Department of Economics, UCSC

This paper presents a model comparing the optimal degree of asset class diversification abroadby a central bank and a sovereign wealth fund. We show that if the central bank manages itsforeign asset holdings in order to meet balance of payments needs, particularly in reducing theprobability of sudden stops in foreign capital inflows, it will place a high weight on holding saferforeign assets. In contrast, if the sovereign wealth fund, acting on behalf of the Treasury,maximizes the expected utility of a representative domestic agent, it will opt for relativelygreater holding of more risky foreign assets. We also show how the diversification differencesbetween the strategies of the bank and SWF is affected by the government’s delegation ofresponsibilities and by various parameters of the economy, such as the volatility of equity returnsand the total amount of public foreign assets available for management.