Board Recommendations on Strategic Asset Allocation

Presenter: Aya El Ashi

Objectives and risk constraints

As a central bank, the main objective is capital preservation, liquidity, and the desire to achieve returns of at least 1% annually. Investment constraints:
1. 2.

Minimize the probability of negative returns over a 1-year horizon. Maximum allocation to credit sector is limited to 30% of total market value of the overall portfolio.

Eligible asset classes

The eligible asset class are the following: 1. US Treasury Bills. 2. UST 0-3 Index 3. UST 1-3 Index 4. UST 1-5 Index 5. US Agency 1-3 Index 6. US MBS Index 7. G7 1-3 Index hedge into USD 8. G7 1-5 Index hedge into USD

We used historical yields to calculate the betas using the Nelson Sieguel model in order to estimate the US, Euro, UK, and Japan yield curves. Then, using market consensus about expected yields after 1 year, we calculated the expected NS factors in order to estimate the forward yield curves through an exponential autoregressive model.

Risk and return characteristics of eligible asset classes

Based on the estimated yield curves at the end of the investment horizon (1 year) for each government index, as well as the 10 year swap spread for MBS index, and the 2 year agency spread for the US agency index; the model estimated the following risk/return characteristics for the eligible asset classes.
US 3mth US 0-1 Index US 0-3 Index 0.48% 0.62% 0.94% 0.25% 0.24% 0.66% 0.11% 0.23% -0.17% 0.06% 0.07% -0.59% 0.10% 0.20% 8.30% Consensus Expectations US 1-3 Index US 1-5 Index Agency 1-3 Index 1.01% 0.98% 1.69% 1.01% 1.73% 1.07% -0.65% -1.84% -0.03% -1.30% -2.79% -0.85% 16.50% 29.50% 5.40% US MBS 2.55% 1.73% -0.62% -2.01% 8.10% G7 1-3 Index 0.75% 0.44% 0.02% -0.24% 4.20% G7 1-5 Index 0.82% 0.82% -0.50% -1.05% 16.30%

Expected return Volatility VaR return (95%) VaR return (99%) Prob. of neg. returns

1. Optimal portfolio with 95% minimum return of 0%; only US Treasuries

2. Optimal portfolio with 95% minimum return of 0%; all asset classes, 30% constraint on non-government

3. Optimal portfolio with a target return of 1%; all assets, 30% constraint on non-government

4. Optimal portfolio with target return of 1%; all asset classes excluding MBS, 30% constraint on non-government

Asset Allocation of the Chosen Portfolios

Optimal Portfolio 1 Optimal Portfolio 2 Optimal Portfolio 3 Optimal Portfolio 4 Alternative 5 US 0-1 Index 25% 15% 73% 46% 0% US 0-3 Index 75% 55% 0% 24% 50% US Agnecy 1-3 Index 0% 0% 15% 30% 20% US MBS Index 0% 30% 12% 0% 10% G7 1-3 Index Hedged 0% 0% 0% 0% 20%

Risk and return statistics for optimal portfolios

Stress Test 1 Upward parallel shift of US curve, 100bps

Stress Test 1 Upward parallel shift of US curve, 100bps

Stress Test 2 Flattening of the US yield curve

Stress Test 2 Flattening of the US yield curve

Recommendation

We recommend to the Board the following portfolio (Optimal portfolio 3), which has the following composition:

73% 0-1 US Index 15% US Agency Index 1-3 12% US MBS Index

We chose this portfolio as it satisfies the two constraints imposed by the Board, and performs well under the applied stress-test scenarios