Applied Economics Letters, 2013, 20, 250254

Foreign exchange reserves

management in the presence
of jump risk
Dewei Zhang and Chunyang Zhou*
Department of Finance, Shanghai Jiao Tong University, Room 314, Building
No 10, No 535, Fahuazhen Road, Shanghai, Shanghai 200052, China

This article investigates how the jump in the exchange rate and risky asset
can affect the central banks foreign management. We find that the jump in
the exchange rate has a positive impact on the need for the risky asset,
whereas the jump in the risky asset has a negative impact. However, the
overall impact relies on how effective the central bank can intervene in the
exchange market. Specifically, if the central bank can intervene in the
market effectively, the safety of foreign reserves becomes a more
important issue, which will decrease the need for risky asset.
Keywords: foreign reserves management; exchange rate; intervention;
jump risk
JEL Classification: E58; F31
I. Introduction
It has been well recognized that the foreign exchange
reserves serve as an important policy tool for exchange
rate management and external debt management, and
it is vital for the central bank to manage them in an
efficient way. For instance, the book Risk management
for central bank foreign reserves (Bernadell et al., 2004)
published by European Central Bank collects a number
of articles dealing with foreign reserve asset allocations
and risk managements. Considering the policy requirements of central banks, Joachim et al. (2006) further
investigated the foreign reserves managements with a
policy objective. More specifically, in their paper,
through efficient foreign reserves assets allocation and
foreign exchange interventions, central bank aims to
prevent currency undervaluation.
Motivated with their insights, in this article, we follow Joachim et al. (2006) and assume that the objective
of central bank is to maintain the foreign exchange rate
above a particular level. We distinguished our study

from Joachim et al. (2006) by allowing for the presence

of jump in the dynamics of exchange rate and risky
asset returns. Specifically, Joachim et al. (2006)
assumed that the exchange rates follow the normal
distribution; however, it is a well-stylized fact that the
financial returns are fat-tailed distributed.1 Among the
models that are capable of describing the fat-tailed
property, jump diffusion process is representative. To
illustrate, using the Markov Chain Monte Carlo
(MCMC) approach (Johannes 2004), we separate the
jump components of the USD/JPY daily exchange
rates during the period from 17 March 2010 to 16
September 2010. As shown in Fig. 1, a number of
jumps are detected during the 126 trading days.
Therefore, the purpose of this article is to investigate
whether the jumps are important for the foreign reserve
managements.
The rest of this article is organized as follows: Section
II introduces a one-period foreign reserves management model and Sections III presents the empirical
results. Finally, Section IV concludes the article.

*Corresponding author. E-mail: cyzhou@sjtu.edu.cn

1
See Coronado (2000) for a detailed list of empirical works that demonstrate the fat-tailed property of financial returns.
Applied Economics Letters ISSN 13504851 print/ISSN 14664291 online # 2013 Taylor & Francis
http://www.tandfonline.com
http://dx.doi.org/10.1080/13504851.2012.689106

250

Foreign exchange reserves management

0.03

0.03

0.00

0.00

0.02

0.02

251

20

40

60

Fig. 1.

80

100 120

20

40

To simplify, in this article, we build a one-period

model for foreign exchange reserves management.
Specifically, let et denote the logarithm of foreign
exchange rate at time t, where t = 0 or 1. Suppose
there is an equilibrium exchange rate B that can be
determined by purchasing power parity or uncovered
interest parity. The objective of the central bank is to
minimize the probability that the exchange rate at time
1 falls below the bottom line rB; r 2 0; 1, by means
of efficient asset allocation and exchange market intervention.2 Therefore, the objective function of central
bank can be written as
min Pre1 <rB

Suppose the amount of foreign currency used for

intervention at time t = 1 is I1 and  is effect parameter, then the dynamic of exchange rates can be
written as
e1 B be0  B I1 e

120





min Pr y0 x r  rf e<rB

logcR1 if B be0  B e<rB

0
otherwise

y0 B be0  B  log c  logR0  expI0

rf
and x = a.
It remains to determine the distributions of the
exchange rate residuals e and the risky asset return r.
Joachim et al. (2006) assumed that they follow the
normal distributions. However, considering the volatile nature of exchange rate and risky asset, which are
especially subject to event risk, this article assumes
that e and r follows the jump diffusion process
(Merton, 1976; Sato, 2007). Specifically, e and r are,
respectively, given by

Here, c 2 0; 1 is the proportion of foreign reserves

used for intervention and Rt is the total foreign
exchange reserves held by the central bank at time t.
Assume that at time 0, the central bank puts a 2 0; 1
of its foreign exchange reserves in the risky asset with a
return rate of r, and 1 a in the risk-free asset with a
return rate of rf, then R1 could be determined by the
following equation:


R1 R0  expI0 exp ar 1  arf

Ne
X

Jei ; r mr er

i0

where

where I1 is given by:

100

Therefore, from Equations (1) to (4) the optimal

solution a of the one-period foreign reserves management model could be determined by solving

e ee

I1

80

Jump size and daily changes of USD/JPY exchange rates

II. A One-Period Model

60

Nr
X

Jri

i0







whereee ,N 0; s2e , er ,N 0; s2r , Jei ,N 0; s2Je and
Jri ,N 0; s2Jr . Ne and Nr follow the Poisson distrusting with the arrival rates of le and lr, respectively.
Substitute e and r in Equation (5), then we write the
objective function as
Ne
Nr
X
X


min Pr y0 x m  rf xer ee
Jei x
Jri <rB
i1

i0

Under the assumption that all random variables are

independent, we have e xer ee follows the normal
distribution
mean zero and variance x2 s2r s2e ,
PNe ewith P
Nr
r
and
i1 Ji x
i0 Ji follow compound poisson

For instance, to push the home currency up, the central bank can sell an amount of foreign currency in the market.

D. Zhang and C. Zhou

252
distribution (Kaas et al., 2008, p. 47). In other words,
we have
Ne
X

Jei x

i1

Nr
X
i0

Jri

N
X

Ji

i1

where means equality in distribution, N follows the

Poisson distribution with the arrival rate of
l le lr and Ji follows the mixture of two normal
distributions, with the probability density given by
 l 

le 
r
fN y; 0; s2Je fN x; 0; x2 s2Jr
l
l


Here, fN x; 0; s2 is the normal probability density
with mean zero and variance s2.
In the presence of jump, there is no analytic solution
to the optimization problem (5). Therefore, we calculate the optimal solution using Monte Carlo method
(Fishman, 1996).
fz

III. Empirical Results

To investigate how the jumps in exchange rates and
foreign risky assets affect the foreign reserve management, we consider two models in this article. The first
model, which was previously adopted by Joachim
et al. (2006), assumes that the exchange rates and
foreign risky assets follow normal distribution, and
the second model proposed in this article allows the
presence of jump in their dynamic process. Based on
the monthly JPY/USD exchange rates and the Dow
Jones Industrial Average (DJIA) index covering the
period from January 2002 to December 2011, we use
MCMC algorithm to calculate the parameters estimates of the models (Fujisaki and Zhang, 2009).
Table 1 tabulates the estimation results. We can find
that the jump intensities of both exchange rates and

DJIA index returns are significant at 1% level, suggesting there exists significant jump component in
both time series.
We then calculate the optimal weight of risky asset.
To proceed, the values of the parameters are listed as
follows: e0 4:343; c 0:016; rf 0:00089; r 0:92;
 0:02; R0  expI0 8000. The optimal weights
of risky asset are listed in the last column of Table 1.
We can find a large difference of a between these two
models: 1.63% of total wealth is put in the risky asset
under normal distribution assumption, but the proportion increases to 14.28% when jump model is specified.
In other words, the central bank should invest more in
the risky asset if jump is taken into account. The results
are certainly dependent on the values of the parameters
we pre-specified and deserve further investigations how
the jump in exchange rate and risky asset could affect a.
From Fig. 2, we can find that a will increase if the
jump intensity or jump size volatility increase of
exchange rate increases. Therefore, the presence of
jump in the exchange rate makes it more likely to lie
below the bottom line, which in turn increases the need
for risky asset with higher expected return. On the
contrary, from Fig. 3, we find the jump in the risky
asset has a negative impact on a. Since the presence of
jump in risky asset makes the terminal wealth become
volatile, this is undesirable for exchange rate management. Although the terminal wealth affects the
exchange rate through the intervention effect parameter , from Fig. 4, we find that the need for risky
asset decreases as the effect of parameter increases.
Therefore, the impacts of jumps in exchange rate
and risky asset are quite different. Specifically, the
jump in the exchange rate increases the need for
risky asset because it has higher average return,
whereas the jump in the risky asset decreases the
need for it. Overall, the impact of jump in the exchange
rate is much larger than that in risky asset, so a
becomes very large when taking the jump into
account. However, if the central bank can intervene

Table 1. Estimation results and optimal weight of risky asset

Model
Normal
e
re
Jump
e
re

s2

s2J

0.9893*

0.00175

0.0007*
0.0020*

0.9914*

0.00175

0.00053*
0.00065*

0.4986*
0.9410*

0.00034*
0.00150*

a
1.63%
14.28%

Note: We set the equilibrium exchange rate B equal to the mean of log exchange rates 4.649, and let m equal to the sample mean
of DJIA index returns.
* Represents the estimates are significantly different from zero at the 1% level.

Foreign exchange reserves management

253

0.195

0.328

0.175

0.242

0.155

0.156

0.239

0.42

0.176

0.32

0.113

0.22

15
00

Jr2

0.

11

13
00
0.

00
0.

09

07

00
0.

00
0.

05

03

00
0.

00

0.

Fig. 3.

0.

01

0.12
00

3.

8
3

2.

2.

2.

2.

8
2

1.

1.

1.

1.

8
1

0.

0.

0.

0.
00
13
0.
00
15

0.05

Impact of jump in risky asset on a

We find the jump in the exchange rate has a positive

impact on the need for the risky asset, whereas the jump
in the risky asset has a negative impact. When the
central bank cannot intervene in the exchange market
very effectively, the jump in the exchange rate plays a
dominant impact, which increases the weight of risky
asset. However, if the central bank can intervene in the
exchange market effectively, the safety of foreign
reserves becomes more important, which decreases the
need for risky asset.

0.296

0.204

0.112

0.
08

0.
07

0.
06

0.
05

0.
04

0.
03

0.
02

0.02
0.
01

Je2

Impact of jump in exchange rate on a

Fig. 2.

Fig. 4.

0.
00
09
0.
00
11

0.07
0.
00
05
0.
00
07

0.
00
01
0.
00
03

0.
4
0.
6
0.
8
1
1.
2
1.
4
1.
6
1.
8
2
2.
2
2.
4
2.
6
2.
8
3
3.
2

0.135

Impact of intervention effect parameter on a

in the exchange rate market very effectively, safety of

foreign reserves becomes a more important issue, and
the weight of risky asset becomes small.
IV. Conclusion
We model the exchange rate and risky asset returns as
jump diffusion process and then investigate how the
jump can affect the central banks foreign management.

Acknowledgements
This study is supported by the National Science
Foundation of China (No. 70831004, 71001071).

References
Bernadell, C., Cardon, P., Coche, J., et al. (2004) Risk
Management for Central Bank Foreign Reserves,
European Central Bank, Frankfurt am Main.
Coronado, M. (2000) Extreme value theory (EVT) for risk
managers: pitfalls and opportunities in the use of EVT
in measuring VaR, in Proceedings of the VIII Spanish
and III Italian-Spanish Conference on Actuarial and
Financial Mathematics, Madrid, Spain.

254
Fishman, G. (1996) Monte Carlo: Concepts, Algorithms, and
Applications, Springer, Berlin.
Fujisaki, M. and Zhang, D. (2009) Bayesian analysis of
compound poisson mixture model and its application
to financial data, International Journal of Innovative
Computing Information and Control, 5, 10917.
Joachim, C., Koivu, M., Nyholm, K., et al. (2006) Foreign
reserves management subject to a policy objective,
European Central Bank Working Paper Series
No. 624, European Central Bank, Frankfurt, Germany.

D. Zhang and C. Zhou

Johannes, M. (2004) The statistical and economic role of
jumps in continuous-time interest rate models, The
Journal of Finance, 59, 22760.
Kaas, R., Goovaerts, M., Dhaene, J., et al. (2008) Modern
Actuarial Risk Theory, 2nd edn, Springer, Berlin.
Merton, R. C. (1976) Option pricing when underlying stock
returns are discontinuous, Journal of Financial
Economics, 3, 12544.

Sato, K. (2007) Levy

Processes and Infinitely Divisible
Distributions, Cambridge University Press, Cambridge.

Copyright of Applied Economics Letters is the property of Routledge and its content may not be copied or
emailed to multiple sites or posted to a listserv without the copyright holder's express written permission.
However, users may print, download, or email articles for individual use.