March-14 Central Bank of Egypt 1 Strategic Asset Allocation

March-14 Central Bank of Egypt 2 Index I.What is Strategic Asset Allocation? 1.Definition of SAA 2.Process of Setting the Investment Policy II.SAA Process 1.Objectives & Investment Horizon 2.Risk Tolerance 3.Identify Eligible Asset Classes 4.Determine Market Assumptions 5.Portfolio Construction 6.Optimal currency composition III.Validation of SAA IV.Implementation of SAA

March-14 Central Bank of Egypt 3 Index V. Details on SAA Techniques 1.SAA Approaches 2.Historical Analysis 3.Shortfalls of Historical Analysis 4.From Historical to Forward-Looking Approach 5.The Nelson-Siegel Yield Curve Model 6.SAA Model

March-14 Central Bank of Egypt 4 What is Strategic Asset Allocation? I- What is Strategic Asset Allocation?

March-14 Central Bank of Egypt 5 1. Definition of SAA “The process by which an institution determines the appropriate neutral asset allocation at any point in time to achieve its long-term investment objectives”

March-14 Central Bank of Egypt 6 2. Process of Setting the Investment Policy 1.Articulate Objectives and Investment Horizon 2.Specify Risk Tolerance and Constraints 3.Identify Eligible Asset Classes 4.Determine Capital market assumptions (e.g. expected returns) on a forward-looking basis 5.Decide on neutral asset allocation and Implement the SAA * Source: World Bank

March-14 Central Bank of Egypt 7 II- SAA Process

March-14 Central Bank of Egypt 8 1. Objectives & Investment Horizon Objective: Capital Preservation Achieve a minimum required rate of return Match assets and liabilities Minimize volatility of returns. The investment horizon is the time over which the portfolio is used and over which returns and risks should be managed and measured.

March-14 Central Bank of Egypt 9 1. Objectives & Investment Horizon Based on historical USD Government bond returns Source: World Bank

March-14 Central Bank of Egypt Risk Tolerance Risk tolerance is defining how much the institution tolerates in terms of risk, which needs to be translated into a risk measure such as; -shortfall probability -probability of not achieving a certain target return -worst case outcome at a certain confidence level.

March-14 Central Bank of Egypt Risk Tolerance Commonly risk measures: Duration Volatility of total returns Downside risk measures 1. Shortfall probabilities Probability of negative return Probability of underperforming a hurdle rate / benchmark 2. Minimum return at given confidence level Value at risk 3. Expected Shortfall Expected Loss Conditional Value at Risk

March-14 Central Bank of Egypt Identify Eligible Asset Classes Selection of eligible asset classes is an important step in the asset allocation process. Section should not be based on the riskiness of stand alone asset class. Asset classes could include; cash, Government bonds, Agencies, TIPS, Corporates, ABS, MBS.

March-14 Central Bank of Egypt Determine Market Assumptions Expected returns for each asset class Historical Factor models Autoregressive models Volatilities and correlations Historical Autoregressive models such as GARCH models Regime switching model

March-14 Central Bank of Egypt Portfolio Construction Most Common : Mean variance optimization Assumption: returns are normally distributed. Inputs:  Expected return of each asset class  Standard deviation of each asset class  Correlation of returns between asset classes Output:  The efficient frontier, i.e. the set of portfolios with the highest expected return for a given level of risk.

March-14 Central Bank of Egypt Portfolio Construction Efficient frontier: set of portfolios which have the lowest possible variance for a given target expected return.

March-14 Central Bank of Egypt 16 III. Validation of the SAA Back-testing of SAA:  Robustness checks: compare ex-ante risk limit with ex- post risk of the portfolio Sensitivity analysis of key parameters  Impact analysis: How much do the portfolio weights change when expected return assumptions or risk assumptions are changed.  Marginal analysis: how much does the risk of the portfolio change for a small change in the weight of one of the assets

March-14 Central Bank of Egypt 17 IV. Implementation of SAA SAA optimal allocation is implemented through selection of benchmarks (neutral point) Decide on Rebalancing rules. Active or passive management. Risk budget for active management.

March-14 Central Bank of Egypt 18 Details on SAA

March-14 Central Bank of Egypt SAA Approaches Historical Approach Forward-Looking Approach

March-14 Central Bank of Egypt Historical Analysis Carry historical Analysis on historical returns for different durations. Calculate different risk measures for different duration benchmarks in order to reflect the bank objective and risk tolerance over a certain time horizon. Source: World Bank

March-14 Central Bank of Egypt Shortfalls of Historical Analysis The shortfalls of Pure Historical Analysis:

March-14 Central Bank of Egypt Shortfalls of Historical Analysis Capital preserving portfolio indeed? See February and March, 2005

March-14 Central Bank of Egypt Shortfalls of Historical Analysis What happened to 2 yrs yield?

March-14 Central Bank of Egypt Shortfalls of Historical Analysis Historical Analysis Approach assumes “Constant duration though not constant risk” –If our portfolio has an average duration of 2 years with a current yield of 1.5%, and yields go up by 1%, we will achieve a –ve return –However, if the current yield is 5%, and yields go up by even 3%, we will not achieve a –ve return Hence, for the same duration, as yield decreases, the probability of negative returns increases (and vice versa) so: Prob of –ve return is a function of current yield level, volatilities and market environment.

March-14 Central Bank of Egypt Shortfalls of Historical Analysis

March-14 Central Bank of Egypt From Historical to Forward Looking Approach First step towards forward-looking analysis: Scenario Analysis by estimating different yield curve scenarios A Simple Approximation:

March-14 Central Bank of Egypt From Historical to Forward Looking Approach Limitation: Scenario Analysis is good as a start for forward looking approach; however, it undermines the roll- down component.

March-14 Central Bank of Egypt The Nelson-Siegel Yield Curve Model Nelson and Siegel FORMULA The Level Factor. The Slope Factor. The Curvature Factor.

March-14 Central Bank of Egypt The Nelson-Siegel Yield Curve Model The long-term factor β0 governs the yield curve level. An increase in β0 increases all yields equally, thereby changing the level of the yield curve. An increase in β1 increases short yields more than long yields thereby changing the slope of the yield curve. An increase in β2 will have little effect on very short or very long yields but will increase medium-term yields, thereby increasing yield curve curvature.

March-14 Central Bank of Egypt The Nelson-Siegel Yield Curve Model What if we estimated this model every week for an entire year. It turns out that it is better to keep λ fixed across time. This adds quite a bit of stability to the model. Each week would give us three different parameters. We would get slightly different values each week for b 1, b 2, and b 3. We could then look to see how these parameters evolve over time.

March-14 Central Bank of Egypt SAA Model The weekly data over the past years has provided us with time series data for the Nelson-Siegel model’s parameters. Estimate parameters of vector autoregressive model “VAR(1)” based on historical Nelson Siegel factors. Define asset classes: return on these asset classes is a function of the fundamental variables Simulate VAR model over a certain horizon and calculate return of diffe rent asset classes. Output: different yield paths over a certain investment horizon (1 year) where government bonds with different maturities can be priced on the expected curve.

March-14 Central Bank of Egypt 32 Thank you