Optimal Allocation between International Reserves and Sovereign Wealth Funds for Different Horizons

Abstract

We present a dynamic model to allocate international reserves and sovereign wealth funds for different horizons. Particular attention is paid to dynamic rebalancing cases. The numerical method was used to obtain optimal allocation ratio of two assets. The results show that, in both buy-and-hold and rebalancing cases, there are strong horizon effects. Government with a longer horizon chooses significantly more reserves than someone with short horizon in buy-and-hold case. The reason is long-horizon governments have an intrinsically larger need for reserves to quell possible M2 flight and repay short term external debt for stability purpose. In rebalancing case, however, when the horizon is lengthened, the government should hold less liquid reserves, for high yield of SWFs makes the demand for liquid assets decrease when government extends its horizons in rebalancing case. We also conclude that, for horizon presented here, the governments who optimally rebalance their portfolio at regular intervals would hold significantly less reserves than ones implementing buy-and-hold policy. A possible reason is they could receive updated information at the end of each period and rebalance portfolio based on existing information.