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EDHEC proposes integrated approach to sovereign wealth risk management

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The EDHEC-Risk Institute has published a new publication – “An Integrated Approach to Sovereign Wealth Risk Management,” – containing the results of the second-year research work conducted in the Deutsche Bank research chair on asset-liability management (ALM) techniques for sovereign wealth fund (SWF) management.

The publication extends earlier work on the optimal investment policy and risk management practices of sovereign wealth funds by integrating these funds into the economic balance sheets of their sponsoring countries. This echoes recent advances in corporate pension fund management that consider the fund an integral part of the corporate balance sheet and jointly analyse capital structure and pension fund allocation choices. The research shows how to derive the optimal asset allocation for sovereign assets given different drivers of economic risks as well as varying degrees of indebtedness.

It puts forward a model that decomposes a SWF’s demand for risky assets into a combination of speculative and hedging demands. Speculative demand is the demand for assets which maximise risk-adjusted returns while total hedging demand arises from liability-hedging motives and from the demand for assets whose dynamics mitigate fluctuations in combined sovereign assets or lessen shocks to government budgets. Assets with low correlation with changes in the sovereign’s budget or that offer insurance against tail risks for the sponsor are desirable from a hedging perspective. Speculative demand is an important driver of total asset demand only if risk aversion is low or if financial wealth is very large relative to the underlying economy. Other things equal, (high) economic leverage is found to (strongly) reduce speculative demand while leaving hedging demand unchanged.

The publication comments on the asset allocation implications of both the key budgetary risks and the leverage of China, Russia, and Gulf Cooperation Council countries. It also uses an empirical application to illustrate the impact of leverage and the relevance of dynamic allocation for a commodity SWF.

Finally, the publication looks at constraints on dynamic asset allocation. Dynamic decision making increases the amount of equity risk a SWF can take and the advantage is greatest for high leverage. Although they may appear conservative, investment constraints such as narrow allocation bands are found to limit a SWF’s ability to manage its risks. This analysis has important implications in terms of investment and risk management advice for sovereign investment vehicles, central banks, national treasuries, and ministries of finance.

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