Use of Structured Products in Reserves Management

By Violet Chatsika
2007
The recent rise in reserves, general economic developments and availability of portfolio management tools in the MEFMI region have put the central banks in a more favourable position to consider use of investments products traditionally viewed as complex. Not surprising, most of the central banks in the region are seeking for ways to enhance return from their reserves management.

Analysis of the region’s reserves management approach shows that reserves are not managed at their optimal levels in most central banks. This is mainly due to overemphasis by central banks on liquidity objective which results in investing in suboptimal assets. This paper has attempted to break new grounds in exploring a new and fast-growing financial instrument known as structured product, as a potential reserve asset to enhance return in the MEFMI region. Structured products are composites of different conventional assets, such as bonds, currencies, equities or commodities, and derivatives instruments moulded into a single package. These products can guarantee capital or income and offer the opportunity to add value not only in rising markets but also in flat or falling market.

Inclusion of derivatives or option-like securities, such as structured products, complicates the normal linear relationship between the performance of the individual assets and the total portfolio by producing non-linear risk and return outcomes. Market scenarios generated through a Monte Carlo process where structured products are included in a portfolio, show improved return and reduced risk. This is due to the fact that a portfolio manager is at liberty to include structured products with low correction with other assets in his portfolio. The result is a shift of the whole efficient frontier curve upwards/leftwards.

Market size and key players are some of the weaknesses identified for structured products. Despites the products being is existence since in 1970s, their acceptability and growth has been slow. Since most structured products are traded privately, over the counter, rather than on a stock exchange, it is difficult to obtain reliable data relating to the overall size of the market and trading volumes.

The paper concludes with the opinion that structured products can potentially enhance return and reduce risk in reserves portfolio. This would be a better alternative to increasing duration (exposure to interest rate risk) in pursuit of higher returns.