DEUTSCHE BANK RESEARCH CHAIR

Presentation of the Partner

About Deutsche Bank

Deutsche Bank is a leading global investment bank with a substantial private clients franchise. Its businesses are mutually reinforcing. A leader in Germany and Europe, the bank is continuously growing in North America, Asia and key emerging markets. With more than 100,000 employees in 73 countries, Deutsche Bank offers unparalleled financial services throughout the world. The bank competes to be the leading global provider of financial solutions, creating lasting value for its clients, shareholders, people and the communities in which it operates.

Despite turbulence in financial markets, Deutsche Bank maintained its capital strength. This gives the bank a firm foundation from which to focus on its responsibilities: responsibilities to its clients, who continue to look to the bank as a dependable business partner; responsibilities to its shareholders and staff, to whom the bank seeks to remain attractive in future; and finally, the responsibilities to the financial system, of which the bank is a part, and which now needs to be rigorously analysed and re-engineered.

Deutsche Bank comprises three Group Divisions: Corporate and Investment Bank (CIB); Private Clients and Asset Management (PCAM) and Corporate Investments (CI).

Within Asia Pacific all of the bank’s key business divisions are long and well established with over 18,000 staff located within 17 markets. The region was recently highlighted in the fourth phase of the bank’s Management Agenda, announced in late 2009, as a key driver of additional revenue growth.

While this is a significant statement of intent, Deutsche Bank already has a world-class operation across Asia of significant scale, having invested in the region throughout many financial cycles. The strength of its CIB business is nonetheless a standout in terms of scale and success. As a result, the region has made a major contribution to the bank for a number of years, with EUR 3.77 billion in revenues derived from Asia Pacific in 2010. The bank recently celebrated 30 years of business in India, where it has a large and highly successful franchise; while in China, a priority growth market, the bank holds all the operating licenses required to compete in its core global business lines.

Presentation of the Partnership

Objectives

EDHEC-Risk Institute has created a research chair in “Asset-Liability Management Techniques for Sovereign Wealth Fund Management”, in partnership with Deutsche Bank, under the scientific responsibility of Lionel Martellini, Director of EDHEC-Risk Institute.

It is now widely recognized that sovereign funds represent a dominant force on international financial markets. By some estimates, the total size of sovereign wealth funds currently stands at $2.9 trillion, which amounts to approximately 60% of the world’s foreign exchange reserves and exceeds the estimated size of the world’s hedge fund industry (around $1.5-$2.0 trillion). The growth of sovereign wealth funds is in fact likely to continue, and is expected to reach around USD28 trillion by 2022, which is more than double the amount of FX reserves ($13 trillion), with their share in global financial asset holdings expected to grow from 2.5% in 2007 to 9.2% in 2022 (Morgan Stanley (2007)).

This rapid growth of sovereign wealth funds and its implications pose a series of challenges for the international financial markets, but also for sovereign states. The purpose of this research chair is to focus on improving our understanding of optimal investment policy risk management practices for SWFs. In particular, we ambition to analyse the optimal investment policy of a SWF in a dynamic ALM framework that will allow us to formalize the impact on the optimal allocation policy induced by the presence of risk factors affecting i) the state surplus dynamics and ii) the (implicit or explicit) liabilities the fund is facing.

Once the long-term strategic allocation has been defined, a number of implementation issues remain, in particular those related to reconciling a top-down asset allocation perspective and a bottom-up long-term security selection strategy. In fact, it is very legitimate for SWFs to seek long-term alpha opportunities, and/or consider reaching strategic stakes in selected target companies, an effort for which they are better equipped than hedge funds, which have a shorter time-horizon, or pension funds, which have lower risk budgets/margins for error and are subject to a number of short-term regulatory constraints.

This research programme will include the following developments:

Introducing a formal dynamic asset allocation model that will incorporate the most salient factors in SWF management
Proposing an empirical analysis of the risk factors impacting the inflows and outflows of cash for various sovereign funds, with a specific example in each of the two main categories (foreign reserve fund and natural resource fund)
Discussing how investment banks and asset managers could design dedicated solutions for SWFs based on the financial engineering of customised building blocks aimed at facilitating the implementation of the intertemporal hedging demands related to the presence of a variety of risk factors impacting sovereign surpluses (where the money is coming from) and liabilities (what the money will be used for).

Research Outputs:

What Asset-Liability Management Strategy for Sovereign Wealth Funds?
March 2012
Frédéric Ducoulombier, Lixia Loh, Stoyan Stoyanov
This publication presents the industry reactions to the EDHEC-Risk Institute study entitled “Asset-Liability Management Decisions for Sovereign Wealth Funds”. That study put forward a model to optimise the investment and risk management practices of sovereign wealth funds, which can be regarded as the extension to sovereign wealth funds of the liability-driven investing paradigm recently developed in the pension fund industry. The model suggested that the investment strategy of a sovereign wealth fund should involve a state-dependent allocation to three main building blocks: a performance-seeking portfolio, an endowment-hedging portfolio, and a liability-hedging portfolio. The objective of the current publication is to compare these research conclusions with current perceptions by sovereign investment professionals.

An Integrated Approach to Sovereign Wealth Risk Management
June 2011
Bernhard Scherer
Sovereign wealth funds (SWFs) typically have no direct earmarked liabilities. Nor should they, as the financial asset they represent is only part of total sovereign assets, which in turn guarantee all sovereign liabilities. The objective of this paper is to incorporate the economic balance sheet of the sovereign sponsor into the optimal asset allocation problem of the SWF. This paper outlines an easy to implement solution that nests well in the literature on SWFs.

We show that economic leverage will reduce speculative demand but leave hedging demand (against fluctuations in the net fiscal position of the sovereign state) unchanged. We also show how to extend our one-period methodology to a multi-period context by solving a dynamic stochastic programme. Allowing for optimal dynamic decision making increases the amount of equity risk an SWF can take. The advantage is greatest for large values of economic leverage. Finally, we conclude that narrow tactical asset allocation ranges limit the SWF’s ability to manage its risks.

Press release announcing the publication of the research: 21/07/2011

Asset-Liability Management Decisions for Sovereign Wealth Funds
October 2010
Lionel Martellini, Vincent Milhau
This paper proposes a quantitative dynamic asset allocation framework for sovereign wealth funds, modelled as large long-term investors that manage fluctuating revenues typically emanating from budget or trade surpluses in the presence of stochastic investment opportunity sets. The optimal asset allocation strategy takes into account the stochastic features of the sovereign fund endowment process (where the money is coming from), the stochastic features of the sovereign fund’s expected liability value (what the money is going to be used for), and the stochastic features of the assets held in its portfolio.

Our results suggest that the investment strategy for an SWF should involve a state-dependent allocation to three building blocks, a performance-seeking portfolio (PSP, typically heavily invested in equities), an endowment-hedging portfolio (EHP, customised to meet the risk exposure in the sovereign wealth fund endowment streams), and a liability-hedging portfolio (LHP, heavily invested in bonds for interest rate hedging motives, and in assets exhibiting attractive inflation-hedging properties, when the implicit or explicit liabilities of the sovereign wealth funds exhibit inflation indexation), as well as separate hedging demands for risk factors impacting the investment opportunity set, most notably interest rate risk and equity expected return risk.

Press release announcing the publication of the research: 23/11/2010

Related Research:

Portfolio Choice for Oil-Based Sovereign Wealth Funds
October 2009
Bernhard Scherer
Given recent interest in the activities of sovereign wealth funds (SWFs), this paper reviews the financial economics of portfolio choice for oil-based investors. It views the optimal asset allocation problem of a sovereign wealth fund as the decision-making problem of an investor with non-tradable endowed wealth (oil reserves). Optimal portfolios combine speculative demand (optimal growth) as well as hedging demand (hedging resource fluctuation risk) and the level of risk taking should depend both on the fraction of financial wealth to resource wealth and on the oil shock hedging properties of the investments. As a novelty in the theoretical literature, it introduces background risk for a SWF in the form of oil reserve uncertainty. SWFs with great uncertainty about the size of their reserves should invest less aggressively and vice-versa. It also identifies the optimal speed of the extraction policy (oil-to-equity transformation) as a driving force for portfolio adjustments across time and presents a dynamic programming approach to approximate portfolio adjustments.

Macroeconomic Risk Management for Oil Stabilization Funds in GCC Countries
September 2009
Bernhard Scherer
The existence of oil stabilization funds as the largest category of sovereign wealth funds relies on oil prices as a main source of macroeconomic risk for oil exporting countries. Given the often contingent spending policies of oil stabilization funds (accumulating wealth when oil prices are rising and spending wealth to support the local economy when GDP is shrinking) it is important to understand the magnitude and relative importance of oil price shocks relative to other sources of macroeconomic risk.

Using the Bernanke/Sims approach, this paper establishes oil price innovations as the most important short- and long-term economic drivers of local GDP for GCC (Gulf Cooperation Council) countries. Investment guidelines for oil stabilization funds should therefore stress the necessity to invest in assets with negative correlation to oil price movements to protect the total wealth of an oil-exporting economy. Using a Bayesian VAR, the paper projects the impact of different oil price scenarios on local GDP and hence the likely growth of oil stabilization funds.

About EDHEC-Risk Climate Impact Institute

Marking the priority assigned by the School to sustainability issues and building on its research programmes exploring the relationships between climate change and finance, EDHEC-Risk Institute became EDHEC-Risk Climate Impact Institute in October 2022. The Institute's mission is to help private and public decision-makers manage climate-related financial risks and make the best use of the financial tools available to transition to low-emission and climate-resilient economies. The Institute’s research programmes explore the relationships between climate change and finance and our key ambition is to become a leading academic reference point for long-term investors, helping them to manage the asset-pricing implications of climate change as well as mitigation and adaptation efforts.