ZHANG, FAN (2014) Management of Foreign Reserves: An Approach Based on Vine-Copula, Regime-Switching Dependence and Bayesian Opinion Pooling. Doctoral thesis, Durham University.
|PDF - Accepted Version|
This research is constructed to address the issue of structure management for colossal foreign exchange reserves holders, such as China and other emerging economies. Contrary to the discussion of optimal quantity on the reserve level, structure management considers the ideal applications of the national wealth, specifically the compositions in the reserves' financial investments. Two perspectives are considered for the safety and liquidity tranche of the foreign reserves, and another one for the return tranche. The thwo perspectives are further developed into three chapters of this thesis and they form a comprehensive set of analyses for the structure management.
First, the optimal currency composition for huge foreign reserves in the safety and liquidity tranche is investigated. The asymmetry fat-tails and complex dependence structure in distributions of currency returns are examined for their vital role in the portfolio risk appraisal. In a D-vine copula approach, it is shown that under the disappointment aversion effect, the central bank in our model can achieve sizeable gains in economic value by switching from the mean-variance to copula modelling. It is also found that this approach will lead to an optimal currency composition that allows China to have more space for international currency diversification, while maintaining the leading position of the US dollar in the currency shares of China’s reserves.
Next, the strategic asset allocation for China’s foreign reserves in the same safety tranche is studied using a risk-based approach. Four aspects of the risk management are investigated: investment universe, dependence structure, allocation strategies under risk minimization and trade-off between risks and returns. A regime-switching copula model is developed to investigate the dynamic dependence between assets. The optimal allocation is derived following two strategies: risk minimization and trade-off between risk and returns in utility maximization with disappointment avoidance. If the central bank focuses solely on risk minimization, the asymmetries in the asset return dependence encourage the flight to safety. However, if higher risks are allowed in exchange for higher returns, even if the exchange is very conservative, the asymmetries would discourage the flight to safety. Therefore, we suggest that China should mitigate its flight to safety after 2008 and increase holdings of short-term bank deposits, long-term treasury bonds and euro bonds.
Finally, the strategic asset allocation problem for China's Sovereign Wealth Fund, the China Investment Corporation, is examined. This is considered to be the return tranche of China's foreign reserves. Bearing the responsibility to pursue higher returns for China's huge volume of foreign exchange reserves, the China Investment Corporation is endowed with a capable funding position. However, its emphasis on safety is still considered more serious than that of other institutional investors. A new method combining the merits of the shrinkage estimation, vine-copula structure, and Black-Litterman model, is proposed and tested to satisfy the revealed investment objectives. Empirical analysis suggests that there is more emphasis on emerging market economies rather than advanced economies when diversifying in fixed-income securities; whereas that emphasis is reversed on the equities side. In addition, using the commodity ETFs to represent the significance of gold in the portfolio, it is discovered that gold is a formidable competitor to the investment in equities.
|Item Type:||Thesis (Doctoral)|
|Award:||Doctor of Philosophy|
|Keywords:||foreign reserves, vine-copula, bayesian opinion pooling|
|Faculty and Department:||Faculty of Social Sciences and Health > Economics, Finance and Business, School of|
|Copyright:||Copyright of this thesis is held by the author|
|Deposited On:||20 Nov 2014 15:09|