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The following decisions were made:. Based on the in-depth research conducted, the Discourse has found that individual spot forex electronic transactions contain elements of usury riba in the imposition of rollover interest, resemble a sale contract with credit term by way of leverage, is ambiguous forex online analytics terms of the transfer of the possession of items exchanged between the parties, include the sale of currency that is not in possession as well as speculation that involves gambling. Furthermore, it is also illegal under the laws of Malaysia. In relation to the above, the Discourse has agreed to decide that the hukum islam main forex individual spot forex electronic transactions are prohibited as they are contrary to the precepts of the Shariah and are illegal under Malaysian law. Therefore, the Muslim community is prohibited from engaging in forex transactions such as these. The Discourse also stressed that the decision made is not applicable to foreign currency exchange operations carried out at licensed money changer counters and those handled by financial institutions that are licensed to do so under Malaysian law. Click here to view.

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Most central banks which adhered to the gold standard in the Interwar period strove to maintain a set ratios between their gold reserves and foreign exchange holdings and the banknotes and short term paper they issued It determines the ability to meet the shortest term obligations in case of hindered access to new foreign currency sources.

Authorship of the indicator is ascribed to former Argentine finance minister Pablo Guidotti Where balance of payments current account deficits are high, the part of deficit seen as unstable and unsustainable in the long term boosts the ratio. Foreign liquidity position is assessed on the basis of a broad circle of possible values of related financial variables ex- change rate, basic commodity prices, and debt interest, inter alia. Lizondo, C.

Do Indicators of Financial Crises Work? Wijnholds, A. The Theoretical Foundations ability e. Tables below present the state of some of the aforementioned in- dicators. Note: Data relate to the close of They are an important part of the overall analysis of financial stability.

The Theoretical Foundations Chapter Two Financial Asset Risk and Return Foreign reserve management by modern central banks is a proc- ess which employs financial asset investment theory, and this Chap- ter presents a basic set of the concepts and terminology used by the BNB.

A resume summarizes accumulated modern knowledge in in- vestment portfolio management and yield curve theories. Financial Assets Chapter One explained that central banks keep reserves in foreign currency, financial assets, and gold. This Chapter presents BNB views on financial assets. Financial assets have tangible expressions one may see or touch, such as land, buildings, or other chattels.

They are paper, and ever more electronic, records of certain ownership title, holder rights. In essence these rights concern the distribution of income from diverse origins and forms. Financial assets distribute and redistribute income created by business, within households, or arising from government. Financial assets defer consumption by some economic agents, and hasten current consumption by others.

They are a conduit be- tween those agents who create deficits in their business and those who create current surpluses. They may serve as ways of assuming risk or guarding against it, since the income generated and distrib- uted among agents may be dependent on a certain event. The simplest financial asset features fixed interest. It sets up a relationship where a party is obliged to pay a defined sum on a de- fined date.

Financial Asset Risk and Return hand. Fabozzi 40 lists two main subgroups of fixed interest income assets: debt and privilege shares. Debt includes bonds, mortgages, equity backed bonds, and bank loans. In managing foreign reserves, central banks traditionally invest in fixed income financial assets, and moreover in tradable debt most often issued or underwritten by for- eign governments or supranational bodies. Naturally, some central banks and other public bodies may also invest in assets not featur- ing fixed income.

For instance, the Hong Kong central bank has in- vested in foreign equity and in the Norwegian Petroleum Fund. Types of Asset Risk41 Central banks face manifold risks when investing foreign re- serves. They stem from the objective natures of financial assets and the international financial markets where they are traded.

Financial risks ought to be thoroughly understood, defined, quantitatively clas- sified, and managed. This is an ongoing and complex process. Be- low we restate that, in the broadest sense, risk for financial market participants arises from the conditions of insecurity under which they have to implement investment decisions. Investment risk reflects the degree to which an asset or a portfo- lio of assets is open to risk.

Risk factors are reasons for uncertainty as to the eventual income at the close of the investment horizon. They are parameters which determine the probable distribution of return. These risk factors define the main risks to which a financial asset or asset portfolio is subject: currency risk; interest rate risk, and credit risk.

Currency and interest risks are varieties of market risk, being functions of evolutions in important market variables such as ex- change rates or base rates. Market risks may lead to occasionally temporary falls in the market value of an asset. Each participant in the financial markets is subject to the risk of imbalance between the structures of his assets and liabilities.

Below are definitions of the most widespread types of risk in finan- cial asset or portfolio management. Currency Risk. This is the danger of losses resulting from a change in the exchange rate of the currency in which the asset is priced against the base currency in which financial results are ac- counted. Currency risk for each financial institution stems largely from the difference between the currency structures of assets and liabili- ties, and ought not to be linked exclusively with assets, as is often done.

The greater the currency structure disparities between assets and liabilities, the greater the risk the institution courts. Interest Rate Risk. This is the danger of falls in the market value of fixed income paper bonds stemming from changes in the yield curve. Modified duration42 is a basic measure of interest rate risk. Since interest risk is undoubtedly the most significant risk factor in bond portfolio management, we exam- ine it in detail further below.

Credit Risk. This is the danger of an irrecoverable partial or com- plete loss of the market value of a given asset resulting from insol- vency or bankruptcy on the part of the issuer or debtor. Due to its irreversibility, credit risk is seen as one of the gravest risk factors in asset management.

It is impossible or very hard to determine quan- titatively. Financial Asset Risk and Return analyses, ratings agencies assign credit ratings to public companies, and especially to financial institutions. These ratings are measures of the credit risk an institution carries. Alongside this, ratings agencies prepare and publish comparative tables on credit rating evolution. These matrices comprise the probability of a credit rating cut or of direct bankruptcy over a set period say, a year for companies grouped by credit ratings.

Probabilities are extrapolated from histori- cal data. Ratings are crucial in central bank asset management credit risk analysis and assessment. Spread Risk. This is the danger of loss stemming from changes in the yield curve spreads of assets subjected to credit risk against the benchmark government bond yield curve.

All fixed interest paper not issued by a government is subject to spread risk. Some analysts view spread risk as market related, while others see it as credit re- lated. We feel it is essentially much closer to market risk. Apart from the aforementioned risks, many other and often no less significant dangers attend financial asset or portfolio management and foreign reserve management in particular.

They affect liquidity, operations, the law, the model used, and reputation. Liquidity Risk. This is the danger of a company, and particularly a financial institution, not having enough liquidity to meet its obligations. Liquidity risk management is particularly important in every central bank. The second expression of liquidity risk is in the danger that a finan- cial institution may not be able to sell its assets at fair prices, or within set or reasonable timescales. Because of this, central banks usually keep the greater part of their assets highly liquid and low risk.

Operational Risk. The Theoretical Foundations tempts at fraud or abuse of privilege. Operational risk is regarded as among the most hazardous forms of risk; it is hard to quantify and there are as yet no widely accepted models of measuring and man- aging it. History shows that where operational risk rears its head, large companies can go to the wall. Operational risk is mostly man- aged by implementing clear rules, separating payments from trans- actions, establishing independent control and internal audit, account- ing independence, and clear organizational structures preempting conflicts of interest.

Model Risk. This is the danger stemming from models which fail to describe reality well enough. Relying on such models and using them in practice would lead to wrong conclusions and potential financial loss. Model testing is particularly important in managing this type of risk. Literature very often classifies it as part of operational risk. Reputation Risk. As re- gards central banks, it would manifest itself in the partial or complete loss of confidence in a central bank, in turn eroding confidence in the local currency and boosting demand for foreign currencies.

Interna- tionally, reputation risk would complicate relations with business part- ners and lower market quotations or cause them to be withheld. Legal Risk. Broadly present in every business, this type of risk is the danger of losses as a result of poor awareness of legislation gov- erning transactions. Central banks are exposed to legal risk in man- aging foreign reserves because some or all transactions are subject to foreign statutes which may not dovetail with national ones.

This calls for detailed study of specialist foreign legislation. Communications advances in the s put financial markets across the world into a single information environment. World trade in goods is growing even faster than world GDP. Regional diversification is ever harder to sustain, with most institutional investors seeking diver- sification based on asset and financial product groups. Financial Asset Risk and Return Structural changes to world financial markets since the s set new challenges in the form of systemic financial crises.

Systemic cri- ses combine high exchange rate fluctuations and banking and eco- nomic crises with sudden switches in financial asset liquidity. Thus the past seven years witnessed events whose financial market con- sequences were unprecedented in scale. Two South East Asian and Russian financial crises of and caused record asset price and exchange rate fluctuations, as well as record risk spreads.

To protect financial markets from further contagion, in the Fed cut interest rates by 25bp and led the rescue of the Long Term Capital Management hedging fund43 whose foreign positions including off- balance sheet ones had reached over USDb. The largest US equity market correction since came in After the dotcom bubble burst alongside related irrational expectations of future high tech sector earnings, equity investors lost almost half the value they had accumulated.

The credit for the failure of such a huge loss to cause serious shocks in the global business cycle goes to the ener- getic Fed policy of cutting interest rates by a record bp in a year, starting at 6. Aggressive bp cuts by the ECB accom- panied this. The Yield Curve 3. It is calculated based on the assump- tion that, theoretically, the returns are normally distributed.

After the end of the investment horizon, it may turn out that the actual or so-called realized return differs from the expected. The probability to realize return different form the expected one is called 43 LTCM was a closed type investment fund managed by Nobel Prize winning economists Robert Merton and Myron Scholes. The Theoretical Foundations investment risk and is measured by standard deviation volatility of the return , or other risk measures.

In case some particular return, specified in advance in the investment objectives of a given portfo- lio, need be attained — the so-called target return, naturally the invest- ment risk comes to be the probability to receive return different from the target one.

Yield Curve A key concept for the fixed income assets markets is the yield curve. It is comprised of a set of points defining the relation between the return on a financial asset and its time to maturity. A starting point for all parties involved in the investment process is the so-called benchmark yield curve — the one which shows the yields of the most recently issued government bonds.

The Eurozone benchmark curve comprises French government bonds for the maturity sectors up to one year and German government bonds for the maturities longer than one year. The current yield levels of the curve are also known as spot yields in order to differentiate them from the so called forward yield curve, another important concept on the fixed income markets, which shows the announced or contracted future yields of the same type fixed income securities which are to be issued.

Financial Asset Risk and Return There exist mathematical relations between the spot and forward yield of securities. Figure 2 Spot rates Forward rate nfm is the rate which we negotiate today and which we will receive each period in the course of m periods if we give out a loan commencing after an n number of periods.

Formula 2 shows that the spot rates are in fact the geometric mean of the single-period forward rates. From formulas 1 and 2 follows that we can define forward ates using spot rates and vice versa. The yield curve is used to determine the prices of the bonds traded on the financial markets because the spot rates are used in forming the discount factors for calculating the present value of the cash flows. Financial Asset Risk and Return Figure 5 Price of a coupon bond at moment t In the formula, the variable t is an independent variable both for the price of the bond and the level of the spot rates in order to under- score that the latter change with time.

The relative change in the price of a bond between two moments in time, t0 and t1, determines the return on that bond Rt0,t 4. It is obvious from formulas 3 and 4 that, if we are at moment t0, in order to calculate the return on the bond at moment t1, it is neces- sary to forecast the yield curve at that future moment. Because of this, the market participants use the expected return on the bonds in for- mula 4 in order to determine the expected price of the bond P t1 at moment t1.

Within a future, even if particularly defined, investment horizon, however, the yield curve is only probabilistically determined and de- pends on different factors. In the first place, these are the expected changes in the short-term interest rates. The aforementioned central banks make decisions with respect to the in- terest rates based on the expected deviations of the current inflation levels from the implicitly or explicitly defined inflation target.

Another 44 This formula is valid when there is no coupon payment in the period under consideration. The Theoretical Foundations factor that informs their decisions regarding the short-term interest rates is the extent of deviation of the current GDP level from the po- tential one or the so-called output gap The second factor that determines the yield curve is the level of uncertainty embedded in the expectations of the market interest rates.

This uncertainty stems from the fact that the future levels of the short- term interest rates are unknown and from the reaction of the central bank to shocks. The uncertainty leads to an increase of the term risk premium for the different maturity sectors.

Thirdly, the yield curve is also affected by a host of factors related to the long-term interest rates. These are the expectations for: the long- term inflation rate, the productivity of labor in the economy, the poten- tial rate of economic growth, the demographic features of the popula- tion and the structural fiscal position of the governments in the USA, EU and Japan the so-called structural deficit.

The changes in the above- listed factors affect the long-term interest rates — usually in the sectors over 5 years. In the last decade, a couple of persistent trends in the factors de- termining the yield curve became salient. In the first place, there is a tendency for a global reduction of inflation rates related to the enforce- ment of rules on monetary policy of central banks, the focus of the central banks, mandate on price stability, and an increase in the mon- etary policy know-how.

With the introduction of stricter discipline and of subordination of the fiscal policy to dynamic rules in most industri- alized nations, a reduction of the structural fiscal deficits was accom- plished. At the same time, the ubiquitous financial liberalization induced globalization of the financial markets and flows, which, in turn, contrib- uted to the lasting reduction of the long-term interest rates and an in- crease in the interdependence of the prices of financial securities in the different parts of the world.

The unprecedented decrease in interest rates to record lows over a very short period of time that was undertaken by the two leading central banks spurred a record increase in the value of fixed income securities investments worldwide. This is an unprecedented value compared to the historical return realized from investing in fixed income instruments.

It is the result of an extraordinary clustering of events re- lated to the aggressive reaction of the central banks and the congru- ence in the cycle of the world interest rates observed in that period. As mentioned above with regard to the factors determining the monetary policy of central banks, the short-term interest rates have procyclical behavior.

In times of boom the interest rates rise, and in times of recession they fall. Because of that we cannot expect inves- tors in fixed income securities, especially central banks, to always re- alize such a high return for such a short time. In case of reversal in the cycle of interest rates in the next years, the return form investment in fixed income bonds is bound to decline. The extent of this decline depends mostly on how fast the interest rates go up and on how pro- longed this increase is.

Yield Curve Theories and Empirical Evidence Several theories have been created to explain the changes in ex- pected return on bonds. The most popular of these are the pure ex- pectations hypothesis, the liquidity preference theory, and the pre- ferred habitat theory. Pure Expectations Hypothesis One of the earliest theories that comes to explain the shape of the yield curve, as well as to predict the future spot rates, is known as the Pure Expectations Hypothesis PEH According to it, the expecta- tions of the market participants are reflected in the current yield curve and can be extracted from it using forward rates.

More precisely, a key assertion of this theory is that the forward rate for a given future period, which is embedded in the yield curve today, equals the ex- pected future spot rate for the same period. The Theoretical Foundations From formula 5 follows that the expected change in the m-period spot rate i. Moreover, by the shape of the yield curve we should be able to determine what the future behavior of spot rates would be.

In Fig. Figure 6 Shapes of the yield curve Based on formulas 2 and 5 it can be shown that when the yield curve grows with maturity Fig. When the yield curve has a shape similar to that in Fig. When the yield curve has a shape as in figure 6c, according to PEH, the market participants expect future spot rates to fall. Another key corollary of PEH is that the expected return on all bonds is one and the same regardless of their maturity.

In other words, according to this theory, the investors will require one and the same return, no matter the maturity. In this sense, the long-term and short-term bonds are viewed as perfect substitutes. Financial Asset Risk and Return plete certainty or that investors are indifferent to the market risk they take. As both conditions are unrealistic, another hypothesis which does not necessitate these assumptions is later proposed. The Liquidity Preference Theory The liquidity Preference Theory LPT introduced by Hicks asserts that the forward rates contain additional information apart from the expectations of the market for the future interest rates.

Ac- cording to this theory, investors are not indifferent to risk but try to avoid it unless compensated for taking it. The theory assumes that for short investment horizons49 the long-term bonds are riskier than the short-term bonds since the latter are more sensitive to changes in the interest rates. That is why for the investors to be willing to invest in long-term bonds, they need to receive a positive premium added to the expected return in order to make higher income.

An alternative interpretation of the higher expected return sought after is that investors seek compensation via positive income because of loss of liquidity due to investing in a longer-term bond. The reasoning for both formula 7 and 8 is built around the fact that they both depend on the time to maturity of the long-term bond or, respectively, on the number of periods m over which interest is compounded. The longer the bond, the greater the premium since the probability for change in the short-term interest rates is greater.

Ac- cording to LPT, however, the premiums are constant over time. Un- fortunately, though this theory does specify the sign of the premiums, it does not say anything as to how determine their size. A chief source of criticism against this theory is the fact that al- though the long-term bonds are riskier than the short-term bonds for a short horizon due to the greater capital risk of the former, the case may be just the opposite for long-term horizons. This stems from the 49 I.

The Theoretical Foundations fact that the strategy of buying short-term bonds on a rolling basis till the end of the long-term horizon has reinvestment risk which, de- pending on the length of the horizon may be greater than the capital risk of the strategy of holding the long term bond to maturity. The PHT allows either positive or negative premiums and their size is determined by the demand and supply of bonds in a given maturity sector.

For instance, the institutional investors such as pension funds usually prefer bonds in the long-term sectors whereas banks could prefer the short-term sectors. Moreover, if an institutional investor is to move from one preferred maturity sector to another, it would seek higher return.

Figure 7 schematically summarizes the three theories and their assertions. As of late, the view that both types of premiums are essentially risk premiums is gaining momentum; hence both the size and the sign of the premiums depend on whether, at a given moment, the investors deem the longer-term bonds riskier than the shorter-term bonds or vice versa.

Financial Asset Risk and Return Empirical Evidence Classical empirical tests of the theories reviewed above have been conducted by Fama and Bliss 50, Campbell and Shiller 51, and later again Fama In an attempt to verify the theoretical conclusions using monthly data on the spot and forward rates spanning a period of nearly 40 years, Fama and Bliss establish that for short periods up to 1 year the forward interest rates do not possess significant prediction power over the realized spot interest rates.

With the increase of the length of the period forecast to an interval from 2 to 4 years, the one-year forward interest rate inferred from the four- and five-year spot rates significantly increases the precision of its prediction. The authors explain the behavior observed with the presence of a risk premium which is variable over time but averages to a constant. However, the recent empirical research conducted by Fama , which wields monthly data over a considerably longer pe- riod — observations span the period —, rejects the former findings of Fama and Bliss.

The period can be factored into two subpeiods. During the first period — , a there is a marked trend for rise of the spot rates, which peak in late During the second period — , the reverse trend of fall in spot rates is observed. Within each subperiod, the quality of predictions using PEH for long-term horizons is comparable and indeed good, but when the whole period is taken under consideration, the quality of predictions considerably deteriorates.

Fama explains this fact alleging that although interest rates do have the property to tend to some mean level, this very level is not stationary but changes over 50 Fama, E. American Economic Review, Vol. The Review of Economic Studies, Vol. The Theoretical Foundations time. Because of that the spot rates locally tend to the current long- term interest rate level. The lack of stationarity is due to the influence of unforeseeable shocks on the current mean level caused by struc- tural changes in the economy or monetary policy which have taken place in the meantime.

These shocks have been previously dis- cussed in the text above. Due to the unpredictable nature of these shocks, the market participants cannot reflect them neither in the expected changes of the spot rates, nor in the requisite risk premium. Campbell and Shiller in research similar to that by Fama and Bliss use monthly data for the period — and prove that the spread between long-term and short-term interest rates does not posses prediction power for horizons shorter than 3—4 years. Hence the empirical evidence rejects the Pure Expectations Hypothesis for short-term horizons.

For long-term horizons, similarly to the findings by Fama and Bliss, the empirical evidence does not reject the Pure Expectations hypothesis. In order to explain the inability of the Pure Expectations Hypothesis to account for the realized interest rates, the authors assume that the size of the term risk premium between the long- and short-term interest rates varies over time depending on the changes in short-term interest rates. Another classical empirical study analyzing the factors deriving the yield curve dynamic was conducted by Knez, Litterman and Scheinkmann This fact naturally turns the yield curve level and slope into candidates for variables in the estimation of the expected yield curve changes.

Thus, information conditional on the current market informa- tion on these two variables should be sought. Other variables oftentimes used for conditional estimation of the expected change in spot rates are the difference between forward and spot rates or the combination of forward rates.

Litterman and J. Financial Asset Risk and Return For short-term horizons ranging from a few months to a year, how- ever, most of these models cannot manage a statistically significant improvement of their prediction power compared to the simplest econometric model — random walk.

According to that model, the yield curve has an expected change of 0, i. This makes the random walk model often used for estimating the expected return on bonds. Fundamentals of the Contemporary Portfolio Management Theory Harry Markovitz 54, is the founder of modern portfo- lio theory.

According to him, we have a choice between two alternative ap- proaches when constructing an investment portfolio of securities. The first alternative is to maximize the expected return given a fixed level of risk variation ; the second alternative is to minimize the expected risk given a level of expected return. Later, portfolio theory undergoes further development.

The model by Markovitz is based on a single period optimization and is based on the assumption that economic agents make decisions in each investment interval regardless of the actual return in the preced- ing interval. In practice, however, the actual returns and variations in the different time intervals are interconnected. They are based on multiperiod 54 Markovitz, H.

Journal of Finance, Volume 7, Issue 1, March , pp. The Theoretical Foundations optimization. On the whole, despite the various modifications and development, the optimization based on risk and expected return forms the core of nowadays portfolio theory as well. American Economic Review 60, — Journal of Business 41, pp. Process Organization Chapter Three Process Organization As the prior Chapter shows, foreign reserve management by a modern central bank is a routine investment process.

Yet however routine it may be, central banks need appropriate legislative and regulatory frameworks and suitable internal organizations due to the nature and function of reserves see Chapter One and the attendant risks see Chapter Two in the constantly changing conditions of in- ternational financial markets. Legislation should define exchange and monetary rules clearly and unambiguously: they are the limits the public sets the central bank in its monetary policy.

At the same time legislation must be suf- ficiently flexible to afford the central bank leeway to react to interna- tional market trends. Managing foreign reserves became routine during the s sub- sequent to an analysis of the experience of the international financial community, as well as experience within individual countries and their central banks after the Second World War.

Cukierman 57 shows unequivocally that inadequate legislative definition of monetary policy and the rules for managing foreign reserves, as well as of account- ability, limits the scope for clear cut public assessment of central bank performance. The Theoretical Foundations Rising to the above challenges, modern central banks took the initiative for a gradual unification of investment decision standards and of accountability as regards foreign reserves as part of interna- tional financial accountability standards.

These steps boosted the volume, regularity, and quality of information to the public and to un- biased analysts. Comparability between central banks in foreign reserve manage- ment at the close of the s became an important basis for assess- ing their investment process skills. The BNB is part of this initiative. The establishment of the ECB with its legal standing as an institu- tion independent of national governments and the EC, had a positive bearing on all accession states.

Legal regulation of the performance of accession state central banks became uniform, including foreign reserve management. All these changes set new and higher require- ments before national central banks which are members of the ESCB, requiring regular, clear, unambiguous, and highly detailed account- ability before the broad public.

The above challenges apart, central banks constantly face the eternal dilemmas of whether to put up with lower yield on their assets, or to give head to their appetite for greater risk by broadening its definitions naturally, within legal bounds. Made at the highest man- agement level within the central bank, this choice is a strategic one Fig. This decision making level also defines the margin of toler- ance from this strategic portfolio choice as part of tactical positioning. Strategic and tactical positioning are elective factors, affecting antici- pated yield directly see Chapter Two, Item 3.

In recent years central banks improved and largely standardised decision making approaches on strategic and tactical positioning in foreign reserve management. Process Organization committed in formulating and analyzing monetary policy. Assessing diverse factors and risks within a set investment horizon became the job of teams whose terms of reference differ form those of portfolio managers. Stages Within any legislative framework foreign reserve management comprises several stages Fig.

Figure 8 The Investment Process The first basic stage is for central bank management to set the investment objectives of foreign reserve management. At this stage sees public policy as encoded in legislation translated into the opera- tional jargon of employees dealing with foreign reserves.

The strate- gic structuring of reserves includes delimiting maximum risk appetite risk tolerance by central bank management. This sets bounds to foreign exchange structure and financial instruments and portfolios, sets benchmarks, and outlines possible other investment limits form- ing the overall framework of tactical reserves management Tactical reserve positioning is a stage which encompasses the actual invest- 58 Operational management and tactical asset structuring as used below may be taken as synony- mous with tactical management.

The Theoretical Foundations ing of foreign exchange by individual portfolio managers. The control stage involves comparing the results of tactical allocation with strate- gic allocation. This generates information for the next stage. The re- porting stage includes preparing reliable data on the outcomes of this particular central bank business for bank managers and the public.

Analyses of reserve management effectiveness, assessments of the degree to which investment objectives have been fulfilled, and feed- back are obligatory here. Central Bank Investment Objectives After the s changes to central bank status and performance, maintaining and managing foreign reserves became one of the most important and significant central bank functions. While for most European central banks the security objective has the leading priority, all three objectives are very closely linked as shown in the theoretical overview of the investment process in Chapter Two.

This current understanding stems from the new imperative to pro- vide financial stability which independent central banks and the ECB discharge within the European economy. The rise of security as a priority since the s entailed major consequences for the process of managing reserves.

Process Organization the expense of those which conduct international financial market operations. Liquidity follows security closely due to the nature and significance of foreign reserves as reviewed in Chapter One. Changes in the priority of investment objectives also stemmed from the effort of independent central banks to gain deeper aware- ness and more knowledge of the objective nature of financial risk in managing foreign reserves. Strategic Asset Allocation As with all investors, central banks have differing subjective views of risk, with some being less, and others more, tolerant to it.

Hence balancing between subjective decisions and the application of theo- retical probabilistic models Chapter Two are serious issues in or- ganising the investment process. Theoretically, structuring the foreign reserve portfolio of a central bank comprises solving an optimisation riddle whose solution is the optimum structure of a portfolio from the standpoint of maximum yield60 within a set risk tolerance.

Certain assumptions need to be made to make the riddle solvable, some of which are inevitably sub- jective and thus within the ambit of senior management. It is formulated at the highest management level, most often at board or governor level, or by a deputy governor in charge of foreign reserves. SAA traditionally defines three basic input components in the op- timization task Fig. First of these is central bank investment risk tolerance: the degree to which potential loss is acceptable.

Second is the classes of asset into which the central bank would invest within its statutory leeway. Third come subsidiary investment constraints, if 60 This entails a mathematical expression i. The Theoretical Foundations any, governing the aforementioned classes of asset; these are usu- ally limits to minimum and maximum portfolio shares for a given as- set class or minimum and maximum exposures to a given risk Once set, all three components tend to stick for lengthy periods; given no sharp anomalies on international markets and no significant innovation, they may be reviewed annually or less often.

Figure 9 Basic Elements of Strategic Asset Allocation Once these three components are specified by senior manage- ment, the optimization problem may be tackled. Its solution is a port- folio featuring the asset allocation which may bring the investor the maximum reward within the investment horizon, in line with the set risk tolerance and investment limitations. Process Organization benchmark or a model portfolio.

Its parameters are reassessed at set times, e. There are two basic approaches to solving the optimisation task when designing a benchmark. They differ in their definitions of reward yield and their risk tolerance, and may lead to different solutions: different optimum benchmark structures Fig. Figure 10 Portfolio Optimisation Approaches The Expected Utility Model Under this approach investor behaviour is modelled by a utility function dependent on asset yield.

Reward is measured in abstract utility units derived from the utility function and asset yield. Risk tol- erance is set by the analytical utility function, its level controlled by the risk aversion parameter, a factor of the utility function. Since future asset yield is a random value, the usefulness of keep- ing a given combination of assets is also a random value.

Hence the overall optimization task under this approach comes down to maxi- mizing anticipated usefulness under a utility function relevant to a given investor and a risk tolerance ratio set by him. For more on the expected utility model, see Harvey 62 and Kroll, Levy, Markowitz Levy and H. Markowitz Mean-Variance Versus. Direct Utility Maximization. Journal of Finance 39 1 , 47— The Theoretical Foundations The benefits of the approach lie in its deep link with the fundamen- tals of classical economics, and in the single solution it offers for sin- gle period optimization, involving optimum weights for individual as- sets over a broad range of utility functions.

Another very important benefit is that the approach is sufficiently flexible for use in signifi- cantly more complex multi period optimizations. The expected utility model also has serious drawbacks. One is that all too often the expected utility function has no apparent analyti- cal expression, rendering optimization difficult and calling for simula- tion techniques. A second and more serious drawback is that setting specific utility functions to describe individual investor risk appetites is not easy, while defining individual investor risk tolerance ratios is even harder.

The difficulties this approach entails limit its practical use greatly compared with the second optimisation approach. The Expected Return Model Under the expected return model the overall optimization task is solved directly using yield and risk. As distinct from the expected utility model, this approach defines investor reward as anticipated yield, with risk tolerance assigned a risk measure. Solving the over- all optimization task comes down to maximising anticipated portfolio yield while keeping risk within limits corresponding to central bank risk tolerance.

For more on the expected yield model, see Haugen 64 and Kroll, Levy, Markowitz Diverse forms of the approach may be applied depending on risk measure. Widely applied risk measures include fluctuation, value at risk VaR , and conditional value at risk CVaR see below. Risk measures are functions of the probabilistic distribution of asset yield and show the probability of variation in actual versus anticipated port- folio yield. Pearson Higher Education, 5th edition, Process Organization Box 2 Main Statistical Parameters of the Model Fluctuation, the standard deviation of portfolio yield, characterises the degree of yield variance from expectations i.

Thus when portfolio yield has a normal probabilistic distribution, it could be claimed that for some two thirds of the time yield would fall between plus and minus one standard deviation fluctuation of expectations. Where the yields of different portfolio assets are evenly and nor- mally distributed, the above three risk measures give equivalent op- timum asset structures.

Where portfolio yield is probabilistically dis- tributed and differs from normal, optimal portfolio structure would depend on which risk measure expresses investor risk tolerance. Compared with the expected utility model, the expected return model offers a more logical, tighter approach, allowing risk tolerance to be expressed by explicitly setting maximum portfolio risk.

This ad- vantage has made the model preferred by central banks. The basic noted drawback is that optimum solutions are likely to be localized: that a true global solution for the optimization task is elusive. Moreover, the approach is hard put to solve multi-period optimization problems. A drawback shared by both models is their undue sensitivity to input data such as expected yield and asset covariance structure.

This means that minor changes in input data lead to significant changes in optimum weights, rendering optimization exceptionally dependent upon the quality of assessment of these asset parameters. Tactical Asset Allocation The tactical asset allocation is the actual portfolio creation and maintenance under the adopted investment limits and the bench- mark.

It targets shorter term objectives reflecting mostly short term changes in market expectations of returns on asset classes or using temporary market anomalies. Its conduct assumes that the risk toler- ance of a central bank remains constant. As a process, tactical as- set allocation comprises the steps of taking and implementing invest- ment decisions shown in Fig.

Figure 11 Steps in Operational Portfolio Management Tactical management comes down to passive or active strategies by central bank portfolio managers. Passive strategies aim at attain- ing the portfolio structure, return, and risk of the selected benchmark.

An active strategy sees the taking of relatively long or short positions as regards certain benchmark risk parameters with a view to attain- ing higher relative return. The benchmark is taken as a risk neutral po- sition, or as defining absolute risk and hence expected return from portfolio management.

In order to attain higher income, and in com- pliance with his or her risk appetite and investment limits, a portfolio manager may assume additional risk relative risk over benchmark settings. This risk may be with interest, credit, coupon income, or sectoral distribution related, or of another nature.

Investment decisions are taken under one of two approaches: top- down or bottom-up. The former sees portfolio managers conduct analyses and forming expectations as to the future of the economy, then determining that yield curve sector or that asset class into which he or she will invest government bonds or spread products66 , and 66 In principle the debt of non-government issuers is called spread debt since it is often quoted with a spread against a given benchmark yield curve e.

Process Organization finally defining the actual paper he would buy. The bottom-up ap- proach sees portfolio managers focus primarily on analyzing and forming expectations as to future bond yield, with less significance assigned to economic conditions. An active position on duration primarily calls for the top- down approach, while a passive strategy may rest on a bottom-up approach.

The two approaches may be applied simultaneously, for instance in combining an active strategy as regards duration and relative trading buying bonds seen as underpriced and selling ones seen as overpriced. Tactical positioning of bond portfolios combines investment deci- sions with horizons of between one day67 and one or more weeks Adopting short or long term positions depends on expectations as to interest rate levels and temporary market anomalies.

As new informa- tion on the economy or the market becomes known, portfolio structure scenarios are reviewed. Possible repositioning follows, given accept- able transaction costs, with a view to utilizing any new investment opportunities. Future interest rate movements depend on a multitude of factors as shown in Chapter Two: economic conditions, new debt offers, technical factors, market fluctuations and the readi- ness of market participants to assume risk.

Future interest rate levels may be glimpsed from, inter alia, forward interest rates as seen in Chapter Two ; information on positions and cashflows between mar- ket participants; market expectations; relationships between forex, equity, and bond markets; and macroeconomic models of interest rates.

The Theoretical Foundations The next step is determining the desired relative portfolio position regarding the yield curve. Long relative higher weight positions tend to be taken, in sectors seen as underpriced, and appreciation is awaited with frequent technical or collective analyses. Short or lower weight positions are taken in sectors seen as overpriced, their depre- ciation awaited in line with other sectors.

The next step in the investment process concerns the choice of specific paper. Buying or selling a given paper also involves assess- ing it as either rich with a potential fall, or cheap with a potential rise. When choosing paper, its liquidity risk is taken into account, since lower liquidity leads to higher transaction costs, expressed as a larger bid offer spread.

Achieving a better diversification effect74 often calls for making use of investment opportunities in the spread product trade. Process Organization measured as a movement against the swap curve, and hence ex- pected movements in this curve are seen as highly influential on the prices of these bonds. In turn, spread movements within a given class of paper may depend upon changes in anticipated sector cred- itworthiness, increased market sensitivity to worse general solvency in the economy as a whole, or changes in the methods of calculating some bond parameters within a sector say a new benchmark curve or changing supply and demand conditions.

Once a given security is seen to fall within the set investment lim- its as regards, inter alia, interest, credit risk, structure, and type , transaction timing is defined. Positioning the portfolio too early vis-a- vis anticipated market changes may hit overall relative portfolio yield. Attaining higher or lower relative overall yield is linked mainly with the vigor and duration of one of these: price changes, coupon income, and reinvestment income. Thus where interest rate cuts are antici- pated, taking a relatively long position earlier may deny us higher reinvestment income, cutting overall relative income.

A positive yield curve slope where long term interest is higher than short term is taken to show expectations of future interest rate hikes. Where inter- est rates are rising, shorter durations are better maintained. Taking up short durations, however, means occupying the short end of the yield curve, meaning lower incomes until maturity. If the interest rate hike is delayed or fails to take place, the end result of such a position would be lower relative income.

Comparing actual income and assumed risk with those of the re- lated benchmark is an indicator of successful portfolio management. Where the portfolio structure fails to bring the expected results or new investment opportunities arise, the above process is repeated. The law also provisions the general framework of transparency and accountability in which the BNB operates, also introducing con- trol mechanisms. The instrument limits the scope of subjective man- agement decisions, introducing a rule-based approach which man- ages reserves with a high degree of automatism.

The quality of the legal definition makes reserve management predictable to market participants and observers, rendering central bank policy less likely to be volatile over a long term. These features of the definition of for- eign reserves are an important factor supporting confidence in the currency board and the Bank. Article 28, paragraph 3 of the law states that the gross interna- tional reserves of the Bulgarian National Bank shall be equal to the market value of the following assets of the Bank: 1.

The fact that the above definition has remained unchanged for almost eight years shows the precision and lack of ambiguity in the original draft. The first amendment to Article 28, paragraph 3, item 6 intro- duced mark-to-market valuation to accounting and reporting mon- etary gold at the close of each day, instead of the former value cap of Deutsche marks per ounce.

Since at the time of the amend- ment the market price of gold was significantly higher than the pre- vious nominal price, this constituted a positive valuation reserve form- ing an additional stability buffer for the currency board.

The BNB received the legal mandate for managing cash equivalents, de- posits, and other foreign currency assets on the balance sheet. Second, the definition of foreign reserves called on the BNB to be proactive in pursuing very high asset liquidity and marketability. The Law stipulated that currency mismatch in assets shall not exceed 2 per cent with respect to liabilities in the same foreign currency.

The law was tighter with respect to the euro because that currency is the reserve of the Bulgarian currency board. It also reflected the growing use of the euro in asset management and international trade76 and underlined the strategic Bulgarian goal of euro area accession. BNB adherence to the rule constrains currency risk in foreign reserve management. Consequently, the currencies of denomination for foreign assets are the euro and the US dollar. Experience of the BNB in Managing Foreign Exchange Reserves under Currency Board Arrangement follows below in the discussion on the specific features of the Bulgar- ian currency board and the description of the investment process at the Bank.

Peculiarities of the Bulgarian Currency Board as a Monetary and Foreign Exchange Regime As is widely known, Bulgarian monetary and foreign exchange policy changed acutely in June following an economic and fi- nancial crisis. In place of discretionary central banking and a floating exchange rate, the BNB was legally obliged to adopt a currency board. The legal framework of the currency board was introduced by the Law on the BNB promulgated in the Darjaven Vestnik, issue 46 of 10 June and came into force on the same day.

A government policy of full liberalisation of the movement of capital accompanied the change in monetary regime. The major move in this direction was the adoption of the Currency Law in September The Bulgarian currency board shared some typical features with traditional currency boards.

The local currency was legally pegged to a stable foreign currency the anchor currency ; in this case the Deutsche mark and later the euro, at the fixed exchange rate of one lev BGL to one mark The Law on the BNB foresaw an automatic transition to the euro when it became legal tender in , based on the rate between it and the Deutsche mark at that instant The BNB was legally bound to exchange local for foreign currency at the fixed exchange rate and vice versa on demand The Law80 precisely defined what constituted BNB foreign reserves and monetary liabili- ties, setting a minimum coverage rate of per cent of BNB mon- etary liabilities with foreign reserves The Nature and Significance of Foreign Reserves under a Currency Board Arrangement The Bulgarian currency board also had certain features which were not typical of this type of monetary regime as adopted else- where earlier.

First, BNB monetary liabilities included alongside banknotes in circulation other balances, including banking reserve accounts and fiscal deposits and accounts except IMF liabilities Indeed, research in showed that arguments for adopting the US dollar as the anchor currency in Bulgaria were dominant The Law on the BNB did not provide any legal mechanism for changing the currency board.

Indeed, on the eve of board launch, a dominant view among its most prominent supporters was that in- serting it into the Constitution84 would be the ultimate safeguard of confidence in the currency system; the National Assembly deemed it sufficient to introduce the currency board through the Law on the BNB. Accord- ing to the Law on the BNB, the main duty of the Issue Department was to maintain full coverage of BNB monetary liabilities with foreign reserves and to manage these reserves effectively.

All this denies the widely held academic and public belief that there is parity between a tradi- tional currency board and its Bulgarian instance. The Issue Department reports its balance sheet weekly and monthly The balance sheet includes foreign reserves on the assets side and all monetary obligations on the liabilities side.

The Department has no independent legal per- sonality, and its part of the BNB underpins the integrity of the central bank. The Banking Depart- ment, however, could lend to banks only up to the amount of deposits placed with the Issue Department under Ordinance No 6 on lending to commercial banks against security. The market value excess of Issue Department assets against li- abilities is equal to the balance of the Banking Department deposit.

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Forex robot programmer Choice of Investment Objectives and Investment Constraints The Manual is kept in paper and electronic formats. Total Taxable Resources. Countries fear- ing contagious global recession in case the Bretton Woods institutions the IMF and the World Bank fail to guarantee liquidity elect to have greater reserves than others Abdou Fayez A.
Mercado forex pdf files Yield Curve Read article and Empirical Evidence These are the expectations for: the long- term inflation rate, the productivity of labor in the economy, the poten- tial rate of economic growth, the demographic features of the popula- tion and the structural fiscal position of the governments in the USA, EU and Japan the so-called structural deficit. When their level got critically low, the likeliest outcome would be a successful speculative raid on the fixed rate, causing a sharp drop in the local currency, often combined with the loss of the remaining reserves. Second, the definition of foreign reserves called on the BNB to be proactive in pursuing very high asset liquidity and marketability. Terrorist Finance Tracking Program. A positive yield curve slope where long term interest is higher than short term is taken to show expectations of future interest rate hikes.
Zhong wang ipo The main body of the abstract should demonstrate the result. Authors of the issue Talla M. Discussion Here the interpretation of the results obtained during the research is made. A resume summarizes accumulated petrov ivan forex news knowledge in in- vestment portfolio management and yield curve theories. The lack of stationarity is due to the influence of unforeseeable shocks on the current mean level caused by struc- tural changes in the economy or monetary policy which have taken place in the meantime.
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