Chapter

6 Colombia

Author(s):
International Monetary Fund
Published Date:
April 2005
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Introduction

368. In 1997 the Banco de la República (BR), Colombia’s central bank, developed a long-term strategic project designed to manage the international foreign exchange reserves of the country in the most efficient manner, given the stated objectives for holding reserves in line with the highest international standards and practices. This ambitious project, which is reviewed periodically, has led to significant changes in the organizational structure, the decision-making process, the human resource policy, the technological platform, the risk control procedures, as well as the reserve management policies.

Governance and Institutional Framework

Reserve management objectives, scope, and coordination

Objectives

369. Reserve management seeks to maintain an adequate level of assets denominated in convertible foreign currencies readily available to meet a defined range of objectives for holding reserves in the most efficient manner. In order to understand reserve management policy in the case of the BR, it is important to first identify its objectives for holding reserves.

370. There are three reasons for holding reserves: (i) for transactional purposes, to support trade in an open economy; (ii) for precautionary motives, associated with potential balance of payments crises; and (iii) as collateral, to improve a country’s access to the international capital markets via maintaining sound foreign exchange liquidity policies. The first two motives have traditionally had strong theoretical support, whereas the last motive has been referred to in the literature only recently.

371. Before the 1990s, the main objective of reserves was the transactional motive, for which reserve adequacy was set in terms of the months of imports required to support its trade-related operations. The reserve adequacy objective also took into account the fact that the country was under a crawling peg foreign exchange system and had a low exposure to capital outflows due to restrictive regulation. During recent years, the BR has reviewed its reserve adequacy objective in light of the following: (i) the deregulation that has taken place during the last decade; (ii) empirical evidence of the growing impact of contagion in developing nations; and (iii) a review of the relative importance of sound liquidity policies in the country’s overall creditworthiness.

372. On the domestic front, three main developments had an important impact on the reserve adequacy objective. In 1991, Congress approved Law 09, by which the foreign exchange market was deregulated in order to encourage foreign direct investment and facilitate trade-related operations. In the same year, the crawling peg was gradually replaced by a currency band system, and in 1999, a free float exchange regime was introduced.25 Finally, the traditional sources of funding for public debt in the international markets via syndicated loans were replaced by the issuance of bonds in the international capital markets, and the private sector’s exposure to external indebtedness increased.

373. During the same time period, the Mexican, Asian, and Russian/LTCM crises highlighted the vulnerability of developing countries to contagion. Based on empirical evidence of the impact of such crises in developing nations with sufficient but limited access to the international capital markets, Bussiere and Mulder (1999) concluded that countries that maintained during this period a ratio of at least 1 in the reserves/short-term debt indicator were less vulnerable to contagion, even in conditions of slight misalignments in their current account and real exchange rates.26 For larger misalignments in these variables, the authors recommended a higher reserve adequacy objective.

374. Furthermore, the motive for holding reserves as collateral is emphasized by the fact that the international capital markets use the Bussiere and Mulder indicator as a yardstick to measure appropriate liquidity levels, an important variable in the country risk models that determine a country’s creditworthiness and the cost of its access to international capital markets.

375. As a result of this evaluation, the central bank adopted as the minimum reserve adequacy objective the expected value of one year’s public and private residual debt payments and amortizations due, plus a provision for current account deficits that can range from zero to the standard deviation of the long-term component of the current account, given that the country has a tendency to run current account deficits.27 The inclusion in the reserve adequacy objective of real exchange rate misalignments is under study.

Implications on reserve management

376. The changes that took place in the determination of the reserve adequacy objective of the BR had three important implications on reserve management policy.

377. The amount of reserves invested to cover immediate liquidity requirements in a Working Capital liquidity bucket was significantly lowered from almost 90 percent of total reserves before 1994 to 5 percent, given that under a free float exchange rate regime the probability of recurrent intervention decreased.

378. In order to lower the opportunity cost of maintaining reserves for precautionary and collateral purposes, two additional liquidity buckets were defined with investment guidelines that are consistent with their expected investment horizon. These were the Intermediate Liquidity bucket to cover potential intervention requirements over a one-year period and the Stable Liquidity bucket for such funds with the lowest probability of being used over a one-year period.

379. As the higher return objectives for the new liquidity buckets implied additional risks, the central bank committed resources for the enhancement of its risk control capabilities and delegated the management of the Stable Liquidity bucket to specialized asset managers.

380. A more detailed description of the criteria used by the BR to determine the size of each liquidity bucket, its liquidity policies, its investment guidelines, and its risk management capabilities is provided later in this chapter.

Scope

381. The scope of reserve management is limited to those assets denominated in convertible currencies that are readily available and are under the control of the central bank to meet its objectives, including claims in the derivatives market used to hedge currency and interest rate exposures. The BR also manages the liabilities it acquires for the sole purpose of supporting the liquidity of reserves. However, it does not manage the liabilities of the central government, which are under the control of the Ministry of Finance (MOF).

Coordination and strategy

382. The key elements that influence current reserve management policy are the country’s transition to a free float exchange system, characterized by a rapid process of deregulation in its exchange/capital controls, and its increasing dependency on the international capital markets for financing. The maintenance of a high level of foreign exchange reserves in order to reduce the impact on the country of contagion is also deemed to be a very important element in setting reserve management policy.

383. The BR does not use the purchase or sale of reserve assets against domestic currency as an instrument of monetary policy. It determines the value of reserves in accordance with the desired reserve adequacy level, for which monetary effects that are derived from changes in the level of reserves are sterilized, if necessary through open market operations, in order to keep the monetary base within the ranges defined by the BR’s Board of Governors.

384. On exchange rate policy, the central bank is committed not to influence the exchange rate, unless it is to maintain an orderly market in extreme volatility conditions for which it auctions volatility options to the market whenever the exchange rate is above or below 4 percent of its 20-day moving average. The BR at its discretion may also tender options to accumulate or sell reserves to adjust its reserve adequacy objectives. Any changes in the policy of intervention trigger a review of the central bank’s liquidity and investment policies.

385. On the fiscal front, there is no clear link between reserve management and debt management as each pursues different investment objectives. Nevertheless, at a macro level there is a close coordination between the MOF and the central bank Board of Governors in order to ensure the sustainability of fiscal policy and the maintenance of adequate liquidity levels.

Transparency and accountability

386. The BR’s mandate that supports its management of the country’s foreign exchange reserves is defined in the political constitution of Colombia and in Law 31 of 1992.

387. Chapter 6, Article 371, of the political constitution of Colombia determines that the central bank “…will be organized as a public legal body with administrative, patrimonial and technical autonomy, subject to its own legal regime.” Among the functions that the Constitution assigns to the central bank is the administration of the foreign exchange reserves and the requirement that it should inform Congress periodically on the performance of its different responsibilities, including reserve management.

388. Law 31 of 1992 Chapter IV further elaborates on the mandate the central bank has in the management of the foreign exchange reserves in the following way: “The Board of Directors of Banco de la República will administer the foreign exchange reserves in conformity with public interest, to benefit the national economy and with the objective of facilitating the external payments of the country. Its administration involves the management, investment, custody and disposition of reserve assets. Reserve assets will be invested subject to criteria of security, liquidity and return in assets denominated in freely convertible currencies or gold.” Furthermore, the Law permits the BR to set up capital subscriptions with international multilateral institutions, so long as such subscriptions can also be considered reserve assets; it cannot grant loans on account of the international reserves; it is allowed to open margin accounts to enable it to execute operations in the derivatives markets for hedging purposes; and it allows it to contract credits to support the balance of payments as long as the product does not affect the monetary base. The law establishes the immunity of the foreign exchange reserves against seizure.

389. Insofar as the IMF Code of Good Practices on Transparency in Monetary and Financial Policies section 2.1 refers to operations of the central bank in the domestic markets, the BR has defined rules and procedures for the implementation of its monetary and exchange rate policy. These rules and procedures clearly define the conditions, obligations, and rights a counterparty should meet in order to participate in open market and foreign exchange operations with the central bank. The rules and procedures are publicly disclosed in regulation that is easily accessible to the public, for example, at the BR’s website.

390. For the management of the foreign exchange reserves, in which the BR does not act as a market maker, it selects its trading counterparties through internal formal processes of selection where the relevant criteria are established at the highest levels of decision-making hierarchy depending on the type of service required, restricted to counterparties that are members of well-established trading associations such as the Bond Market Association (BMA), the International Securities Market Association (ISMA), or the Commodities Futures Trading Commission (CFTC). In certain cases, standard legal contracts are entered into with counterparties to strengthen the procedures of trading in addition to market practices established by the relevant trading association.

391. The BR is fully compliant with the Special Data Dissemination Standard (SDDS), and its associated data template on international reserves and foreign currency liquidity position, which is published according to specified schedules. Additional information on foreign exchange reserves is disclosed to the public on a preannounced schedule through the central bank’s website as follows:

  • Position and foreign exchange liquidity on a weekly basis.

  • Monthly and quarterly audited accounting balances are delivered to the Superintendency of Banks and the General Public Accounting Office of Colombia. At the beginning of every year, the annual balance sheet as of December 31 of the previous year is published in a widely distributed national financial newspaper.

392. The semiannual report to the Congress provides an overview of the Central Bank’s activities and includes a summary of the level, composition, investment criteria, and performance on reserve management during the previous period.

Auditing

393. The political constitution of Colombia establishes that the President of the Republic exercises the control of the central bank. Law 31 of 1992 establishes that the President delegates the function of control of the central bank to an external auditor, appointed by him, for the purpose of “certifying the Bank’s financial statements, comply with the functions that the code of Commerce of Colombia assigns to the agent responsible for fiscal supervision, and exercise the control over the activities and performance of the entity,” including its management of the foreign exchange reserves. As such, the auditing process has an autonomous budget from any other department within the BR and is conducted by an auditor who is independent of the central bank.

394. The auditor’s notes on the central bank’s financial statements, which constitute the end result of its functions, include commentaries on the management and performance of the international reserves that are publicly available at the Bank’s website and widely disseminated through national newspapers. The auditor certifies that the accounting of reserve assets is conducted in conformity with accounting principles determined by the Superintendency of Banks of Colombia and presents quarterly evaluations on the different aspects of the management of the foreign exchange reserves to the President, the Superintendency of Banks, and the Board of Governors.

395. This year, apart from the external auditor appointed by the President of Colombia, the BR engaged the services of an international auditing firm, Deloitte & Touche, to audit its financial statements.

Accounting

396. The accounting procedures for reserve management follow the guidelines set by the Financial Accounting Standards Board (FASB), insofar that they are not in conflict with the accounting regulations of the Superintendency of Banks of Colombia.28 The reserve’s portfolio is marked to market on a daily basis, with the P/L affected by both realized and unrealized profits and losses. However, it must be highlighted that there are distinctive characteristics to the distribution of P/L results over a financial year. In the case of profits due to interest rate exposure, including hedging, these are distributed to the government within the first three months after the end of each financial year. Profits on the foreign exchange exposure to non-U.S. currencies in terms of the U.S. dollar may be registered in a special reserve to cover future losses. Finally, the results of the valuation of the reserves in local currency terms do not affect the P/L but are reflected in changes in equity in the balance sheet of the institution.

Institutional framework

Legal foundation

397. As mentioned earlier, the BR’s mandate to manage the international foreign exchange reserve of the country is established in the political constitution of Colombia and Law 31 of 1992.

Internal governance

398. The organizational structure of reserve management is described in Figure 5.

Figure 5.Organizational Structure

399. The Reserves Committee and the Internal Reserves Committee were created by an internal resolution approved by the Board of Directors that establishes the objectives, functions, and responsibilities of each Committee, updated last year in accordance with the recommendations contained in the “Guidelines for Foreign Exchange Reserve Management” approved by the Executive Board of the IMF in September 2001.

400. The Reserves Committee meets every two months, and is presided over by the Governor of the central bank and integrated by the Board of Directors. It is responsible for the determination of the objectives, principles, and general policies for reserve management.

401. The Internal Reserves Committee was created last year in order to define the operational procedures for reserve management, in accordance with the objectives, principles, and general policies determined by the Reserves Committee. It meets monthly, and it is presided over by the Technical Manager of the central bank (not a member of the Board of Directors) and integrated by the Executive Vice President of the Monetary Affairs and Foreign Reserves Department and the Director of the Reserves Department.

402. The Director of the Reserves Department is responsible for ensuring that the investment policies set by both the Reserves Committee and the Internal Reserves Committee are observed. Within the Reserves Department, the front office is responsible for the trades of the portfolio managed internally. The middle office is in charge of compliance, risk management, and performance attribution for both the internally and externally managed portfolios, reporting directly to the Internal Reserves Committee to guarantee transparency and independence. A Research Unit was created to support the Department’s training, development, and research requirements.

403. The Operational Department is in charge of accounting, confirmation, and settlement of operations carried out by the Reserves Department in a highly automated environment. Additionally, it keeps track of operational issues with the custodians, counterparties, correspondent banks, and asset managers. Reserve assets are reconciled on a daily basis by a separate Department.

404. The Internal Control Department was created in accordance with Law 87 of 1993, by which the procedures that regulate the exercise of internal controls of public entities were stipulated, in order to evaluate independently from the areas in charge of implementing reserve management policy, their procedures, and practices on a recurrent basis.

Human resource policy

405. The Bank’s human resource management strategy includes specialized selection, training, remuneration, evaluation, and promotion policies. Selection of the staff involves recruiting the top 10 percent of graduates in different disciplines from the top-tier universities in the country, out of which personnel are selected on the basis of an evaluation process that includes their level of technical expertise, their proficiency in English/computer skills, and an evaluation of their personal characteristics.

406. The training program is structured in three levels, as described in Table 4.

Table 4.Training Programs
LevelObjectives and Activities
BasicLearning specific procedures/manuals of the area and an overall knowledge of the Bank, reserve management theory, and basic financial and economic concepts.
IntermediateSponsorship of three levels of Chartered Financial Analyst (CFA) certificates to all front and middle office personnel (as of this year, replacing the ISMA General Certification Program). Internships with external managers. Management skills programs are given to senior members of the group to ensure the continuity of the department’s development.
AdvancedThis level includes the sponsorship of postgraduate studies at top international universities in fields such as financial engineering, international economics, and business administration, with a strong emphasis in finance; this step implies a long-term commitment between the employee and the Bank.

407. In order to reduce the risk of staff’s rotation, a special remuneration scheme is used based on the HAY GROUP methodology. Under this system a salary/benefit curve is established for the bank based on a comparison with that of its peer group within the country for each area.29 Each position is evaluated and graded according to the required know-how, responsibility, and problem-solving skills, for which the attainment of each level of CFA by the employee is crucial in order to establish the salary and benefits within the Bank’s overall salary curve.

408. In 1999, a five-year human resource management plan was deployed with the support of external specialized consultants. This plan included the definition of technical and personal competencies required for the bank’s employees, annual performance indicators, and development plans to promote these competencies. The Reserves Department uses this framework to determine the different types of training and salary base for employees with basic, intermediate, and advanced proficiency levels.

409. All employees are subject to both Colombia’s Disciplinary Code for public servants established by Law 200 of 1995 (later modified by Law 734 of 2000) and the Bank’s general code of employment conditions that establishes their rights and obligations, including the appropriate code of conduct that every employee must observe. Employees of the Reserves Department are also subject to a special internal code of conduct that concerns the nature of the operations on reserve management. The institution that regulates Public Service in Colombia requires that every year, all employees declare their assets and liabilities for the period.

Establishing a Capacity to Assess and Manage Risk

Risk management

410. The overall framework for risk management at the BR seeks to enable it to comply with its reserve management objective at all times; that is, to ensure that an adequate level of foreign exchange reserves is maintained readily available to meet intervention requirements in the most efficient manner. It must be highlighted, however, that some of the policies described below are in a transition phase due to be fully implemented at the end of this year.

Liquidity risk

411. The financial risk management framework of the central bank is based initially on the assessment of its liquidity requirements that are determined largely by the fact that under a floating exchange rate regime the probability of recurrent intervention has fallen and, at the same time, the level of reserve adequacy has increased. As such, in order to cover intervention requirements in the most efficient manner, total reserves have been segregated into three liquidity buckets as follows:

  • Working Capital to cover immediate liquidity requirements, composed mostly of overnight investments at the Federal Reserve Bank. This bucket may fluctuate within a range defined by the Reserves Committee, according to current intervention policy, and is managed internally by the Bank.

  • Intermediate Liquidity Bucket to cover up to one year’s liquidity requirements, which are estimated to be equivalent to the annual volatility of historical percentage changes in foreign exchange reserves with a 99 percent confidence level.30 These funds are managed internally by the BR under an indexation mandate to a benchmark that reflects the currency composition of the balance of payments consisting of a combination of money market instruments referenced to LIBID and highly liquid government bonds with a modified duration of 1.45 years. As such, its main source of added value over the Working Capital is its higher exposure to short-term credit risk, duration exposure, and currency diversification.

  • Stable Liquidity Bucket, composed of the excess of reserves over the value of the first two buckets, which by definition have the lowest probability of being used for intervention purposes over a one-year period. At a benchmark level these funds reflect the currency composition of the balance of payments, invested in a combination of money market instruments referenced to LIBID and highly liquid government bonds with a modified duration of 2. Furthermore, this bucket is delegated almost in its entirety to specialized external managers under non-indexation mandates that permit the possibility to invest in a range of nongovernment asset classes, credit risk, non-benchmark currencies, and active duration strategies.

412. The rationale behind the construction of such liquidity buckets is to allow the central bank sufficient time to liquidate the Stable Liquidity Bucket to cover unexpected intervention requirements under extreme market conditions, in order to minimize the risk of either assuming higher than normal transactions costs in liquidating less-liquid nongovernment asset classes or being unable to meet such needs in a timely manner. As such, a formal liquidity policy was devised in order to reduce further this risk.

413. The value of the Working Capital and the Intermediate Liquidity Bucket together can fluctuate within a sufficiently ample range (the equivalent of the historical volatility of reserves changes with a 90 percent, minimum, and 99 percent, maximum, confidence level) before liquidating the Stable Liquidity Bucket.

  • A policy on the use of repos to attend to unexpected liquidity requirements on a temporary basis when the cost of such arrangements, collateralized by securities traded as “specials,” which are part of the Intermediate Liquidity Bucket, is lower than the cost of liquidating a particular security in the Stable Liquidity Bucket in abnormal market conditions.

  • A policy on the use of contingency lines available through multilateral institutions.

414. Furthermore, periodically the Internal Reserves Committee reviews the liquidity requirements in light of the changes in the intervention policy and/or changes in the underlying assumptions that support the value of each bucket.

415. To determine the investment guidelines and risk management policies of the Intermediate and Stable Liquidity Buckets, the Reserves Committee drew on the international standards and practices documented by the IMF, the Bank for International Settlements (BIS), the Group of Thirty, and the Colombian Superintendency of Banks. As a result, the bank defined a risk management policy framed in a five-step dynamic process: identification, measurement, monitoring, limits/control, and validation, to be fully implemented by December 31, 2002. The overall risk management framework is depicted in Figure 6.

Figure 6.Overall Framework for Risk Management

Benchmark risk

416. The benchmark approved by the Reserves Committee represents the most efficient long-term strategy to accomplish the reserve management objectives of the BR for its investment portfolio (both the Intermediate and Stable Liquidity Buckets), constrained to assets with the highest liquidity characteristics. The benchmark embodies the following two objectives:

  • The currency composition of the benchmark of the total investment tranche, both the Intermediate and Stable Liquidity Buckets, must reflect the moving average of three years of the currency composition of the out-flows of the balance of payments, in order to maintain the capacity of reserves to respond to external pressures.31 As such, in order to measure this risk, an in-house model was developed in order to determine the currency composition of the outflows of the balance of payments.

  • The interest rate exposure of the benchmark of the total investment tranche, both the Intermediate and Stable Liquidity Buckets, is limited to a 95 percent confidence level that it will not register negative returns in any given year. This limit is set so as not to hinder the desired reserve adequacy level with adverse price movements and/or to expose the central bank to criticism for its handling of reserve management. The exposure of the benchmark to interest rate risk is determined by its sensitivity to parallel, twist, and curvature changes in the term structure of interest rates for a given modified duration/convexity, using an exponentially time-weighted VaR associated with these factors and a variance-covariance matrix to estimate the correlation between different index components. In addition, historical stress tests are conducted to evaluate the consistency of the model and determine worst-case scenarios.

417. The composition of the benchmark that complies with these two objectives is described later in this chapter. At the end of each financial year the Reserve Committee reviews both the currency composition and interest rate exposure of the benchmark in light of the changes in the underlying assumptions in the models that support these decisions to determine adjustments, if any, in its currency composition and modified duration to comply with these investment objectives over the next financial year. Normally, such adjustments on the total investment tranche are applied to the Intermediate Liquidity Bucket only, in order not to incur unnecessary transaction costs implicit in the types of assets in which external managers invest the Stable Liquidity Bucket.

Portfolio risk

418. The overall annual tracking error the portfolio managers may take against the benchmark is limited to 0.50 percent of the total value of the investment portfolio (both Intermediate and Stable Buckets). The Intermediate Bucket is managed internally under an indexation mandate to the benchmark, as a result of which its contribution to overall tracking error is minimum. Most of the authorized tracking error is allotted to the Stable Bucket that is managed exclusively by external asset managers. The allowed tracking error, currently around 1 percent available for external managers, is as a result higher than for the overall portfolio, depending on the weight of the Intermediate Bucket with respect to the Stable Bucket at any given moment in time. The Reserves Committee also limits the amount of tracking error allotted to any individual mandate to a tracking error of around 1 percent, so long as it does not exceed 0.125 percent of the value of the total investment portfolio, to ensure manager type diversification.

419. The measurement of the concurrent tracking error of the portfolios is based on a multifactor model based on two regressions. In the first regression, it determines the exposure of the portfolios with respect to the benchmark to parallel, twist, and curvature changes in the term structure of interest rates. In the second regression, it estimates three additional sources of risk: economic sector risk, issuer credit risk, and prepayment risk. Foreign exchange risk is calculated as a separate component. Overall tracking error is estimated using a variance-covariance matrix.

420. At the beginning of each financial year the Reserves Committee reviews the limits on tracking error in order to maintain a 95 percent confidence level so that in addition to benchmark risk, portfolio risk is not inconsistent with either the currency or the interest rate objectives.

421. In addition to the constraints on tracking error, the Reserves Committee also limits exposure to the different specific types of risks that can be taken by the portfolio managers as presented in Table 5. The investment guidelines of the portfolio are presented later in this chapter.

Table 5.Decomposition of Portfolio Risk
IDMeasurementMonitoring/ValidationLimits
Asset class liquidity riskQualitative drivers of liquidity Inclusion in global indicesReview of asset classes included in global indicesEligible asset classes must be part of at least two published global indices
Market microstructure
Heterogeneity of investor’s basePeriodic market surveyEligible asset classes must maintain a broad investor base
Number of market makersPeriodic market surveyEligible asset classes must be traded by at least five recognized market makers
Standardized market practicesReview of trading associations and regulatorsPractices must be regulated by at least one recognized entity
Security-specific structure
Outstanding issue sizeAverage outstanding issue size according to global indicesMinimum issue size of eligible securities is $500 million; maximum exposure per issue is limited to 10 percent
Ease of hedgeExistence of future contracts/substitutionsAvailability of liquid futures markets or substitute instruments for hedging
AgeIssue date of each securityRecently issued are preferred
Quantitative drivers of liquidity
Tightness
Average bid/offer spreadPeriodic surveys to principal market makers for each asset classAverage spread against governments must cover average transaction costs within 4 months
Depth
Transaction sizes that do not affect bid/offer spreads or market pricesPeriodic surveys to principal market makers for each asset classLimits on maximum transaction size according to asset class
Resiliency
Recovery time to normal market conditions after an external shockRecovery time of the performance of eligible assets against government bonds after a crisisEligible asset classes’ cumulative total return must exceed that of the risk-free asset within six months after a crisis
Derivative riskEstimated VaR resultant of difference in key rate duration of underlying asset and hedging instrument calculated daily to minimize basis riskIn-house model back-tested for ex post return mismatchMaximum net key rate duration in each node of underlying and hedging derivative is limited
Credit riskSystematic risk eligibility criteria Historical return/risk profile of representative indices for each rating category against a duration-matched government indexAnalysis of corresponding index returns—reviewed periodically to check required eligibility criteriaThe quantification of degree/type of non-linearity of historical return distribution of index returns for each rating category determines eligibility. Exposure to each eligible credit rating is limited so that the maximum shortfall against government bonds complies with an annual cap of 50 basis points with a 99 percent confidence level.
Systematic risk control
Spread duration* historical volatility of spreads at each rating category/ economic sector.Multifactor model, back-tested.Maximum percentage exposure to each credit rating within each asset class and economic sector.
Nonsystematic risk
Average and worst-case transition matrices/recovery rates coupled with simulations.Follow-up of transition events informed by international rating agencies and changed in index composition.Maximum percentage limits per issuer based on the minimum number of issuers required to post index returns with a low tracking error under stress scenarios of transition.
Issuer risk
Issuer selection risk is delegated to external managers with outstanding capabilities for specific issuer credit risk analysis.Review of transition events that affect securities held by each manager.N.A.
Interest rate riskDuration to parallel (D1), twist (D2), and curvature movements (D3) of the term structure of interest rates* historical volatility of each factor with respect to index. Scenario analysis and historical stress tests are applied.Multifactor model, back-tested.Limits to portfolio’s effective and spread duration against the index, and maximum exposure to mortgages.
Mortgage riskEffective spread and duration calculated based on a prepayment model.Prepayment model, back-tested.Limits to portfolio’s effective and spread duration against the index, and maximum exposure to mortgages.
F/X riskTracking error based on historical volatilities and correlations against benchmark positions. Scenario analyses and stress tests are applied.Currency risk model, back-tested.Maximum 5 percent of unhedged currency positions against the benchmark in eligible currencies.

Operational risk

422. Operational risk arises from inadequacies, failures, or nonobservance of internal controls and procedures, which threaten the reliability and operation of business systems. The Director of the Reserves Department is responsible for identifying and establishing the controls or procedures to mitigate these risks. In addition, the Internal Control Department and the Audit Department evaluate the procedures to control this risk, and make recommendations in this respect, based on their own independent risk analyses that are supported by international standard methodologies of audit and control like the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and the AS/NZS 4360:1999 (Australian and New Zealand Risk Management Standards).

423. The key operational risks identified in reserves management are the following: fraud risk, dealing risk, settlement risk, custodial risk, financial error or misstatement risk, loss of potential income, information technology risk, contingency events, and legal risk. The Reserves Department and Operations Department rely upon a series of tools to mitigate these risks, of which the most important is a well-established culture of auto-control, where the personnel are aware of the importance of the management of operational risk and are encouraged to verify every task and process. The specific approach to control each of the operational risks is as follows:

424. Fraud risk: Frauds or thefts are prevented through strict control of the reserves operations through manuals of procedures, the assignment of key responsibilities according to levels of hierarchy, and an appropriate segregation of duties within the organization.

425. Information technology risk: The assessment of this risk responds to the failure of the information systems and guarantees the security and maintenance of critical information. The network infrastructure, distributed in two nodes, uses a cluster architecture that allows load balancing and redundancy for disaster recovery of the most critical services on just one node. Disaster recovery is possible using online mirroring of data on top of a fiber-optic interconnection. From a security perspective, passwords and access controls are required to access computers and applications, and all data transmissions of sensitive information over the extranet and Internet use regular security features. The portal Servicios Electronicos del Banco de la Republica (SEBRA) handles authentication, encryption, and firewall functions. The management of the international reserves is based on eight principal applications systems that are described in Table 6.

Table 6.Information Systems
ApplicationPlatformFunctionVendor
Bloomberg, Reuters, and DatastreamWorkstation NTInformation services for news, prices, exchange rates, and analytics.Bloomberg Monitor Trading and Thompson Financial
DEALING 2000ProprietaryFront-end trading system for Forex and time deposit trades.Monitor Trading
OPICSClient/server: NT/NT Oracle 8iBack office application, trade entry system, settlement (SWIFT), credit risk, pricing, cash flows, and accounting.Frustum
ABACUSClient/server: NT/W2000 DB2Performance measurement system.Wilshire Associates
AXIOMClient/server: NT/W2000 C-treeMultifactor risk and performance attribution system, investment guideline compliance, and portfolio analysis.Wilshire Associates
SWIFTClient/server: NT/UNIXPayment system.SWIFT

426. Dealing risk: OPICS is a straight-through processing system with a single point of entry of trade operations restricted to authorized traders, limited by the system to the type of operations each trader is allowed to enter; limits on transaction size; authorized counterparties; the observance of credit risk limits; and a price tolerance check of the operations to ascertain that trades were transacted at current market levels. Once entered, the system generates a confirmation message of each trade that matches automatically to the trade details of the confirmation received from the counterpart, including a verification of the standard settlement instructions that a counterpart must provide as a requisite to be allowed to trade with the Bank, after which it generates the appropriate payment instruction via SWIFT.

427. Settlement risk: Trading counterparties are reviewed and approved by the Internal Reserves Committee. Standard settlement instructions are required for each counterpart and, in the case of disputes such as late settlement claims, these are conducted based on the laws, rules, and recommendations of ISMA or any other internationally recognized trading association.

428. Custodial risk: The prevention of a possible failure by the custodian is done at the selection process, which focuses on selecting professional and globally recognized entities for its custodial operations. Specific requirements include: experience, size (measured by the volume of assets under custody), the maintenance of sound technological resources to carry out its operations, the robustness of its contingency plans, its sub-custodian network, its reporting capabilities, and its management of fail trades. Once the custodian has been selected, its responsibilities are defined in a contract, and its performance is monitored through the daily reconciliation of portfolios with the central bank and external managers.

429. Financial error or misstatement risk: The definition of reserve assets or liabilities follows the Balance of Payments methodology from the International Monetary Fund. All components of reserves must be registered in the balance sheet, and the International Exchange Department calculates the total value of reserves on a daily basis, with the support of the Accounting and Economic Information Departments, to evaluate the consistency of this information.

430. Loss of potential income: The control of the ledger accounts of the BR is executed through the Cash Management Systems provided by its correspondents, which control in real time both debits and credits on the account, represent an alternative to SWIFT to execute payments in a contingency, and permit investment of excess funds throughout the day in different overnight alternatives. In addition to the above, the BR is in the process of contracting with its correspondents’ overnight repo facilities to generate liquidity collateralized by government bonds as part of its general liquidity policy. The cash flow module in the OPICS processing system is used in addition to the Cash Management System to determine the required balances of the ledger accounts, a process that the Bank intends to automate via an interface between the two systems, and a separate Department from the Reserves Department, which is in charge of the control of treasury operations, conducts daily reconciliation of the ledger accounts using the nostro conciliation system provided by SWIFT.

431. Contingency events: Based on the methodology documented by the Disaster Recovery Institute International, the Reserves and the IT Department have established contingency plans to guarantee the continuity of reserves operations at different levels of contingency. Important aspects of the contingency plan include a daily backup system with an updated copy of all vital information and an off-site contingency location that fulfills all trading and system requirements.

432. Legal risk: The management of legal risk is under the responsibility of the Reserves Department and the Legal Department of the BR, with the support of an external advisory firm. The process focuses on the administration of contracts and legal documents associated with the reserves operations; that is, external management, securities lending, futures trading, custody, etc. These contracts specify each party’s right and obligations, fees, investment guidelines, warranties, the sovereign immunity of the reserves, and the applicable legislation and jurisdiction. They also involve the establishment of new contracts, as well as the maintenance of the current contracts in accordance with the central bank’s internal regulations and international market regulations.

External management program

433. The objective of the external management program is to add value to the benchmark through the specialized management of risks that the Bank cannot manage internally. The framework for the external asset management program includes:

  • Program size: The Stable Investment Bucket is allocated to external managers, with the exception of a small portfolio managed internally under a non-indexation mandate.

  • Tracking error: 0.50 percent of the value of the total investment portfolio (which equates currently to 1 percent of the value of the Stable Liquidity Bucket), of which 0.125 percent can be allocated to one single external manager to ensure manager type diversification (currently around 1 percent per mandate).

  • Benchmark and investment guidelines: The total program shares the benchmark and investment guidelines described in Section D.

  • Types of managers: Manager diversification is promoted through the selection of global managers and U.S. sector rotation managers, with appropriate benchmarks and specialized investment guidelines for each that together reflect the overall desired exposure to the different specific types of risk.

  • Selection process: The selection of the managers is based on a Request for Proposal (RFP) that evaluates the company, organization, investment philosophy, historical performance, risk management capabilities, back-office processes/reporting, and additional services provided, such as research facilities. Finalists in the RFP process are visited on-site and asked to provide an economic offer.

  • Fee structure: A performance fee structure based on percentages of the normal fixed fee charged by each manager for a given market value of the mandate, tailored in such a manner that at the expected long-term excess return of each type of mandate (Global or U.S. Asset Rotation) the normal fixed fee and the performance fee are equal.

  • Performance evaluation: A three-year horizon is used to measure the performance of each mandate.

434. Managers for each mandate are classified as outstanding when excess return is above the long-term expected average, acceptable when it is in a range between the normal fixed fee of the manager and the long-term expected average, and low when performance is below the normal fixed fee.

435. Each category is reclassified according to the information ratio obtained by each manager.

436. Guideline compliance and operative errors are also evaluated in terms of both the numbers of errors and potential cost.

437. On the basis of this evaluation the Reserves Committee adjusts the mandates of external managers. The Internal Reserves Committee reviews the performance of the asset managers on a monthly basis, as well as any breaches of the guidelines or operative errors. The middle office in the Reserves Department is responsible for the day-to-day control of the asset managers who have to report their operations daily to both the OPICS processing system for accounting purposes and Axiom for risk, performance, and compliance control.

Performance measurement and attribution

438. Performance measurement is based on a daily mark-to-market valuation of the portfolios calculated by the Abacus system from Wilshire Associates Inc., which complies with the AIMR (Association for Investment Management and Research) and GIPS (Global Investment Performance Standards). A daily time-weighted rate of return that is geometrically linked is used to calculate a monthly figure. Performance is measured for time horizons such as monthly, year to date, yearly, rolling three years, and since inception, using U.S. dollars as the base currency. This is applied to both the benchmark and the portfolios and therefore returns can be measured on an absolute and a relative basis. Both gross and net returns are calculated for the portfolios, deducting operating costs such as fees, custody, and administrative expenses. In addition, risk-adjusted returns are also calculated through the use of the following measures:32

  • The information ratio that measures average excess return over the benchmark per unit of observed risk. This indicator evaluates the efficiency with which the managers have utilized risk.

  • The risk ratio that measures average excess return over the benchmark per unit of tracking error ex ante. This indicator evaluates the success of managers’ use of allowed tracking error.

  • The efficiency ratio measures the consistency of the risk models used by the managers by comparing observed tracking error with ex ante tracking error.

439. Attribution analysis is performed by Axiom using its multifactor model for each of the risk factors at the following levels: security, asset classes, countries, currencies, portfolio, and composites. This model offers an attribution measurement that goes beyond the traditional approach33 since it allows an integrated analysis of return and risk factors, which determines the efficiency of the overall investment strategy.

The role of efficient markets

440. As explained later in this chapter, the BR is extremely sensitive to liquidity risk. On the one hand, it constrains its reserve management activities to markets that have sufficient liquidity as measured through qualitative and quantitative factors that determine the quality of the liquidity of a particular market, factors that are reviewed periodically. Furthermore, the central bank sets limits on its exposure to a specific market, asset class, and individual issuer/issue in accordance with the quality of the liquidity of each investment alternative in order not to affect the relevant market through its own operations. Finally, the BR is also sensitive to trading in abnormal market conditions for which it has set rules to buy time to liquidate less-liquid assets at such times. It also must be highlighted that the central bank delegates to external managers the management of non-government asset classes since they have the necessary capabilities to liquidate them more efficiently in any market environment.

General Investment Guidelines

Working Capital

Reference rate: Fed funds.

Size: Range from US$390 to US$750 million.

Currency denomination: U.S. dollar-denominated assets.

Investment guidelines: Up to $390 million may be invested in overnight facilities provided by the Federal Reserve Bank of New York, of which up to $180 million may be invested in the overnight facilities provided by other treasury correspondents. No limit is imposed on U.S. Treasury Bills and Fixbis. A limit of $80 million each is imposed on money market instruments issued by the World Bank, Fannie Mae, Freddie Mac, and Federal Home Loan Banks.

Maximum maturity of investments: Three months.

Investment portfolio

441. The investment portfolio is segregated into two liquidity buckets: the Intermediate Liquidity Bucket and the Stable Liquidity Bucket.

442. The size of the Intermediate Liquidity Bucket, including investments in Working Capital, can range between $2,120 million (the volatility of the percentage changes in the foreign exchange reserves with a 90 percent confidence level) and $4,378 million (the volatility of the percentage changes in the foreign exchange reserves with a 99 percent confidence level).

443. Excess funds over $4,378 million may be invested in the Stable Liquidity Bucket.

444. In the case of a reduction in the foreign exchange reserves, the Working Capital Bucket and then the Intermediate Liquidity Bucket will be used until the sum of the two buckets reaches the minimum authorized level. After such level is reached, reserve reductions will be covered proportionally by the Intermediate and Stable Liquidity Buckets. In order to delay further the liquidation of the Stable Liquidity Bucket, repos and contingency lines may be used.

1. Aggregate Benchmark

445. The Money Market portion (MM) is referenced to the iMoneyNet First Tier Institutional index and the bond portion is referenced to the Salomon Smith Barney Government bond index weighted by country and sector as described in Table 7. Benchmark weights in each currency must be adjusted over time to reflect the three-year rolling average composition of the outflows of the Balance of Payments of Colombia. The overall average effective duration of the aggregate benchmark (Intermediate and Stable Liquidity Bucket) must be consistent with a 95 percent probability that its exposure to interest rate risk will not register negative returns over any given year.

Table 7.Benchmark Composition(In percent)
Intermediate Liquidity BucketStable Liquidity Bucket
MarketMarket
SectorUSDEURJPYUSDEURJPY
MM40001500
1–5 years4611371113
Total8611386113

2. Investment Guidelines for the Money Market Portion of the Benchmark (applicable to both Intermediate and Stable Liquidity Buckets)

3. Investment Guidelines: Intermediate Liquidity Bucket

446. The objective of the mandate is to replicate the risk/return characteristics of the benchmark of the Intermediate Liquidity Bucket depicted in paragraph 445, with the lowest possible tracking error, following the Investment Guidelines for the Money Market Portion described in Table 8, and matching the composition of the bond portion of the benchmark.

Table 8.Investment Guidelines for the Money Market Portion of the Benchmark
StrategyGuideline
DurationThe maximum weighted average maturity (WAM) of the money market portion of the benchmark is 90 days.
Exchange risk100% U.S. dollars. Investments are also allowed in the following currencies with their respective currency hedge against U.S. dollars: Canadian dollar, Japanese yen, euro, British pound, Swiss franc, Swedish krona, Danish krone, Norwegian krone, Australian dollar, and New Zealand dollar.
Credit risk
  • 100% of the value of the money market portion of the benchmark may be invested in U.S. Federal Government explicitly guaranteed assets or in issuers/issues with a minimum credit rating of P–1 by Moody’s Investor Services, A1+/A1 by Standard and Poor’s, and F1 by Fitch Ratings.

  • At the time of purchase the issuer of an eligible asset or the eligible asset itself must be rated by at least two of the following rating agencies as: P–1 by Moody’s Investor Service, A1+/A–1 by Standard and Poor’s, and F–1 by Fitch Ratings. The ratings by two agencies can be used if and only if the third agency does not issue an opinion about the rating status of the issuer and/or issue. The lowest of the available ratings applied by any of the agencies to an issuer or issue at the time of purchase will prevail over the others. Exception is made for U.S. Government securities.

  • Downgrades after purchase to P–3/A–3/F–3 by any of the rating agencies mentioned above must be sold within the 10 Trading Days following this event. These rules also apply to downgrades to P–2/A–2/F–2 in excess of 5% of the money market portion of the benchmark.

  • The maximum non–U.S. Federal Government sector exposure as a percentage of the money market portion of the benchmark is 100% in U.S. agencies, sovereigns in eligible currencies, and supranationals in eligible currencies; 75% in banks; 50% in corporates; and 50% in asset-backed commercial paper (ABCP).

  • The maximum non–U.S. Federal Government exposure (current face*price/100 as determined on the date of purchase) allowed per issuer as a percentage of the money market portion of the benchmark is 5%. In the case of ABCP, when an entity guarantees more than 10% of an issue, such amount guaranteed must be added to the credit exposure of the entity.

  • Eligible issuers of corporate/bank debt must have a minimum book equity of $5 billion.

Liquidity risk
  • Any type of negotiable instruments issued by eligible issuers in eligible currencies with a maximum maturity of 397 days.

  • Investments are also allowed in term deposits with a maximum maturity of 1 month and up to 10% of the value of the money market portion of the benchmark.

4. Investment Guidelines for the Stable Bucket: U.S. Asset Rotation Mandates

447. Of the total value of the Stable Liquidity Bucket, 50 percent is allotted to U.S. asset rotation mandates with the following investment guidelines:

Objective

448. The objective of the mandate is to generate returns over the performance of the benchmark (as described below) in excess of 30 basis points per annum over three-year rolling periods, within a maximum ex ante expected tracking error objective of 100 basis points per annum and in compliance with the investment guidelines set forth below.

Benchmark

449. The benchmark composition is as presented in Table 9.

Table 9.The Benchmark
SectorCurrencyWeight1Reference
Money MarketU.S. dollar15%iMoneyNet First Tier Institutional (gross of fees and taxes).
BondsU.S. dollar85%1–5 yr. Salomon Smith Barney U.S. Government Bond Index Component of the World Government Bond Index.

These weights are not final and will be adjusted to achieve the relevant effective duration near the date of funding of the account.

These weights are not final and will be adjusted to achieve the relevant effective duration near the date of funding of the account.

Risk limits

(i) Currency risk

The Mandate may invest up to 50 percent in eligible assets (as described below) denominated in eligible currencies provided that they are fully hedged to the U.S. dollar within a tolerance limit of ±0.25 percent of the value of the Mandate in unhedged exposure to non–U.S. dollar currencies. The following are the eligible currencies: U.S. dollar, euro, Japanese yen, Swiss franc, British pound, Canadian dollar, Australian dollar, Swedish krona, Danish krone, Norwegian krone, and New Zealand dollar.

(ii) Interest rate risk

450. The effective duration of the Mandate may vary in a range between ±1 with respect to that of the benchmark; its convexity may not be below −1 in absolute terms and spread duration may not exceed ±2.85.

(iii) Money market investment guidelines

  • In addition to the investment guidelines described in Section 2 for the Money Market portion of the benchmark, the mandate may invest up to 100 percent of its value in U.S. Federal Government securities and up to 15 percent in First Tier Short-Term Investment Funds (STIF) available with the Custodian.

  • The restriction in Section 2 on the maximum WAM of 90 days for the Money Market portion of the benchmark is replaced by the overall restrictions on interest rate risk in Section 2.3.ii applied to the value of the overall mandate.

(iv) Bond investment guidelines

  • Eligible assets: bonds and debentures without attached options in eligible currencies, bonds, and debentures with embedded options denominated in U.S. dollars only, Fixed-Coupon Mortgage-Backed Pass-Through Securities (MBS) denominated in U.S. dollars only, Asset-Backed Securities (ABS) denominated in U.S. dollars only, collateralized by credit card receivables and auto loans, Collateralized Mortgage Obligations (CMOs) denominated in U.S. dollars only, restricted to first or currently paying tranches of sequential bonds, planned amortization classes (PAC), targeted amortization class bonds (TAC), and floating rate bonds that are not support tranches. Private placements, including 144a securities, are not considered an eligible asset class.

  • Eligible investments must have a debt seniority of guaranteed, Senior secured, or Senior.

  • At the time of purchase the issuer of an eligible asset or the eligible asset itself must be rated by at least two of the following rating agencies as: A3 by Moody’s Investor Service, A- by Standard and Poor’s, and A3 by Fitch Ratings. The ratings by two agencies can be used if and only if the third agency does not issue an opinion about the rating status of the issuer and/or issue. The lowest of the available ratings applied by any of the agencies to an issuer or issue at the time of purchase will prevail over the others. Exception is made for U.S. Government securities.

  • In the case of a downgrade after purchase below the minimum acceptable level by any of the rating agencies mentioned above, the investment must be sold within ten trading days following this event.

  • Sector limits as a percentage of the total value of the mandate: 100 percent in U.S. Federal Government securities, 100 percent in Sovereign securities issued in local eligible currencies, including fully guaranteed agencies, 8.2 percent in Sovereign/Supranational securities issued in non-local eligible currencies, including fully guaranteed agencies of which 4.1 percent may be invested in Supranationals, 11 percent in U.S. Agencies without explicit guarantee from the U.S. Federal Government, 45 percent in Ginnie Mae, 8.2 percent in U.S. corporates, and 8.2 percent in U.S. Asset-Backed Securities guaranteed by credit card receivables and auto loans. Sector limits described in this section are exclusive of the sector limits described in Section 2 for the Money Market.

  • Issuer limits as a percentage of the total value of the mandate (Current Face*price/100 as determined on the date of purchase) are presented in Table 10.

  • Investments must have a minimum issue size of $500 million in accordance with the index inclusion criterion established by the Salomon Smith Barney indices, with the exception of MBS, CMOs, and ABS, where this limit does not apply.

  • The maximum holding of any specific issue is restricted to 10 percent of the issue size of any security, with the exception of MBS, CMOs, and ABS, where this limit does not apply.

Table 10.Issuer Limits
IssuerCredit QualityLimit in Percent
United States governmentU.S. governmentNo limit
Sovereign in local currency (includes agencies fully guaranteed)AAA35.4
AA21.2
A10.6
Sovereign in nonlocal currency (includes agencies fully guaranteed)AAA4.1
AA1.4
A0.3
SupranationalAAA2.0
AA0.7
A0.1
U.S. agencies without explicit guarantee—GSEsFederal Home Loan Banks10.6
Fannie Mae5.3
Freddie Mac3.5
U.S. agencies explicitly guaranteedGinnie Mae44.7
U.S. corporatesAAA0.8
AA0.8
A0.2
U.S. dollar-denominated ABS (restriction per individual program)AAA0.8

(v) Investment guidelines for instruments with embedded options

  • The mandate may invest in assets with embedded options other than MBS or its derivatives and ABS up to 8 percent of the total value of the mandate. This provision does not apply to Treasury Inflation Protected Securities (TIPS).

  • For MBS a limit is set at 45 percent of the market value of the mandate, of which 7.5 percent can be allocated to eligible CMOs. For CMOs the notional amount of any security purchased will be added to the exposure of the issuer of the security, not to the exposure of the issuer of the underlying asset, and they are to be issued and collateralized by an eligible GSE.

  • For Asset-Backed Securities, the limit is set at 8.2 percent of the market value of the mandate.

Other restrictions

(i) Restriction on eligible financial markets

451. Eligible issuers may not be located in the offshore financial markets described in Table 11.

Table 11.Noneligible Offshore Financial Centers
AfricaMiddle EastWestern HemisphereAsia and the PacificEurope
SeychellesBahrainAnguillaCook IslandsAndorra
Antigua and BarbudaMacao SARCyprus
ArubaMalaysia (Labuan)Gibraltar
BelizeMarshall IslandsGuernsey
BermudaNauruIsle of Man
British Virgin IslandsNiueJersey
Cayman IslandsPalauLiechtenstein
DominicaSamoaMonaco
GrenadaVanuatu
Montserrat
Netherlands Antilles
Panama
St. Kitts and Nevis
St. Lucia
St. Vincent and the Grenadines
The Bahamas
Turks and Caicos Islands

(ii) Restrictions on managers

452. Managers may not invest in securities issued by themselves, their parent company, or any of their affiliates (or any special-purpose subsidiary for which they serve as incorporator, manager, or trustee, or in which they are an investor).

Derivatives

(i) Over-the-counter (OTC) currency forwards

  • Foreign exchange forward transactions can be executed for hedging purposes only.

  • The maximum maturity of foreign exchange forward transactions cannot exceed four (4) months as from the date of transaction.

  • Eligible counterparties for forward and spot foreign exchange transactions must have a minimum credit rating of A-1 by Standard & Poor’s, P-1 by Moody’s Investor Service, and F-1 by Fitch IBCA by at least two of these agencies.

  • If any eligible counterparty with which there is an open position is downgraded below the minimum permitted credit rating by any of the credit agencies, the position must be closed with such counterparty during the ten (10) trading days following such event so long as the Adviser maintains an enforceable netting agreement with such counterparty.

  • The net exposure in open foreign exchange forward and spot operations with any eligible counterparty cannot exceed 10 percent of the value of the mandate at any given moment of time.

  • The maximum amount of foreign exchange operations to be settled on the same date with any eligible counterparty cannot exceed 5 percent of the value of the mandate. For counterparties with which the manager does not have an enforceable netting agreement in place, the limit shall be 2.5 percent.

  • The notional amount of all open foreign exchange forward operations may not exceed 50 percent of the value of the mandate.

(ii) MBS to-be-announced (TBA) trades

  • TBA trades are authorized restricted to a settlement date not exceeding three months from trade date.

  • The underlying pools for TBA trades must come from an eligible MBS.

(iii) Exchange-traded futures contracts

  • The futures contracts and corresponding exchanges that are shown in Table 12 are authorized:

  • The maximum expiration or delivery date of any contract cannot exceed six (6) months from trade date.

  • Eligible counterparties for futures contracts: broker-dealers designated as futures commission merchants by an appropriately designated self-regulatory organization or government body as required by applicable laws and regulations. Eligible broker-dealers must be members of the clearinghouses associated with the following exchanges: Chicago Board of Trade, Chicago Mercantile Exchange, Eurex, and London Financial Futures and Options Exchange.

Table 12.Eligible Exchanges and Futures Contracts
ExchangeContract
Chicago Board of TradeU.S. treasury bond; U.S. 10-year treasury note; U.S. 5-year treasury note; U.S. 2-year treasury note; 5-year and 10-year interest rate swap futures contracts
Chicago Mercantile ExchangeEurodollar
EurexSchatz; Bobl and Bund contracts
London Financial Futures and Options ExchangeEuribor
Long Gilt
Tokyo Stock ExchangeJGBs
Bourse de MontréalCanadian government bond
StockholmsbörsenSwedish government bond
Sydney Futures ExchangeAustralian government bond; New Zealand government bond
Københavns FondsbørsDanish government bond

(iv) Restrictions on leverage

453. The notional amount of all long futures and MBS TBA positions shall not exceed the market value of all assets with a final maturity of less than 397 days.

5. Investment Guidelines for the Stable Liquidity Bucket: Global Mandates

454. Of the total value of the Stable Liquidity Bucket, 50 percent is allotted to global mandates with the following investment guidelines:

Objective

455. The objective of the mandate is to generate returns over the performance of the benchmark in excess of 30 basis points per annum over three-year rolling periods, within a maximum ex ante expected tracking error objective of 100 basis points per annum and in compliance with the investment guidelines set forth below.

The benchmark

456. The benchmark composition is as presented in Table 13.

Table 13.The Benchmark
SectorCurrencyWeightReference
Money MarketUSD15%iMoneyNet First Tier Institutional (gross of fees and taxes)
BondsUSD57%1–5 yr. Salomon Smith Barney U.S. Government Bond Index
EUR22%1–5 yr. Salomon Smith Barney German Government Bond Index
JPY6%1–5 yr. Salomon Smith Barney Japanese Government Bond Index

Risk limits

(i) Currency risk

  • The mandate may invest up to 50 percent of the value of the account in eligible assets (as described below) denominated in eligible currencies, in addition to the eligible assets of the benchmark, provided that they are fully hedged in such a way that the account maintains the currency composition of the benchmark. The following are the eligible currencies: U.S. dollar, euro, Japanese yen, Swiss franc, British pound, Canadian dollar, Australian dollar, Swedish krona, Danish krone, Norwegian krone, and New Zealand dollar.

  • The mandate may deviate up to ±10 percent in unhedged currency exposure in any of the eligible currencies with respect to its participation in the benchmark, subject to the constraint that the maximum aggregate currency exposure is 10 percent of the value of the portfolio. The aggregate currency exposure shall be calculated as the sum of all net long positions in each individual eligible currency against the benchmark.

(ii) Interest rate risk

457. The effective duration of the mandate may be in a range between ±1 with respect to that of the benchmark.

(iii) Money market investment guidelines

  • In addition to the investment guidelines described in Section 2 for the Money Market portion of the benchmark, the mandate may invest up to 100 percent of its value in U.S. Federal Government securities and up to 15 percent in First Tier Short-Term Investment Funds (STIF) available with the Custodian.

  • The restriction in Section 2 on the maximum WAM of 90 days for the Money Market portion of the benchmark is replaced by the overall restrictions on interest rate risk in Section 4.3.ii applied to the value of the overall mandate.

(iv) Bond investment guidelines

  • Bonds and debentures without attached options in eligible currencies. Floating rate notes with a maximum final maturity of five years and a maximum reset period of up to one year. 144a securities, including private placements, are not considered an eligible asset class.

  • Eligible investments must have a debt seniority of guaranteed, Senior secured, or Senior.

  • At the time of purchase the issuer of an eligible asset or the eligible asset itself must be rated by at least two of the following rating agencies as: A3 by Moody’s Investor Service, A- by Standard & Poor’s, and A3 by Fitch Ratings. The ratings by two agencies can be used if and only if the third agency does not issue an opinion about the rating status of the issuer and/or issue. The lowest of the available ratings applied by any of the agencies to an issuer or issue at the time of purchase will prevail over the others. Exception to this stipulation is made in the case of U.S. Federal Government securities.

  • In the case of a downgrade after purchase below the minimum acceptable level by any of the rating agencies mentioned above, the Adviser must sell the investment within the 10 trading days following this event.

  • Sector limits as a percentage of the total value of the mandate: U.S. Federal Government Securities, 100 percent; Sovereign in eligible local currencies, including fully guaranteed agencies, 100 percent; Sovereign/Supra-national in eligible nonlocal currencies, 36 percent, of which 18 percent can be invested in Supranationals; U.S. Agencies (GSEs) without explicit guarantee from the U.S. Federal Government, 11 percent.

  • Issuer limits as a percentage of the total value of the mandate (current face*price/100 as determined on the date of purchase) are depicted in Table 14.

  • Investments must have a minimum issue size of $500 million in accordance with the index inclusion criterion established by the Salomon Smith Barney indices.

  • Investments in any security may not exceed 10 percent of its issue size.

Table 14.Issuer Limits
IssuerCredit QualityLimit in Percent
United States governmentU.S. governmentNo limit
Sovereign in local currency (includes fully guaranteed agencies)AAA35.4
AA21.2
A10.6
Sovereign in nonlocal currency (includes agencies fully guaranteed)AAA17.9
AA6.0
A1.2
SupranationalsAAA8.9
AA3.0
A0.6
U.S. agencies without explicit guarantee—GSEs (Noncallable debentures only)Federal Home Loan Banks10.6
Fannie Mae5.3
Freddie Mac3.5

Other considerations

(i) Restrictions on eligible financial markets

458. Eligible issuers may not be located in the following financial offshore centers described in Table 15.

Table 15.Noneligible Offshore Financial Centers
AfricaMiddle EastWestern HemisphereAsia and the PacificEurope
SeychellesBahrainAnguillaCook IslandsAndorra
Antigua and BarbudaMacao SARCyprus
ArubaMalaysia (Labuan)Gibraltar
BelizeMarshall IslandsGuernsey
BermudaNauruIsle of Man
British Virgin IslandsNiueJersey
Cayman IslandsPalauLiechtenstein
DominicaSamoaMonaco
GrenadaVanuatu
Montserrat
Netherlands Antilles
Panama
St. Kitts and Nevis
St. Lucia
St. Vincent and the Grenadines
The Bahamas
Turks and Caicos Islands

(ii) Restrictions on managers

459. Managers may not invest in securities issued by themselves, their parent company, or any of their affiliates (or any special purpose subsidiary for which they serve as incorporator, manager, or trustee, or in which they are an investor).

Derivatives

(i) Over-the-counter (OTC) currency forwards

  • The maximum maturity of foreign exchange forward transactions cannot exceed four (4) months as from the date of transaction.

  • Eligible counterparties for forward and spot foreign exchange transactions must have a minimum credit rating of A–1 by Standard & Poor’s, P–1 by Moody’s Investor Service, and F–1 by Fitch IBCA by at least two of these agencies.

  • If any eligible counterparty with which there is an open position is downgraded below the minimum permitted credit rating by any of the credit agencies, the position must be closed with such counterparty during the ten (10) trading days following such event so long as the manager holds an enforceable netting agreement with such counterparty.

  • The net exposure in open foreign exchange forward and spot operations with any eligible counterparty cannot exceed 10 percent of the value of the mandate at any given moment of time.

  • The maximum amount of foreign exchange operations to be settled on the same date with each eligible counterparty cannot exceed 5 percent of the value of the mandate. For counterparties with which the manager does not have an enforceable Netting Agreement in place, the limit shall be 2.5 percent.

  • The notional amount of all open foreign exchange forward operations may not exceed 50 percent of the value of the account.

(ii) Exchange-traded futures contracts

460. The authorized futures contracts and corresponding exchanges are depicted in Table 16.

Table 16.Eligible Exchanges and Futures Contracts
ExchangeContract
Chicago Board of TradeU.S. treasury bond; U.S. 10-year treasury note; U.S. 5-year treasury note; U.S. 2-year treasury note
Chicago Mercantile ExchangeEurodollar
EurexSchatz; Bobl and Bund contracts
London Financial Futures and Exchange OptionsEuribor, JGBs and U.S. Treasury contracts Long Gilt
Tokyo Stock ExchangeJGBs
Bourse de MontréalCanadian government bond
StockholmsbörsenSwedish government bond
Sydney Futures ExchangeAustralian government bond; New Zealand government bond
Københavns FondsbørsDanish government bond
  • The maximum expiration or delivery date cannot exceed six (6) months from trade date.

  • Eligible counterparties for futures contracts: broker-dealers designated as futures commission merchants by an appropriately designated self-regulatory organization or government body as required by applicable laws and regulations. Eligible broker-dealers must be members of the clearinghouses associated with the following exchanges: Chicago Board of Trade, Chicago Mercantile Exchange, Eurex, and London Financial Futures and Options Exchange.

(iii) Restrictions on leverage

461. The notional amount of all long futures positions shall not exceed the market value of all assets with a final maturity of less than 397 days.

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