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Strategic Asset Allocation: Balancing Short-Term Liquidity Needs and Real Capital Preservation for Central Banks

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Abstract

The typical central bank strategic asset allocation is mainly focused on attending short-term liquidity needs, but has secondary consideration for real capital preservation criteria. It is well surveyed that though “conservative and very liquid” allocation of foreign reserves to US short-term treasuries, for instance, provides timely and relatively stable access to funds, it is costly in terms of falling behind the adjusted inflation or GDP growth value of foreign reserves. In fact, the probability of the typical Central Bank portfolio (consisting of US 0–3 year treasuries) of suffering negative real returns in a long-term horizon amply exceeds the chances for a typical pension portfolio allocation (60% stocks/40% fixed income). Summers (2007) finds that for a 10 year holding period the probability of having negative real returns investing in US short-term treasuries is 38%, whereas for the pension portfolio it lowers to 12.5%. Not only the probability but the size of the average loss in real terms increases, from −2.3% to −7.7%.

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... More importantly, they assume that such costs are linear in the amount traded and, hence, do not account for market impact. Bonza et al. (2010) propose balancing liquidity needs and real capital preservation for reserves held by Latin American central banks, for which the risk of capital flow reversal is an important concern. While the authors fall short of precisely explaining the sequence of their methodology, they seem to split central bank reserves into two tranches. ...
... The authors assume that this minimum liquidity threshold, labelled as the Barrier of Critical Liquidity (BCL), is equivalent to the sum of 100% of short-term debt, 10% of base money and 20% of imports. In order to assess the probability of breaching the BCL, Bonza et al. (2010) implement a contingent claims approach proposed by Gray (2007), who estimated the comprehensive economic balance sheet using a put option valuation approach. Bonza et al. (2010) argue that such an approach allows the central bank to monitor the so-called 'distance to a liquidity crisis', which serves as an early warning indicator of potential short-term liquidity needs. ...
... In order to assess the probability of breaching the BCL, Bonza et al. (2010) implement a contingent claims approach proposed by Gray (2007), who estimated the comprehensive economic balance sheet using a put option valuation approach. Bonza et al. (2010) argue that such an approach allows the central bank to monitor the so-called 'distance to a liquidity crisis', which serves as an early warning indicator of potential short-term liquidity needs. If the probability of a liquidity crisis is deemed low, any excess reserves above the BCL (i.e. ...
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