This paper sets out a new analytical framework for optimal asset allocation of sovereign wealth, based on the theory of contingent claims analysis (CCA) applied to the sovereign’s economic balance sheet. A country solves an asset-liability management (ALM) problem involving its sources of income and its expenditures. We derive analytically the optimal asset allocation of sovereign wealth, taking explicit account of all sources of risks affecting the
sovereign’s balance sheet. The optimal 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, particularly with respect to sovereign wealth funds and foreign exchange reserves. A real-life application 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. At present, Chile’s sovereign investment is under-diversified.
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