EDHEC-Risk institute study: An integrated approach to sovereign wealth risk management

23 August 2011

The objective of this paper is to incorporate the economic balance sheet of the sovereign sponsor into the optimal asset allocation problem of the SWF. This paper outlines an easy-to-implement solution that nests well in the literature on SWFs.

Sovereign wealth funds (SWFs) typically have no direct earmarked liabilities. Nor should they, as the financial asset they represent is only part of total sovereign assets, which in turn guarantee all sovereign liabilities.

The study shows that economic leverage will reduce speculative demand but leave hedging demand (against fluctuations in the net fiscal position of the sovereign state) unchanged. It also shows how to extend EDHEC's one-period methodology to a multi-period context by solving a dynamic stochastic programme. Allowing for optimal dynamic decision-making increases the amount of equity risk an SWF can take. The advantage is greatest for large values of economic leverage. Finally, EDHEC concludes that narrow tactical asset allocation ranges limit the SWF’s ability to manage its risks.

Full paper

© EDHEC