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Explore the asset allocation process at the Bank of Korea, covering objectives, constraints, tools, benchmarks, and risk management for effective reserve management. Discover the strategic allocation, risk tolerance, currency composition, and investment universe considerations.
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ASSET ALLOCATION PROCESS- The Bank of Korea - Chang-Ho Yoo Reserve Management Department
INTRODUCTION • ■ Objectives of the Presentation • ▷ To explain about the practical limits in implementing the optimal process • ▷ To introduce the BOK’s practice • ■ Major Contents of the Presentation • ▷ Overview of the concepts • ▷ Constraints to be considered • ▷ Optimization tools • ▷ SAA/TAA/Investment Guidelines and active management • ▷ Other related issues
OVERVIEW • ■ Asset Allocation: allocation of reserves to different asset classes • → “Benchmark” (implicit or explicit) • ▷ The simplest form: (e.g.) 50% USD and 50% EUR • ▷ Complicated form: composed of thousands of securities • ■ Benchmark • ▷ More than 90% of the return is explained by Benchmark • ▷ Reveals risk/return preference and investment objectives • ▷ Criterion for measuring risks and relative performance in active management • ⇒BOK introduced benchmark concepts in the middle of 1990s
BASIC CONCEPTS • ■ Strategic vs. Tactical (SAA/TAA) • ■ Total vs. By tranche • ■ Qualitative (Descriptive) vs. Quantitative • ■ Benchmark vs. Guidelines • ■ Customized vs. Market indices • ■ Others • ▷ Rebalancing frequency • ▷ Active vs. Passive
INVESTMENT PROCESS Objectives of reserve mgt. & Constraints ●Risk tolerance and return ● Investment universe ● Reserves classification Asset allocation ●Benchmarks ● Investment guidelines Risk management & Performance evaluation Actual management ● Active management ● External fund management ● Security lending / RP
Actual Management ASSET ALLOCATION PROCESS SAA TAA Middle Office Front Office Front Office Annually/Quarterly Monthly Daily Benchmark & Guidelines Benchmark & Guidelines Take positions Under Guidelines & Risk budgeting
Quantitative Tools STRATEGIC ASSET ALLOCATION - Overview - Objectives Constraints SAA
STRATEGIC ASSET ALLOCATION - Objectives - Liquidity Safety Return • ■ Higher return on the basis of safety and liquidity • → More emphasis on return • ▷ More concerns about opportunity costs of keeping huge reserves • ▷ Less concerns about liquidity with increasing reserves LiquiditySafety Return
STRATEGIC ASSET ALLOCATION - Constraints - • ■ Issues to be considered • ▷ Need to incorporate various realistic aspects • ▷ More constraints → More possibility of sub-optimal allocation in principle Risk tolerance & (Expected) Returns • CONSTRAINTS Investment universe Currency composition Duration
STRATEGIC ASSET ALLOCATION - Risk Tolerance and Return - • ■ Investment objectives are expressed in terms of risk tolerance and (expected) returns • ■ Measurement of risks • ▷ Volatility: Historic (variance), Implied, Model-calculated • ▷ VaR: Maximum potential loss with x% confidence level • ▷ Short-fall risk: x% probability of negative return • ■ Measurement of (expected) returns • ▷ Historic (mean) • ▷ Nelson-Siegel approach or other econometric forecasting models • ▷ Black-Litterman approach (combining market and investor’s view)
STRATEGIC ASSET ALLOCATION - Currency Composition - • ■ Currency composition: Major currencies (USD, EUR, JPY, GBP, etc.) • ▷ 4-factor approach → No currency-allocation • • Currency composition of external debts • • Currency composition of current account payments • • Currency composition in major global bond markets • • Currency composition of other central banks • ■ Issues to be considered • ▷ Frequent changes in currency composition may cause instability in • international FX markets
STRATEGIC ASSET ALLOCATION - Currency Composition - • <Reference>Currency Composition of All Central Banks • Dec 2000 Jun 2007 • (source: IMF)
STRATEGIC ASSET ALLOCATION - Investment Universe - • ■ Investment instruments • ▷ Government bonds • ▷ Government-backed bonds (Agencies) • ▷ Supras & Sovereigns • ▷ MBS & ABS • ▷ Financials & Corporates • ■ Issues to be considered • ▷ How to allocate when introducing new instruments • • Optimization vs. x% rule
STRATEGIC ASSET ALLOCATION - Investment Universe - • <REFERENCE> Trends of Investment Diversification Source: UBS
STRATEGIC ASSET ALLOCATION - Investment Universe - • <Exercise>x% rule plus some quantitative analysis • ■ When adding a new asset to the existing investment universe • ▷ Find “efficient area” with reasonable expected return and risks • • Criteria: Expected return, Sharpe ratio, short fall risk, etc.
STRATEGIC ASSET ALLOCATION - Tranches - • ■ Classification of reserves by tranche • ■ Issues to be considered • ▷ Construct tranches by sources of reserves, if applicable → ALM approach • ▷ Separate allocation by tranche, or overall allocation • To meet short-term payment demand • Relatively small amount of reserves Liquidity Tranche • Return enhancement, while preserving liquidity and safety • Mid- to long-term time horizon Investment Tranche • Higher returns with a longer-term time horizon • External fund managers Long-term Tranche
STRATEGIC ASSET ALLOCATION - Maturity and Duration - • ■ Maturity • ▷ For some currencies/instruments, sectors can be classified • (e.g.) US Treasuries: 1-3 / 3-5 / 5-7 / 7-10 / over 10 years • ▷ Maturity limits • • Deposits: shorter than one year • • Most bonds or notes: not exceeding about 10 years • • For some instruments (MBS): up to 50 years of maturity • ■ Duration • ▷ Target vs. Outcome
STRATEGIC ASSET ALLOCATION - Optimization Tools - • ■ Quantitative tools • ▷ Mean-variance optimization • • Most traditional: Minimize risk while keeping returns fixed • - Corner solution problem, very sensitive to input changes • ▷ To avoid problems using historic mean • • No-view optimization: Changes allocations according to market prices • - Extract expected returns from the current yield curve • • Resampling technique: Monte Carlo simulation • - Produces multiple efficient frontiers • ▷ Black-Litterman Model: Widely used recently
STRATEGIC ASSET ALLOCATION - Black-Litterman Model - • ■ Characteristics • ▷ Combine the investor’s view (Q) with market equilibrium expected return • • Implied equilibrium expected return (Π) = λ ∑w • λ: risk aversion factor, ∑: covariance matrix, w: market weight • ■ Formula: • E(R)= f(Π,Q) = • w=(λ ∑)-1E(R) : allocation result when there is no constraint • τ : constant, Ω: covariance matrix of investor’s view, • P: matrix indicating views • ■ If there are constraints in allocation, use mean-variance optimization • ▷ Consequently, historic mean is replaced by expected return
STRATEGIC ASSET ALLOCATION- Investment Guidelines - • ■ Role of the investment guidelines • ▷ Constraints for risk management purpose • ▷ Allowing for active management • ■ Examples of guidelines • ▷ Eligible currencies, investment products, and credit ratings • ▷ Deviation limits against benchmark (Hard limits) • • sector, duration, maturity weight limits • ▷ Total risk limits or Active risk limits (Soft limits) • • TE (tracking error) limit
TACTICAL ASSET ALLOCATION • ■ Characteristics • ▷ Similar process to strategic asset allocation • ▷ But with more frequency to reflect the recent movements in the market • ▷ Currency overlay allowed • ■ Currency overlay • ▷ Trading FX forwards • ▷ Different weights from underlying assets, according to FX forecasts • ■ Tactical guidelines • ▷ Set within the strategic guidelines
TACTICAL ASSET ALLOCATION • <Efficient frontier>
RISK BUDGETING- For Active Portfolio Management - • ■ Objective • ▷ Maximize active alpha under the given TE* limit • * standard deviation of alpha • ■ Process • ▷ Maximize portfolio IR
FURTHER CONSIDERATIONS • ■ Feedback from qualitative decision-making • ▷ To modify quantitative results • ▷ Especially needed when expanding investment universe • ▷ But needs consistent rationale (not ad hoc basis) • ■ ALM approach • ▷ More efficient if liabilities are incorporated in asset allocation process • ■ Others: • ▷ Need to construct efficient IT system • ▷ Outside (international) consulting is very helpful
Q & A Thank you!