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Sovereign Wealth Funds - August 23, 2011

An Integrated Approach to Sovereign Wealth Risk Management

Sovereign wealth funds (SWFs) typically have no direct earmarked liabilities. Nor should they, as the financial asset they represent is only part of total sovereign assets, which in turn guarantee all sovereign liabilities.

The objective of this paper is to incorporate the economic balance sheet of the sovereign sponsor into the optimal asset allocation problem of the SWF. This paper outlines an easy to implement solution that nests well in the literature on SWFs.

We show that economic leverage will reduce speculative demand but leave hedging demand (against fluctuations in the net fiscal position of the sovereign state) unchanged. We also show how to extend our one-period methodology to a multi-period context by solving a dynamic stochastic programme. Allowing for optimal dynamic decision making increases the amount of equity risk an SWF can take. The advantage is greatest for large values of economic leverage. Finally, we conclude that narrow tactical asset allocation ranges limit the SWF’s ability to manage its risks.

This study was produced as part of the research chair on “Asset-Liability Management Techniques for Sovereign Wealth Fund Management” in partnership with Deutsche Bank.