The United Kingdom's Official Reserves of Foreign Currency and Gold
Asset Allocation and Risk
In accordance with the Remit, the Bank manages the official reserves so as to maintain their liquidity and security and, subject to that, so as to maximize the return from holding them. The Bank and HMT agree in the Remit a series of "benchmarks" for the assets in which the reserves are invested. This is essentially the high-level asset allocation decision, and it is made in accordance with the objectives specified above.
In order to determine the benchmark asset allocation for the EEA, the Bank employs an asset allocation model that explicitly trades off liquidity and return: the model determines an asset mix that maximises expected return for given levels of expected liquidation costs.
The Bank and HMT also agree a benchmark for the currency allocation of the net reserves *. This takes into account past patterns of risk and return, as well as other macroeconomic factors such as trade flows and the currencies likely to be required in any intervention. In 2001-02 this was 40% US dollars, 40% euro and 20% yen. This benchmark is disclosed in the EEA's annual accounts. It has been unchanged since the accounts were first published, for 1997-98.
HMT may decide, on advice from the Bank, to hold assets, or to set a currency allocation for the net reserves, that differ from these benchmarks. These are described as Strategy Positions. The EEA Annual Accounts (see the Published Information on the Reserves section) disclose whether any Strategy Positions were taken during the financial year. In addition, the Bank's portfolio managers are permitted, within limits, to take positions relative to the benchmarks in order to generate returns. This is described as 'active management'.
Market Risk
Market risk is defined as the exposure of a portfolio of assets to movements in market variables. For the EEA, the relevant variables are primarily interest rates, exchange rates, and the spreads between the yields of securities issued by sovereigns and by other types of issuer. The Bank monitors and controls market risk using a Value-at-Risk (VaR) model, which predicts, at a specified confidence level, the maximum likely loss for a portfolio over a certain time period. In agreement with HMT, the Bank applies a 99% confidence interval and a ten-day holding period, such that in 99 ten-day periods out of a hundred, losses should not exceed those suggested by the model. These VaR estimates are derived from the past volatility of, and correlations between, returns on different assets in the portfolio.
The Bank measures the EEA's VaR exposure against limits set by HMT in the Remit. For internal Bank management control purposes RMD also measures Delta. Delta is the change in value of the portfolio for each one basis point shift in the relevant yield curve. It supplements the VaR measure, and helps to test the sensitivity of the portfolio to changes in interest rates.
Furthermore the Bank conducts regular stress tests to explore the vulnerability of the EEA to potential severe market movements and to estimate the potential losses (or gains) in these extreme conditions.
Credit Risk
The management of the reserves involves taking credit exposures to banks and to the issuers of sovereign, supranational and commercial paper. The creditworthiness of these banks and issuers is subject to regular scrutiny by the Bank's internal Credit Risk Advisory Committee (CRAC). As part of this process, limits are agreed for the maximum exposure to each bank and issuer in terms of both amount and maturity. Such exposures are monitored in real time against the limits. In addition, there are limits to contain exposure to each country's banking system, and limits that apply to certain instrument types. Certain derivative instruments entered into by the EEA are conducted under master legal agreements that permit collateralisation of outstanding exposures.
Liquidity Risk
In agreement with HMT, a core level of liquidity is specified in the Bank's asset allocation model, leading to minimum holding thresholds in particular asset classes such as US Treasury bonds.
* This term is defined in the ' The Financing of the Reserves' section.
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