolder, BIS

09:45 The impact of foreign government investments: sovereign wealth fund investments in the United States Elvira Sojli, Rotterdam School of Management, Erasmus University, and Wing Wah Tham, Erasmus School of Economics, Erasmus University, Rotterdam

Discussant: Solomon Tadesse, State Street Global Advisors

BIS Papers No 58 v

Wednesday 3 November (cont)

Reserve management Chair: Robert N McCauley, BIS

10:45 Is gold a hedge or a safe haven? An analysis of stocks, bonds and gold Constantin Gurdgiev, IBM and Trinity College, Dublin

Discussant: Natalie Dempster, World Gold Council, London

11:30 Brazilian strategy for managing the risk of foreign exchange rate exposure during a crisis Antonio Francisco A Silva Jr, Central Bank of Brazil

Discussant: Kurmas Akdogan, Central Bank of the Republic of Turkey

12:15

Should larger reserve holdings be more diversified? Roland Beck and Sebastian Weber, ECB

Discussant: Joachim Coche, BIS

13:00 Closing remarks

BIS Papers No 58 vii

Contents

Programme ............................................................................................................................ iii

Introduction...............................................................................................................................1

Financial turbulence and international investment Robert Z Aliber..........................................................................................................................5

Managing foreign exchange reserves in the crisis and after Robert N McCauley and Jean-Franois Rigaudy ...................................................................19

Diversifying market and default risk in high grade sovereign bond portfolios Myles Brennan, Adam Kobor and Vidhya Rustaman .............................................................49

Combining equilibrium, resampling, and analysts views in portfolio optimization Jos Luis Barros Fernandes, Jos Renato Haas Ornelas and Oscar Augusto Martnez Cusicanqui ......................................................................................75

Portfolio optimization and long-term dependence Carlos Len and Alejandro Reveiz .........................................................................................85

Including linkers in a sovereign bond portfolio: an HJM approach Ricardo Selves and Marcin Stamirowski ..............................................................................111

Inflation hedging portfolios in different regimes Marie Brire and Ombretta Signori .......................................................................................139

The role of SDR-denominated securities in official and private portfolios George Hoguet and Solomon Tadesse ................................................................................165

Optimal active portfolio management and relative performance drivers: theory and evidence Roberto Violi .........................................................................................................................187

Explaining the returns of active currency managers Sam Nasypbek and Scheherazade S Rehman ....................................................................211

An option theoretic model for ultimate loss-given-default with systematic recovery risk and stochastic returns on defaulted debt Michael Jacobs, Jr ................................................................................................................257

Securitization rating performance and agency incentives Daniel Rsch and Harald Scheule........................................................................................287

BIS Papers No 58 1

Introduction1

This volume is a collection of papers presented at the Third Public Investors Conference, which was jointly organized by the Bank for International Settlements (BIS), the European Central Bank (ECB) and the World Bank (WB). This event, which took place on 23 November 2010 at the BISs head office in Basel, brought together over 80 participants from more than 50 institutions comprising central banks, sovereign wealth funds and public pension funds.

The main aim of the current as well as previous Public Investor Conferences has been to create a forum where academics and private and public sector investment professionals can meet to discuss and ponder the issues of specific relevance to public sector investors. It is well recognized that public institutions differ markedly from their private sector peers in their investment activities. Investment rationales, preferences, eligible investments, governance structures and accountabilities as well as aspects relating to the availability of human and technical resources distinguish public investors. These idiosyncrasies have profound effects on how portfolio and risk management activities are organized and performed in public sector institutions.

Having discussed initial reactions to the financial crisis at the Second Public Investors Conference held at the World Bank in Washington DC, the 2010 Conference focused on how public investors are revising asset allocations and investment processes in response to the new financial market environment. Faced with high growth rates in foreign reserves and other pools of publicly managed funds, public investors