6/2005 Andres Vesilind and Toivo Kuus. Application of investment models in foreign exchange reserve management in Eesti Pank

Working Papers of Eesti Pank. No 6, 2005

This paper describes active investment strategy used in the central bank of Estonia and introduces model-based investment decisions as a component of that strategy. The first chapter of the paper describes the evolution of the investment process in Eesti Pank and outlines the framework of reserve management. It describes the role of several forms and styles of investing: active and passive management, qualitative and quantitative management, emphasizing the role of diversification for achieving better performance. The chapter concludes with the description of the investment strategy used in the central bank of Estonia.
The second chapter describes model-based investing as part of active management strategy. Three investment models are estimated and tested: a model for directional positions in the US, German and Japanese 10-year government bond futures, a model for cross-currency positions in ten major currencies, and a model for cross-country yield spread trades in eight major government bond markets. The models extend the framework developed by Ilmanen and Sayood (Ilmanen et al. 2002). After the model estimation the models are combined with a trend-following model and the whole set of diversified models is tested. Finally, correlation study of these results with the results of external asset managers and in-bank discretionary analysis is performed. The paper ends with a discussion on the possibilities for further development of the quantitative investment program and conclusions.
JEL Codes: E44, E47, E58, F37, G11, G15
Key words: Trading rules, active management, central bank reserves

Author's e-mail addresses: vesilind [at] epbe.ee, tkuus [at] epbe.ee

The views expressed are those of the authors and do not necessarily represent the official views of Eesti Pank.

Table of Contents

Introduction
1. The Evolution of Investment Process in Eesti Pank
1.1. General Goals and Framework of Reserve Management
1.2. Combining Different Forms and Styles of Investing
1.2.1. Passive and Active Management
1.2.2. Qualitative and Quantitative Approach to Active Management
1.3. Forming a Diversified Investment Strategy
2. Model-Based Investment Decisions as Part of Diversified Active Investing
2.1. Formulating the Task
2.2. Duration Model
2.3. Model for Currency Positions
2.4. Model for Cross-Country Yield Spread Positions
2.5. Trend-following Model
2.6. Results of the Combined Model Portfolio and its Comparison with the Results of Other Managers
3. The Need for Further Development of Active Model-Based Investing
Conclusions
References
Appendix 1. Description of variables used in duration model

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