Alharbi, Mohanned (2020) Identifying an Optimal Foreign Currency Reserve Composition to Mitigate the Volatility Spillover Effect of Declining Oil Price: The Case of Saudi Arabia. Other Degree thesis, Victoria University.

Abstract

Saudi Arabia, one of the Group of Twenty (G20) economies, has fascinated the world with its increase of foreign currency reserve based on oil revenues. The sharp rise in Saudi foreign currency reserves is one of the most important features of the nation’s rapid wealth accumulation. Foreign reserves are viewed as a national source of economic growth security and financial stability. However, since the 2014–2016 oil price decline, foreign reserves have largely been spent; the depletion has been attributed to sustained government expenditure and declining oil revenues. This study addresses the financial management of the composition of Saudi Arabia’s foreign currency reserve (SFCR) during the 2014–2016 oil price decline. During this period, the Saudi government used its foreign currency reserve to cover government expenditure. Therefore, there is a need to develop a financial management strategy to mitigate foreign currency reserve depletion. The aim of this study is to identify the optimal foreign currency composition that provided a higher return during the examined period. Two approaches are considered regarding foreign currency reserve composition: univariate and multivariate generalised autoregressive conditional heteroscedasticity (GARCH) models for institutional management. The focus of this work is the portfolio composition management viewpoint during the 2014–2016 oil price decline; it considers the suggested distribution of SFCR only during this period. In particular, the research examines SFCR allocation across three groups of currency pairs: major currencies; commodity currencies; and emerging countries’ currencies. The currency groups are analysed and simulated to identify the optimal foreign currency reserve composition. Optimal weights and hedging ratios are used in this study to mitigate risk exposures of oil price volatility by adding currencies that negatively correlated with oil in the SFCR portfolio. This study provides recommendations as general comprehensive guidelines for strategic asset allocation options for consideration by Saudi Arabian Monetary Authority (SAMA) portfolio management authorities. The study uses the GJR-GARCH model, proposed by Glosten, Jagannathan and Runkle (1993) and Lamoureux and Lastrapes (1990), to understand the dynamic behaviour for each currency pair and estimate the persistence in variance using the univariate mean-variance analysis. Further, it employs the multivariate VAR(1)-GARCH(1,1) model, including the Baba, Engle, Kraft and Kroner, constant conditional correlation and dynamic conditional correlation models, to understand the interaction between oil prices and foreign currencies. In addition, cross-correlation function, introduced by Cheung and Ng (1996), also incorporates the univariate GARCH model in two steps to confirm the results of multivariate GARCH and test for the causes in variance between oil and currency pairs. Third, and finally, the optimal weight of the foreign currencies in this study is determined as suggested by Kroner and Ng (1998). The hedge ratio follows Kroner and Sultan’s (1993) approach as a policy recommendation to the SAMA to rebalance the composition foreign currency reserve portfolio. Using the above econometric models, this study will identify and select the possible currencies that can be combined with existing currencies in SAMA’s foreign currency reserve portfolio. Using the result of univariate GARCH analysis for oil and each currency will help SFCR portfolio managers in SAMA to understand the dynamic behaviour of oil and currency exchange rates. Further, it will allow SAMA to introduce an efficient currency-selection strategy that mitigates the risk of depletion by investing in foreign exchange markets. Moreover, it enhances SFCR portfolio composition and maximises dynamic asset allocations when estimating the effect of volatility spillover between oil and the currencies. In this research, SAMA seeks to protect its foreign currency reserve portfolio against price fluctuation by investing in chosen foreign currencies. In addition, the results of the multivariate GARCH models estimate portfolio weights and hedge ratios by using variances and covariances matrices. The results of the multivariate analysis reveal that based on the optimal weights and hedge ratios estimation, SAMA portfolio diversification should increase its focus on some commodities and emerging countries’ currencies to rebalance SFCR composition. This study recommends that, for example, the Japanese yen, Swiss franc, Swedish krona and Polish zloty be added to the current major currencies to reduce the impact of oil volatility.

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