Eesti Pank's foreign exchange reserve management principles

The purpose of Eesti Pank's foreign exchange reserve (FER) and the key management principle

The primary goal of Eesti Pank's FER is to safeguard the stability of the Estonian kroon. The FER must exceed Eesti Pank's liabilities, i.e. the total sum of kroons issued by Eesti Pank. In addition, the task of the FER is to guarantee additional funds necessary for the independent operational functioning of Eesti Pank as the central bank. The key principle behind the management of the FER is to maintain the value and liquidity of the reserve assets while earning optimum income from investments within the established risk limits. The size of the FER and the income earned on it is measured in Estonian kroons.

The decision-making process concerning the management of Eesti Pank's foreign exchange reserve

The FER is managed by the Financial Markets Department of Eesti Pank. The strategic decisions related with the field are made on two different management levels:

1.  The Governor of Eesti Pank;

2.  Head of the Financial Markets Department of Eesti Pank.

The head of every respective level is responsible within their competence for the content and implementation of decisions and for guaranteeing that the decisions made by them are in accordance with higher-level decisions.

In the management of the FER the competence of the Governor of Eesti Pank includes:

    The approval of the decision-making competence related to the management of the FER;

    The approval of the principles on managing the financial risks concerning the management of the FER;

    The approval of the currencies, financial markets and financial instruments granted for managing the FER and the approval of the reporting process related to the FER management;

    The approval of the benchmark portfolio of FER at the proposal of the Monetary Policy Committee.

The decisions made concerning the FER benchmark portfolio are reviewed when necessary but not less frequently than twice a year. Other decisions in the competence of the Governor of the Bank are reviewed by the Governor when necessary but not less frequently than twice a year.

The decision-making competence and duties of the Head of the Financial Markets Department in the management of FER are as follows:

    The approval of the strategic portfolio of the FER (SDO - Scenario dependant optimization) at the proposal of the Investment Committee;

    The approval of limits across risk classes by which the actual investment portfolio may deviate from the benchmark portfolio;

    The approval of the division of Eesti Pank's foreign currency reserves into the investment and liquidity portfolio and the share of the excess reserve above the currency board for the upcoming period. The excess foreign exchange reserve above the currency board serves as a basis for determining various risk limits.

The aforementioned decisions are reviewed according to need, but not less frequently than once a month.

The principles of managing the financial risks related to investing Eesti Pank's FER

Of the financial risks accompanying the management of Eesti Pank's foreign exchange reserve the currency risk, interest rate risk, credit risk and liquidity risk are regulated. When possible, risks are estimated with the risk variable VAR and limited with regard to the benchmark portfolio.

VAR (Value at risk) is a risk measurement used by J.P. Morgan based on variability, which is based on the RiskMetrics© principles and the data acquired by that method. Those financial risks that cannot be measured with the VAR method are limited through volume or another parameter.

The benchmark portfolio against which the limitation of the risk level is performed is theoretical, i.e. actually a non-existing benchmark portfolio that indicates the general risk tolerance of Eesti Pank and based on which the risk level of the actual investment portfolio is measured. The benchmark portfolio includes financial assets which will guarantee the following investment results:

    During the given period, which is three months, the benchmark portfolio will guarantee the preservation of the FER, i.e. the non-negative yield of reserve investments. This means that upon checking the preservation of the FER at three-month intervals, the value of the reserves has remained the same or has increased with a 95% probability.

    In the long-run, the benchmark portfolio guarantees a stable growth for the FER, and the income on investments exceeds that of short-term financial instruments, e.g. deposits or other money market instruments with maturities less than one year.

Thus, the benchmark portfolio is the best passive investment alternative which serves as a basis for the measurement of the actual investment portfolio's yield, i.e. profitability. All in all, the benchmark portfolio for Eesti Pank's FER management serves as a basis for the measurement of the actual investment portfolio's risk level as well as profitability.