Sovereign Wealth and Risk Management. A New Framework for Optimal Asset Allocation of Sovereign Wealth

This paper sets out a new analytical framework for optimal asset allocation of sovereign wealth, based on the theory of contingent claim ana lysis (CCA) applied to the sovereign’s economic balance sheet. A country solves an asset-l iability management (ALM) problem between its sources of income and its expenditures. We derive analytically the optimal asset allocation of sovereign wealth, taking explic it account of all sources of risks affecting the sovereign’s balance sheet. The optima l composition of sovereign wealth should involve a performance-seeking portfolio and three hedging demand terms for the variability of the fiscal surplus, and external and domestic debt. Our results provide guidance for sovereign wealth management, particula rly with respect to sovereign wealth funds and foreign exchange reserves. A real-life ap plication of our model in the case of Chile shows that at least 60% of the Chilean asset allocation should be dedicated to emerging bonds, developed and emerging equities. Ch ile’s current sovereign investment is under-diversified.