Central bank reserves function as a liquidity buffer to mitigate country exposure and vulnerability to external shocks. Emerging Market Economies are the countries most exposed to the volatility of capital flows and have usually preferred to build up large war-chests of international reserves as a self-insurance mechanism, as it is under their full discretion. Nevertheless, the standard practice of immobilizing large amounts of “cash” to insure against jumps in volatility and risk-aversion could be enhanced. The inclusion of hedging strategies in the strategic asset allocation decision can help to enhance the risk management of the national balance sheet, transferring funds to those scenarios when reserves are most needed. This paper presents a practical approach that we propose to enhance the analysis of the strategic asset allocation of a central bank, and to explore the benefits of including in the construction of the efficient portfolio the analysis of correlations between the reserves’ portfolio and the country’s main vulnerabilities to external shocks.
