Risks in the placement of foreign exchange reserves

Foreign exchange risk

The foreign exchange risk is a threat that changes in currency exchange rates will influence the market value of Eesti Pank's foreign exchange reserves and the income earned from investing them. Since, from among financial risks, the foreign exchange risk constitutes the greatest danger to maintaining the foreign exchange reserves and the stability of the Estonian kroon, and its size is the most difficult to project by Eesti Pank, the currency structure of the benchmark portfolio of the foreign exchange reserves is neutral, i.e. 100% in euros and does not involve a foreign exchange risk due to the fixed interest rate between the Estonian kroon and the euro.

Pursuant to the investment strategy the currency structure of the actual investment portfolio may slightly deviate from the neutral. Meanwhile, a foreign exchange risk with a daily VAR of over 0.4% of Eesti Pank's excess reserve above the currency board is not allowed. The daily VAR or the daily relative foreign exchange risk can be viewed as an amount of money, which is with a 95% probability the greatest possible sum by which the value of the investment portfolio may diminish in one day due to changes in the currency exchange rates. Thus, the greatest possible loss of Eesti Pank owing to taking a foreign exchange risk is limited to a sum that corresponds to 0.4% of the excess reserve above the currency board. Upon taking a foreign exchange risk, Eesti Pank is entitled to use only the following currencies: the Australian dollar, the Japanese yen, the Canadian dollar, the Norwegian krone, the Swedish krona, the British pound sterling, the Swiss franc, the Danish krone, the US dollar and the New-Zealand dollar.

Interest rate risk

The interest rate risk is a threat that interest rate changes will influence the market value of Eesti Pank's foreign exchange reserves and the income earned from investing them. The neutral, i.e. acceptable interest rate position of Eesti Pank's FER has been determined by the benchmark portfolio. Similarly to the principles of managing the foreign exchange risk, the investment portfolio's interest rate position may deviate by a certain amount from that of the benchmark portfolio. In managing the FER, it is allowed to take an interest rate risk in ratio to the benchmark portfolio, the daily VAR of which (i.e. the relative daily interest rate risk measured in money) does not exceed 0.4% of the excess reserve above the currency board. This means that with a 95% probability the greatest possible sum by which the value of the investment portfolio may diminish in one day due to interest rate rises is equal to 0.4% of the excess reserve above the currency board.

In addition to the fact that the benchmark portfolio is the basis for measuring the actual portfolio's interest rate risk and profitability, it also determines the investment portfolio of the FER, namely FER without the liquidity portfolio, i.e. the buffer, the neutral inter-country/region and internal structure. The inter-region neutral structure means Eesti Pank's readiness to invest a certain share of the foreign exchange reserves in securities issued in certain regions and by that take a suitable risk for Eesti Pank in every region. The FER benchmark portfolio includes 60% of securities issued in the euro area (the fifteen countries with the single currency) and 40% of securities issued in the USA. According to the investment strategy, the actual portfolio is allowed to deviate from the benchmark portfolio by up to 20%. Thus, the FER investment portfolio may have 40%-80% of securities issued in the euro area and 20%-60% of securities issued in the USA. Within the allowed risk limits the actual investment portfolio may also include bonds issued in countries that do not belong to the benchmark portfolio. Investments are allowed into bonds issued in Australia, Japan, Canada, Norway, Sweden, Great Britain, Switzerland, Denmark and New Zealand.

The intra-region neutral structure of the benchmark portfolio means that the share of securities with various maturities issued in the given region/country in the sub-portfolio of that region/country (the euro area or the USA) is neutral. The longer the maturity of the security, the greater is the interest rate risk related to owning this security and vice versa: the smaller is the maturity of the instrument, the smaller is also the interest rate risk. The intra-region neutral structure of the investment portfolio means a distribution of the securities in the portfolio according to maturities, in which case the risk-weighted share of securities groups, i.e. sectors with all maturities (sectors are money market instruments, financial instruments with maturities of 1-3 years, 3-5 years, 5-7 years, 7-10 years and 10 and more years) in the portfolio is equal. Due to the fact that the interest rate level and maturity of a financial instrument are directly interdependent, the risk is measured with the average maturity of the sector.

Credit risk

Credit risk is the threat that a transaction partner with financial liabilities to Eesti Pank does not fulfil their obligations. Credit risk cannot be measured with the risk variable VAR, thus it is limited and managed via the quality and quantity restrictions placed on issuers and transaction partners. The credit risk limit is determined based on the financial condition of a partner, for which credit ratings from international rating agencies Standard & Poor's or Moody's are used. There are no credit risk restrictions on the International Monetary Fund (IMF), World Bank (WB), Bank for International Settlements (BIS) and central banks of countries approved for the management of the FER.

Credit risk is divided into two separate risk categories: transaction risk and issuer risk. Transaction risk is the threat that a transaction partner of Eesti Pank does not fulfil their operational obligations undertaken with the conclusion of a transaction. In order to hedge this risk the Head of the Financial Markets Department approves a list of partner banks allowed for the investment of FER across every transaction type. The list is updated according to need, but not less frequently than once a quarter.

The issuer risk is a threat that a securities issuer or an institution with other financial liabilities to Eesti Pank is not solvent and cannot fulfil their obligations when the payment due date arrives. The minimum required credit rating of issuers across various transaction types with whom Eesti Pank may take issuer risks has been brought out in the following table:

In addition to the transaction and issuer risk restrictions also other credit risk restrictions apply in the management of foreign exchange reserves.

The share of debt securities of non-governmental issuers may not exceed 30% of FER.

The total position of the debt securities of non-governmental issuers in FER may not exceed 30% of the excess reserve above the currency board.

The share of uncollateralized time claims kept with commercial banks and other financial institutions may not exceed 100% of Eesti Pank's excess reserve above the currency board.

Eesti Pank may not own over 20% of the total issuing volume of any single securities.

Liquidity risk

Liquidity risk is the threat that Eesti Pank has not enough liquid assets for the timely fulfilment of its obligations. Liquidity risk cannot be measured by VAR, thus other below-mentioned restrictions are applied.

In order to guarantee a sufficient amount of liquid instruments the whole FER is divided into the investment portfolio and the liquidity portfolio or buffer, which is used for foreign exchange transactions between Eesti Pank and commercial banks (the forex window for the functioning of the currency board principles) and which has to be usable on the banking day after the next.

The financial instruments used for the management of the whole FER, the investment as well as the liquidity portfolio, have to be traded with on the liquid secondary market where it is possible to perform large transactions fast without influencing the market price significantly. The longest allowed maturity for non-tradable short-term instruments for the management of FER is one month (deposits).

Instruments

The following instruments are allowed for the management of Eesti Pank's foreign exchange reserves:

    demand and time deposits;

    spot and forward transactions with bonds;

    foreign exchange spot and forward transactions with bonds;

    repurchase transactions, reverse repurchase transactions, buy/sellback and sell/buyback transactions;

    interest rate swap, forward and future transactions;

    gold and transactions with gold.

Reporting related to the management of Eesti Pank's FER

The Financial Markets Department of Eesti Pank compiles daily, weekly, monthly and quarterly reports on the FER management results. The reports reflect the taken risks and profitability of investments. Profitability is measured against the version invested in the benchmark portfolio, i.e. the proxy (while the benchmark portfolio consists of an index, the proxy includes specific model bonds, which correspond to that index).

The daily reports on investing FER are intra-departmental and are published electronically on the intra-bank website with limited access. Weekly reports are submitted to the Head of the Financial Markets Department and are published electronically and in print. Monthly reports are submitted to the Executive Board of Eesti Pank and the Internal Audit Department and are published electronically and in print. Quarterly reports are submitted to the Executive Board and Supervisory Board of Eesti Pank and the Internal Audit Department and are published electronically and in print. The approval of the detailed content, form and due dates for the submission of the reports belongs to the competence of the Executive Board.

In investing into the foreign exchange reserve the bank follows the conservative risk limits established to the assets backing the Estonian kroon, which prioritise maintaining the assets and their liquidity while earning investment income.

Risks related to foreign reserves

Limitations have been fixed for all the monitored risks, which depend on the extent of Eesti Pank's excess reserves above the currency board. The lower the net reserve, the smaller is the risk allowed for investing into foreign currency assets.

Exchange rate risk mitigation

Changes in currency exchange rates are the most difficult to project. Thus, in the management of the foreign exchange reserve it has been decided generally not to take exchange rate risks at all. The foreign exchange risk is fully mitigated by harmonising the currency structure of Eesti Pank's assets and liabilities. Since the exchange rate of the Estonian kroon is strictly pegged to the euro, in practice it means that the base currency of Eesti Pank's foreign exchange reserves is the euro, which also comprises the majority of the reserve structure. Although some investments have been made outside euro area markets, derivatives have been used to hedge the foreign exchange risk. Thus, the exchange rate changes of currencies only have a minor impact on the value of Eesti Pank's foreign exchange reserves.

Interest rate risk and benchmark portfolio

As Eesti Pank has no possibility of avoiding the interest rate risk[1] it is actively managed via the benchmark portfolio, which determines the average risk level the bank is willing to accept and is also a result benchmark for the efficiency of the foreign exchange reserve management. Also limits have been set within which the actual investment portfolio may deviate from the benchmark portfolio.

Despite the fact that the liquidity buffer has been separated from the foreign exchange reserve, also the liquidity requirements established to the investment portfolio are high. In order to guarantee sufficient liquidity only active instruments with an extensive share in the secondary market may be used. Limits have also been set on the issue volume as well as on the size of the share Eesti Pank may own in a security issue.

Benchmark portfolio

Credit risk

Credit risk, i.e. the threat that a party with financial liabilities to Eesti Pank does not fulfil their obligations, is managed via the volume and proportion limitations established on securities issuers and various instruments, based on ratings from leading international rating agencies. Most of the reserve is invested into government bonds and the repurchase transactions with them at minimal credit risk.

See also: Speculative currency attacks

[1] Interest rate risk - a risk that when interest rates become less favourable, the amount of earned income will decrease.