Optimal Asset Allocation for Sovereign Wealth Funds: Theory and Practice

Abstract

This paper addresses management of sovereign wealth from the perspective of the theory of contingent claims. Starting with the sovereign’s balance sheet, we frame sovereign fund management as an asset-liability management (ALM) problem, covering all public entities and taking explicit account of all sources of risks affecting government resources and expenditures. Real-life SWFs asset allocations differ strongly from theoretical ones. Financial management of the sovereign balance sheet is hampered by a lack of aggregate data, which compromises the coordination of sovereign wealth management with fiscal policy, monetary policy and public debt management. In this framework, we suggest institutional arrangements that could overcome this obstacle and enable efficient coordination.

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

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