Strategic Asset Allocation for China's Foreign Reserves: A Copula Approach

• Published date: 01 November 2013
• Author: Fan Zhang,Zhichao Zhang,Zhuang Zhang
• Date: 01 November 2013
• DOI: http://doi.org/10.1111/j.1749-124X.2013.12043.x

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China & World Economy / 1–21, Vol. 21, No. 6, 2013

©2013 Institute of World Economics and Politics, Chinese Academy of Social Sciences

Strategic Asset Allocation for China’s Foreign

Reserves: A Copula Approach

Zhichao Zhang, Fan Zhang, Zhuang Zhang*

Abstract

In this paper, we study strategic asset allocation for China’s foreign reserves using a risk-

based approach. Four aspects of the risk management are investigated: an 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. One regime emphasizes a short-term safe asset and

the other regime emphasizes a long-term safe asset. The optimal allocation is derived

following two strategies: risk minimization and trade-off between risks 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 the exchange is

very conservative, and 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.

Key words: copula models, flight to safety, foreign reserves, risk management, strategic

asset allocation

JEL codes: C61, E58, F31, G11

I. Introduction

Sound management of foreign reserves has been a constant concern for central banks

(Nugee, 2000), particularly since the global financial crisis hit in 2008. Yu (2011) maintains

that the real value of China’s foreign reserves has been whipsawed by US treasury price

*Zhichao Zhang, Lecturer, Business School, Durham University, Durham, UK. Email: zhichao.zhang@durham.ac.

uk; Fan Zhang, PhD candidate, Business School, Durham University, Durham, UK. Email: fan.zhang@durham.ac.

uk; Zhuang Zhang, PhD candidate, Business School, Durham University, Durham, UK. Email: zhuang.

zhang@durham.ac.uk.

2Zhichao Zhang et al. / 1–21, Vol. 21, No. 6, 2013

©2013 Institute of World Economics and Politics, Chinese Academy of Social Sciences

drops and the devaluation of the US dollar. Dominguez et al. (2012) and Walther (2012)

point out that, with the global financial crisis, countries are faced with an environment of

low international yield with rising levels of reserves, and social costs incurred for a large

reserve holder are substantial.

The published literature underscores the contribution of strategic asset allocation.

Brinson et al. (1986) show that, in the case of US pension plans over the period 1974 to

1983, 93.6 percent of the return variation for 91 pension plans can be explained by asset

allocation. In terms of cross-sectional variation explained by the strategic asset allocation

(i.e. performance difference among various funds due to their asset allocation), Ibbotson

and Kaplan (2000) use 94 US mutual funds during the period 1988–1998, and find that

approximately 40 percent of the variation of returns among the funds are from asset allocation,

while 60 percent of the variation is influenced by asset-class timing and security selection.

In the present paper, we consider strategic asset allocations for China’s reserves using

an approach based on risk management. The notion of “risk management” implies that this

study focuses on the liquidity and the safety objectives, although the traditional policy

goals include the requirement for returns. This is because the returns objective should be

left to be fulfilled by special investment vehicles, such as sovereign wealth funds; such

arrangements are common practice in reserve abundant nations.

Given the particular importance of the US market to China’s reserve allocation, we use

the data from that market as representative of China’s foreign asset allocation policy. Using

these data, we build our investment universe for possible investment of Chinese reserves.

Then, we consider the impact of the dependence structure on the management of the

Chinese central bank’s investment portfolio. In the dependence structure building process,

we apply the copula approach to model the dependence between assets. The regime-

switching dependence is estimated using the Hamilton (1989) filter.

The conditional value-at-risk (CVaR) is applied as the risk measure in our study. Two

strategies are adopted to derive the optimal asset allocation for China: one is based on the

CVaR and the other on disappointment avoidance utility maximization. Finally, we examine

the influences of dependence asymmetry and the fat tails on the flight to safety, which has

been a widespread phenomenon during the recent global financial crisis.

The present paper makes a number of contributions to the literature. It incorporates

asymmetries and fat tails into the decision on foreign reserve asset allocation and tests

whether central banks should have engaged in the flight to safety in response to the global

financial crisis. A new copula structure is proposed in a multivariate dependence modeling

environment. While in a common vine-copula structure only some of the variable pairs can

be directly described as copulas and their asymmetric dependence be accurately reflected,

we devise a regime-switching model that can enlarge the describable range to all the variables