ASSET ALLOCATION PROCESS - The Bank of Korea -

1. ASSET ALLOCATION PROCESS- The Bank of Korea - Chang-Ho Yoo Reserve Management Department

2. INTRODUCTION • ■ Objectives of the Presentation • ▷ To explain about the practical limits in implementing the optimal process • ▷ To introduce the BOK’s practice • ■ Major Contents of the Presentation • ▷ Overview of the concepts • ▷ Constraints to be considered • ▷ Optimization tools • ▷ SAA/TAA/Investment Guidelines and active management • ▷ Other related issues

3. OVERVIEW • ■ Asset Allocation: allocation of reserves to different asset classes • → “Benchmark” (implicit or explicit) • ▷ The simplest form: (e.g.) 50% USD and 50% EUR • ▷ Complicated form: composed of thousands of securities • ■ Benchmark • ▷ More than 90% of the return is explained by Benchmark • ▷ Reveals risk/return preference and investment objectives • ▷ Criterion for measuring risks and relative performance in active management • ⇒BOK introduced benchmark concepts in the middle of 1990s

4. BASIC CONCEPTS • ■ Strategic vs. Tactical (SAA/TAA) • ■ Total vs. By tranche • ■ Qualitative (Descriptive) vs. Quantitative • ■ Benchmark vs. Guidelines • ■ Customized vs. Market indices • ■ Others • ▷ Rebalancing frequency • ▷ Active vs. Passive

5. INVESTMENT PROCESS Objectives of reserve mgt. & Constraints ●Risk tolerance and return ● Investment universe ● Reserves classification Asset allocation ●Benchmarks ● Investment guidelines Risk management & Performance evaluation Actual management ● Active management ● External fund management ● Security lending / RP

6. Actual Management ASSET ALLOCATION PROCESS SAA TAA Middle Office Front Office Front Office Annually/Quarterly Monthly Daily Benchmark & Guidelines Benchmark & Guidelines Take positions Under Guidelines & Risk budgeting

7. Quantitative Tools STRATEGIC ASSET ALLOCATION - Overview - Objectives Constraints SAA

8. STRATEGIC ASSET ALLOCATION - Objectives - Liquidity Safety Return • ■ Higher return on the basis of safety and liquidity • → More emphasis on return • ▷ More concerns about opportunity costs of keeping huge reserves • ▷ Less concerns about liquidity with increasing reserves LiquiditySafety Return

9. STRATEGIC ASSET ALLOCATION - Constraints - • ■ Issues to be considered • ▷ Need to incorporate various realistic aspects • ▷ More constraints → More possibility of sub-optimal allocation in principle Risk tolerance & (Expected) Returns • CONSTRAINTS Investment universe Currency composition Duration

10. STRATEGIC ASSET ALLOCATION - Risk Tolerance and Return - • ■ Investment objectives are expressed in terms of risk tolerance and (expected) returns • ■ Measurement of risks • ▷ Volatility: Historic (variance), Implied, Model-calculated • ▷ VaR: Maximum potential loss with x% confidence level • ▷ Short-fall risk: x% probability of negative return • ■ Measurement of (expected) returns • ▷ Historic (mean) • ▷ Nelson-Siegel approach or other econometric forecasting models • ▷ Black-Litterman approach (combining market and investor’s view)

11. STRATEGIC ASSET ALLOCATION - Currency Composition - • ■ Currency composition: Major currencies (USD, EUR, JPY, GBP, etc.) • ▷ 4-factor approach → No currency-allocation • • Currency composition of external debts • • Currency composition of current account payments • • Currency composition in major global bond markets • • Currency composition of other central banks • ■ Issues to be considered • ▷ Frequent changes in currency composition may cause instability in • international FX markets

12. STRATEGIC ASSET ALLOCATION - Currency Composition - • <Reference>Currency Composition of All Central Banks • Dec 2000 Jun 2007 • (source: IMF)

13. STRATEGIC ASSET ALLOCATION - Investment Universe - • ■ Investment instruments • ▷ Government bonds • ▷ Government-backed bonds (Agencies) • ▷ Supras & Sovereigns • ▷ MBS & ABS • ▷ Financials & Corporates • ■ Issues to be considered • ▷ How to allocate when introducing new instruments • • Optimization vs. x% rule

14. STRATEGIC ASSET ALLOCATION - Investment Universe - • <REFERENCE> Trends of Investment Diversification Source: UBS

15. STRATEGIC ASSET ALLOCATION - Investment Universe - • <Exercise>x% rule plus some quantitative analysis • ■ When adding a new asset to the existing investment universe • ▷ Find “efficient area” with reasonable expected return and risks • • Criteria: Expected return, Sharpe ratio, short fall risk, etc.

16. STRATEGIC ASSET ALLOCATION - Tranches - • ■ Classification of reserves by tranche • ■ Issues to be considered • ▷ Construct tranches by sources of reserves, if applicable → ALM approach • ▷ Separate allocation by tranche, or overall allocation • To meet short-term payment demand • Relatively small amount of reserves Liquidity Tranche • Return enhancement, while preserving liquidity and safety • Mid- to long-term time horizon Investment Tranche • Higher returns with a longer-term time horizon • External fund managers Long-term Tranche

17. STRATEGIC ASSET ALLOCATION - Maturity and Duration - • ■ Maturity • ▷ For some currencies/instruments, sectors can be classified • (e.g.) US Treasuries: 1-3 / 3-5 / 5-7 / 7-10 / over 10 years • ▷ Maturity limits • • Deposits: shorter than one year • • Most bonds or notes: not exceeding about 10 years • • For some instruments (MBS): up to 50 years of maturity • ■ Duration • ▷ Target vs. Outcome

18. STRATEGIC ASSET ALLOCATION - Optimization Tools - • ■ Quantitative tools • ▷ Mean-variance optimization • • Most traditional: Minimize risk while keeping returns fixed • - Corner solution problem, very sensitive to input changes • ▷ To avoid problems using historic mean • • No-view optimization: Changes allocations according to market prices • - Extract expected returns from the current yield curve • • Resampling technique: Monte Carlo simulation • - Produces multiple efficient frontiers • ▷ Black-Litterman Model: Widely used recently

19. STRATEGIC ASSET ALLOCATION - Black-Litterman Model - • ■ Characteristics • ▷ Combine the investor’s view (Q) with market equilibrium expected return • • Implied equilibrium expected return (Π) = λ ∑w • λ: risk aversion factor, ∑: covariance matrix, w: market weight • ■ Formula: • E(R)= f(Π,Q) = • w=(λ ∑)-1E(R) : allocation result when there is no constraint • τ : constant, Ω: covariance matrix of investor’s view, • P: matrix indicating views • ■ If there are constraints in allocation, use mean-variance optimization • ▷ Consequently, historic mean is replaced by expected return

20. STRATEGIC ASSET ALLOCATION- Investment Guidelines - • ■ Role of the investment guidelines • ▷ Constraints for risk management purpose • ▷ Allowing for active management • ■ Examples of guidelines • ▷ Eligible currencies, investment products, and credit ratings • ▷ Deviation limits against benchmark (Hard limits) • • sector, duration, maturity weight limits • ▷ Total risk limits or Active risk limits (Soft limits) • • TE (tracking error) limit

21. TACTICAL ASSET ALLOCATION • ■ Characteristics • ▷ Similar process to strategic asset allocation • ▷ But with more frequency to reflect the recent movements in the market • ▷ Currency overlay allowed • ■ Currency overlay • ▷ Trading FX forwards • ▷ Different weights from underlying assets, according to FX forecasts • ■ Tactical guidelines • ▷ Set within the strategic guidelines

22. TACTICAL ASSET ALLOCATION • <Efficient frontier>

23. RISK BUDGETING- For Active Portfolio Management - • ■ Objective • ▷ Maximize active alpha under the given TE* limit • * standard deviation of alpha • ■ Process • ▷ Maximize portfolio IR

24. FURTHER CONSIDERATIONS • ■ Feedback from qualitative decision-making • ▷ To modify quantitative results • ▷ Especially needed when expanding investment universe • ▷ But needs consistent rationale (not ad hoc basis) • ■ ALM approach • ▷ More efficient if liabilities are incorporated in asset allocation process • ■ Others: • ▷ Need to construct efficient IT system • ▷ Outside (international) consulting is very helpful

25. Q & A Thank you!