Portfolio selection for management of foreign exchange reserves

Effective management of a country's foreign exchange reserves forms a crucial responsibility of a central bank, drawing from its role as the custodian of the reserves for the nation. Essentially, reserves management means making a choice between alternative portfolios. Portfolio management has developed over the years into a highly sophisticated art despite the fact that the basic principle of portfolio management, viz., to strike a balance among three fundamental considerations of liquidity, safety and yield continues to be the same. Several developments in the international financial markets, beginning with sharper exchange rate volatility consequent upon the major currencies going into generalised floating since the mid seventies to surges in private capital flows experienced from the late eighties, have resulted in significant increase in the size and nature of risks in the financial markets. Two important consequences, each having a bearing on reserves management, followed: first, unlike in the Bretton Woods era when the US dollar provided international liquidity and the US market the instruments for deployment of reserves, the world moved over in the eighties to a multi-currency liquidity system and several other markets grew in size and sophistication. There was the emergence of the Deutsche mark and the Japanese yen as major reserve currencies along with the US dollar. In fact, the share of the US dollar, which was about 84 per cent in 1973, fell to 59 per cent in 1996. Second, increased volatilities in exchange rate, interest rate and prices of commodities like gold and oil saw tremendous strides being made in development of risk management instruments through the so-called derivatives revolution.