Sovereign Wealth and Risk Management: A Framework for Optimal Asset Allocation of Sovereign Wealth

Abstract

This paper sets out a new approach to sovereign wealth and risk management, based on the theory of contingent claim analysis (CCA). To manage sovereign risk, it is essential to analyse the sovereign’s balance sheet. The state has to solve an asset-liability management (ALM) problem between its sources of income and its expenditure. The analytical framework for this approach covers all public entities, not only the state budget, and includes implicit guarantees to the private sector. It has a number of essential applications for sovereign wealth management, particularly with respect to sovereign wealth funds (SWFs) and foreign exchange reserves. We present the conceptual framework, tools and data needed to carry out this type of analysis. We then focus on Chile to provide a practical example of sovereign balance sheet estimation and sovereign ALM.

Keywords: Balance Sheet, Contingent Claim Analysis, Asset-Liability Management, Sovereign Wealth Funds, Central Bank Reserves

JEL Classification: G11, G18, H11, H50, H63