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Evaluation of the Exchange Fund Account

July 5, 2006

Contact:
Deborah Hazell
Managing Director
Fischer Francis Trees & Watts, Inc.
200 Park Avenue, 46th Floor
New York, NY 10166

Tel: 212.681.3124
Fax: 212.681.3217
Email: dhazell@fftw.com
TABLE OF CONTENTS

Proposal to Evaluate the Exchange Fund Account

Executive Summary .............................................................................................................. 3

Objectives and Scope of the Project ................................................................................... 5

Current Structure & Management of Canada’s International Reserves Programme ...... 6

Evaluation and Recommendations ................................................................................... 12

Conclusions ……………………………………………………………………………………… 33

Appendix …………………………………………………………………………………………... 35

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EXECUTIVE SUMMARY
Fischer Francis Trees and Watts (FFTW) has been engaged as a consultant by the Department of
Finance of the Government of Canada (Canada) to evaluate the management of the country’s
foreign exchange reserves. With over thirty years of experience managing foreign exchange
reserves and advising Central Banks on reserve management, FFTW has the skills and experience
to assess the current practices and objectives established for the management of the Exchange
Fund Account (EFA). Our assessment confirms that the EFA is being managed prudently,
effectively and with due regard for the three key objectives, all of which are common and key
parameters for most of the world’s Central Banks:

- Liquidity

- Capital preservation

- Return enhancement

While having similar objectives to many of the world’s Central Banks, Canada differs in so far as
the EFA is funded through borrowing, and the management of the assets is matched against the
cost of funding with the objective of immunizing the primary market risks – interest rate risk and
currency risk. Both the risk and the return of the EFA are evaluated relative to the cost and
structure of the liabilities. By realising a moderate positive return over the cost of funding the
reserves, Canada has met all stated key objectives, and despite a conservative approach to
managing the EFA, has also managed to achieve a contribution to the public purse. The
recommendations outlined in this evaluation focus on ways in which Canada could enhance return,
should it wish in the future to re-consider its current low-risk tolerance policy. These
recommendations focus on two areas: seeking return by reducing liquidity and seeking return by
adding market risk, subject to (i) efforts to ensure that there will be no drain on the public purse, (ii)
an adherence to the stated key objectives as listed above and (iii) maintaining the ability to
explicitly hedge unwanted risks. Areas identified that Canada may wish to consider and that merit
further evaluation are:

(i) Re-evaluating the currency allocation to ensure that the designated neutral allocation is
indeed a neutral position

(ii) Increase the number of eligible currencies to allow for greater diversification and a
reduction in the overall risk of the EFA

(iii) Broaden the list of eligible countries to, again, allow for greater diversification which serves
to reduce the overall risk of the EFA

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(iv) Consider allowing / increasing unmatched duration (interest rate) exposure to increase the
potential for increased return.

(v) Evaluate the impact of yield curve exposure that would result from unmatched duration
exposure.

(vi) Consider adding additional sectors of the fixed income market that provide incremental
yield relative to existing eligible investments.

Given the conservative yet professional approach to managing the EFA, all recommendations
outlined in this evaluation should be regarded as suggestions with the purpose of enhancing return,
subject to an increase in risk, and should not be construed as criticisms of current policies and
practices currently undertaken.

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OBJECTIVES

The objective of this project is for Fischer Francis Trees and Watts, Inc. (FFTW) to evaluate the
existing structure of the Exchange Fund Account (EFA) which comprises the foreign exchange
reserves owned by Her Majesty in Right of Canada (the Government of Canada). In the course of
the evaluation, FFTW will assess the investment practices to ensure that they are compatible with
the conservative nature of the Fund and in line with practices adopted by others in the Central Bank
community. FFTW will also make recommendations regarding both the investment structure of the
EFA and the practices surrounding the management of the EFA given our understanding of the
need to limit risk within the reserve assets in an appropriate way for a country of Canada’s standing
in terms of the size of foreign exchange reserves and the likely role of, and use of, these reserves.
We pre-suppose a desire to optimize the use of such risk but understand that enhancing return,
while important, is not a significant objective of the EFA and the appetite to increase risk to achieve
higher returns is therefore quite limited. The primary factors behind the management of the EFA
are clearly the need to preserve capital and to ensure liquidity, both of which are key and common
parameters throughout the Central Bank community worldwide.

SCOPE OF THE PROJECT

The project covers all aspects of the management of the asset side of the balance sheet and the
EFA will be assessed in a portfolio context, as a portfolio of assets. The funded nature of the EFA
in an asset/liability matched framework, while noted and an important factor in the structure of the
reserves, does not fall within the scope of this evaluation. This framework does, however, allow the
Bank of Canada and the Government of Canada to accurately assess the true cost of holding
reserves which is a valuable metric. Other areas that fall outside the scope of the project are (i) the
size or targeted size of the foreign exchange reserves (ii) the rationale behind holding foreign
exchange reserves, both of which are policy issues for Canada, and (iii) the governance structure
surrounding the management of the EFA, which is a structural but not an investment issue.
Following the initial evaluation, during which detailed information was provided by representatives
from the Bank of Canada and the Department of Finance, the following areas came to light as
requiring comment:
- The portfolio structure and strata definitions
- Limited nature of current sector allocation
- Potential for unmatched duration exposure
- Future management of yield curve exposure
- Neutral currency allocation
The issues raised and suggestions on each of the above will be detailed in this evaluation.

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THE CURRENT STRUCTURE AND MANAGEMENT OF THE EXCHANGE FUND ACCOUNT

An initial meeting in Ottawa with members of the Exchange Fund Account (EFA) management
team allowed FFTW to better understand the construction and objectives of the EFA, and also
provided some insight into the history behind the current structure. Information gathered during this
meeting and subsequent discussions with members of the EFA team in conjunction with publicly
available data have served as the reference sources for this evaluation. FFTW’s goal is to evaluate
the appropriateness of the current reserve management structure given the fund’s objectives and in
comparison to others with similar objectives within the Central Bank community.

Within this evaluation, FFTW has taken into consideration the unique relationship between the
Bank of Canada and the Department of Finance to the extent that it is relevant to the management
of the assets in the EFA. The current structure of the reserve management program is unusual in
that the Bank of Canada and Department of Finance share responsibility for the strategic planning
and operational management of the EFA, a structure that is not common within the Central Bank
community. Given that most, but not all, countries separate the management of the assets and the
management of the liabilities, the ALM approach adopted by the Bank of Canada and the
Department of Finance lends itself to a combined approach, overseen and managed jointly by the
two entities. While the liabilities are not part of the evaluation, it should be noted that changes to
the liability structure or to the method of hedging liabilities will likely impact the asset side of the
balance sheet and hence the management of the EFA.

Oversight of the EFA is assumed by the Fund Management Committee (FMC), comprised of senior
representatives of both the Bank of Canada and the Department of Finance. Risk within the EFA is
overseen by the Risk Committee, which is supported by the Financial Risk Office of the Bank of
Canada. The Risk Committee is responsible for monitoring and reporting on performance and
positions within the EFA. It will be the responsibility of FFTW’s project team to review and raise
issues surrounding the management of the EFA and to provide recommendations on investment-
related aspects of the current reserve management structure that we believe would benefit from
further analysis and consideration for possible changes.

The Department of Finance is responsible for issuing debt on behalf of the Government of Canada,
the proceeds of which comprise the major part of the Government’s foreign exchange reserves.
The other components of the reserves are Gold and a small SDR component, both of which are
outside the scope of this evaluation. The small allocation to SDR, a legacy from the Bretton Woods
days and from IMF payments, is considered operational reserves and is managed separately from
the rest of the reserves. The SDR component of the portfolio is funded with US Dollar liabilities so,

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as the US Dollar is a sizeable component of the SDR basket, the US Dollar element of the SDR is
fully currency hedged. It is therefore only the non-US Dollar component of the SDR that is
unhedged and therefore adds some volatility to the aggregate reserves.

As mentioned above, the relationship between the Bank of Canada and the Department of Finance
is somewhat different from the working relationship between most Central Banks and Ministries of
Finance. Whereas the Department of Finance directly funds the Exchange Fund Account and the
assets of the EFA are structured to match the liabilities, most countries completely separate the
liability and asset functions. Assets are generally managed by the Central Bank reserve
management team whereas the liabilities are managed either by the Ministry of Finance or by a
Debt Management Agency specifically established for the purpose of funding. There are exceptions
however, and in some countries the Central Bank and not the Government manages both the
management of the reserve assets and also the country’s debt issuance. A prominent exception,
to the general experience is the Bank of England which evaluates the assets in the context of the
liabilities and, somewhat similar to Canada, manages the foreign exchange liabilities and assets
together.

The Bank of Canada and the Government of Canada look at the outstanding debt and the foreign
exchange reserves in a ‘whole portfolio’ context which has implications to both funding and
investments. As a result, the objectives of the EFA in certain areas may be different from those of
other more traditional Central Banks who regard, or at the very least evaluate, the investment of
reserves as unrelated to the structure of the debt. However, there are many areas of similarity
between Canada and the management of the majority of Central Bank foreign exchange reserves,
the most notable of which is the conservative and risk averse nature of the EFA and the focus on
liquidity. An area of difference is the relatively low appetite for increasing risk in order to seek
incremental returns and this is an area that will be explored in this evaluation. The size of reserves
and the infrequent use of reserves for intervention purposes is a factor that influences reserve
management strategies and practices across many Central Banks. Lowering the probability of use
of funds for intervention effectively leads to a lengthening of the investment time horizon and allows
greater scope to potentially increase the risk parameters while still retaining a prudent approach to
reserve management. One of the outcomes of this evaluation is to question the level of risk taken
and to explore whether risk may be increased, and if so, by how much, in order to add to returns
while maintaining an acceptable level of downside protection.

The EFA has set currency target levels around which the Fund’s assets will fluctuate very little, so
the segregation of assets by denominated currency with assigned weightings should not be
considered an impediment to the management of the program. The majority of the non-US
exposure is in Euro with a small allocation to Japanese Yen. Although all intervention in the past

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has been executed using the US Dollar, the US Dollar exposure is less than 100% to allow for the
Euro’s rise as a reserve currency – a move that has occurred with a number of Central Banks, and
not just those linked to the Euro. Many Asian Central Banks have gradually increased their Euro
holdings over the last 5 years, as have Central Banks in non-Euro denominated European
countries. More recently, some Middle Eastern Central Banks, despite having currencies pegged to
the US Dollar, have gradually increased the allocation to the Euro versus the US Dollar. The above
increased allocations to the Euro have occurred largely for two reasons (i) to increase allocations to
the Euro in recognition of its potential role as a major reserve currency, (ii) for investment and
return reasons recognizing the poor fiscal and current account fundamentals within the US. The
former has led to more strategic, longer term (benchmark) allocation shifts towards the Euro
whereas the latter can be categorized as tactical allocations and do not impact the neutral
benchmark allocations to the US Dollar and Euro. The Japanese Yen remains a minor reserve
currency, largely given the opportunity cost of holding Yen in income terms relative to the higher
yielding US Dollar and Euro. The majority of the assets of the EFA are denominated in these three
reserve currencies: the Euro, US Dollar and with a small allocation to Japanese Yen.

Generally, the currency allocation within a Central Bank’s reserves is determined as a core
strategic decision and is taken at the senior management level. In some instances, the decision is
taken at the very highest level within the Central Bank, i.e. the Governor’s office, and in many
cases, if not decided at the highest level, it is approved at the highest level. However, the
management of the currency exposures around the strategic allocation remains within the reserves
management department and the tolerances and degree of active management is strictly regarded
as an investment related decision. The currency allocation within the EFA, is determined by the
Fund Management Committee and there is currently very little tolerance for currency risk and
currency exposure outside these currency targets. Given the importance of the neutral currency
allocation decision and the impact on returns within the EFA, we suggest that the process behind
this decision would merit a review in the context of a more analytical framework. Further, the
parameters determining the degree of deviation around the core strategic decision should also be
subject to review.

The assets held in the EFA are invested primarily in money market instruments and government
bonds denominated in the currencies of the predetermined currency allocation. Although the
current investment universe appears to satisfy many of Canada’s investment requirements, we will
be suggesting further analysis into the possibility of the inclusion of non-G3 countries into the
investment program to broaden the investment universe, increase the opportunity set, introduce an
element of diversification and thereby potentially lower the aggregate risk of the EFA.

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The purpose of the EFA is to provide foreign-currency liquidity and sufficient liquidity to allow for
effective intervention in the foreign exchange market should the need arise, while respecting the
need to preserve capital and subject to these two parameters, to obtain a return above the funding
cost. This last factor is currently only a minor focus and return enhancement is not a prominent
objective for the EFA.

The EFA assets are classified into two tiers: a Liquidity tier and an Investment tier. The liquidity
tier is mostly invested in highly rated US Dollar denominated assets while the investment tier is
comprised of a combination of high quality instruments denominated in US Dollars, Euro and Yen.
The liquidity tier is invested mostly in US Treasuries as they are generally acknowledged to be the
most liquid securities in the market. Although we agree that US Treasuries are indeed considered
the most liquid securities available, we would recommend further review as to whether there is a
real need to maintain the highest level of liquidity and this will be discussed later in this evaluation.

On another note, it is our understanding that Canada defines liquidity primarily as asset class
driven, and to a lesser extent as term driven, whereas other central banks typically define liquidity
as a combination of the ability to convert invested reserves into cash at short notice and the
potential exposure to loss in the course of converting those assets into cash in the event that the
assets are required for immediate intervention purposes. The liquidity component of reserve assets
is generally in the base currency of the reserves and defined by duration, not by asset class or
credit parameters. Accordingly, as interest rate risk is a concern for most reserve managers, any
portfolio defined as a liquidity portfolio should have a short duration, generally no greater than three
months, therefore protecting this component of the reserves from mark-to-market losses on an
ongoing basis, losses which could become realized should an unexpected need to liquidate assets
arise.

A second aspect of liquidity, separate from the inherent risk characteristics of the instruments
(duration, credit quality, currency) is the ability to liquidate. Clearly the government asset classes
identified by the Canada and in which the EFA is primarily invested are significantly more liquid
than non-government ‘spread’ sectors in times of stress, which supports the prudence of Canada’s
sector selection decision. However there is an opportunity cost and the question should be raised
as to whether there is a need for all of the EFA to be invested in these highly liquid but lower
yielding asset classes that will provide the liquidity benefit in times of stress.

The investment tier of the EFA represents approximately 50% of the fund’s assets and is invested
in assets denominated in US Dollars, Euro and Yen.. This is the result of (i) an explicit target for
the US Dollar allocation and (ii) attractive yield opportunities in the Euro market in recent years.
However, this allocation should be closely reviewed as the Federal Reserve approaches the end of

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the current rate hiking cycle and the European Central Bank embarks on a rate hiking campaign of
its own. This scenario has the potential to significantly alter the current investment landscape. As
such, the target allocation for US Dollars should also be reviewed as already stated earlier in the
evaluation.

Following the review of the composition and liquidity of the EFA, we would like to address the
return of the EFA in relation to the stated guidelines. The net return over funding earned on the
EFA in 2005 was approximately 9 basis points. Achieving an excess return over funding cost,
while rigorously adhering to the liquidity and capital preservation requirements, is considered a
success for the program, particularly taking into account the minimal unmatched duration and
currency risk parameters of the EFA. The team managing the EFA has both prudently and
successfully achieved all of their objectives and this evaluation is able to categorically confirm that
success. However, we believe that the current practice of matching assets to liabilities and
passively managing the duration and currency exposures within the fund should be open to review
given the potential for additional excess returns while still remaining true to the first two stated
objectives of ensuring liquidity and preservation of capital.

The rationale for not aggressively seeking excess return in the portfolio is clear given the objectives
of the EFA and Canada’s ability to achieve excess return with very little risk given the favorable
funding cost afforded to the Government of Canada. It has historically been a typical approach by
Central Banks to limit their return demands and many have maintained a very conservative
approach to managing assets as a result, albeit, in many cases, independent from any liability
management. However, there has been a steady trend away from this practice over the past ten
years as Central Banks attempt to find the balance between the need for liquidity and the potential
for greater return. We will discuss this topic in greater detail in the benchmark analysis section of
this evaluation. Although most Central Banks do not look at the liability side of the balance sheet,
in other respects, their objectives are the same as those of Canada.

Timeframe is a determining parameter for risk, and it is our understanding that Canada monitors
performance closely on a monthly, quarterly and yearly basis. While the objective of adding risk is
to enhance returns, sometimes the additional risk detracts from returns and we determined through
discussion that, similar to other Central Banks, Canada is likely to be uncomfortable with any loss
of capital over a one year period, though losses over a quarter or over six months may be tolerable.
Subject to these conditions, the issues open for consideration are (i) whether returns can be
enhanced while maintaining the current level of risk; (ii) can the amount of risk in the portfolio be
increased to enhance annual returns and (iii)if so, to what level can risk be increased in order to
generate these incremental returns.

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Risk, for the purposes of prudent reserve management, may be increased through the addition of
unmatched interest risk (duration), currency or non-government sector exposure. We understand
that Canada has researched the latter and has investigated diversifying away from the current
eligible instruments, which in terms of longer terms assets are limited to government, sovereign
and supranational credits. The analysis evaluated the benefits of including credit securities such as
Asset Backed Securities (ABS) and Corporate Bonds, but concluded against broadening the
investment parameters to make an allocation to these fixed income sectors for the time being. The
decision against investing in US ABS securities was part due to the perception that the legal risks
associated with these securities and in particular, the structure of their pools, is too high relative to
the incremental return earned. In contrast, however, a decision has been made to broaden the
eligible short term investment universe to include Commercial Paper and Certificates of Deposits in
addition to repurchase agreements. It is interesting to note that this decision is in contrast to the
allocation decisions of many Central Banks, which opt to include AAA-rated ABS, which represent
fully collateralized credit exposure, and exclude Commercial Paper as Commercial Paper
introduces the reserves to uncollateralized corporate credit exposure which exposes the reserves
to both unsecured credit risk and to headline risk.

In summary, the goal of the Exchange Fund Account, which represents the majority of the
international foreign exchange reserves, is to provide foreign currency liquidity for Canada and to
aid in the management of the domestic currency in the foreign exchange market – a common
objective for most international reserve managers. The current structure and management of the
EFA consists of liquid foreign government, sovereign and supranational assets managed with
emphasis on liquidity, capital preservation and, subject to the first two and to a lesser extent,
incremental returns above funding. The operations of the fund are supported, on an asset and
liability matched basis, by obligations of the Government of Canada. The purpose of matching the
assets and liabilities of the Government of Canada is to reduce exposure to excess currency and
duration risk while attempting to earn a net positive return over funding cost. Interest rate risk is
managed through the ALM approach and is both monitored and measured using a Value at Risk
methodology and by stress testing.

The purpose of the reserves is to be a pool of assets available for intervention should the need
arise and the role of Canada is to manage those reserves in a prudent manner taking into account:

(i) the nature of the assets as foreign exchange reserves

(ii) the source and cost of funding

(iii) the public role of the Bank and the Government of Canada

(iv) the conservative nature of official institutions

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(v) the need for return

EVALUATION AND RECOMMENDATIONS

After reviewing the current structure of the EFA and the Fund’s ability to accomplish its stated
goals, this paper will now focus on evaluating the funds comparability to other Central Banks with
similar objectives. For this review, we will not venture to stipulate the level of risk that we believe
that Canada should be willing to take, but will instead provide a comparison to other Central Banks
and will also offer some tools and ideas for Canada to analyze.

In conducting this evaluation, FFTW’s first step was to identify the level of risk to which the EFA is
currently exposed. As stated earlier, the investment objectives of the Government of Canada are
similar to those that are typically stated by many Central Banks:

(i) Liquidity
(ii) Capital preservation
(iii) Return enhancement subject to (i) and (ii)

This means that we can draw on our knowledge of the reserve management practices of other
Central Banks to determine appropriate parameters, how much risk may be acceptable and where
that risk should be allocated.

Liquidity

As referred to earlier, there are two ways of looking at liquidity. Firstly, liquidity is that component of
the reserves that can be used as the first source of cash in the event of the need to liquidate
investments. In the current structure of the EFA, this would be defined as the Liquidity tranche of
the reserves. The second definition of liquidity is marketability, or the ability to sell assets in size
and within a short period of time without compromising the price. This would be reflected in the
composition of the Investment tranche of the EFA.

Liquidity Tranche
It is very typical for reserves to be structured in layers that reflect the likely call on assets. The
diagram on the following page reflects the typical structure of reserves for a Central Bank with
sizeable reserves. The liquidity component is effectively cash on call and the investments should
have a short maturity and be available for sale and settlement on same day or with one day’s
notice. In many cases the liquidity component does not have a specific benchmark as the purpose
is not to match any term or investment structure but to have the reserve currency, in this case US
Dollar cash, readily available. Where there is a benchmark, it will likely have a 3 month maturity or

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less and investments will be purchased purely for safety and availability. This means that liquidity
reserves are in practice comprised of money market instruments such as Treasury bills, Agency
discount notes, reverse repurchase agreements, time deposits and certificates of deposit.
Commercial paper is generally excluded from this definition and
only a few Central Banks invest in commercial paper, given a
general aversion to taking unsecured credit risk. We note that EXCESS
WEALTH
the EFA guidelines have recently been broadened to
include Commercial Paper as an eligible investment. INVESTMENT
This is something that we would discourage unless
there are dedicated credit analysts reviewing
INTERMEDIATE LIQUIDITY
investments, as rating is not sufficient by itself as
1-3 Year US Treasury Benchmark
a measure of credit worthiness. It is important
to be able to evaluate the direction of the LIQUIDITY
TD’s Repo
rating, or more specifically, the potential
CD’s CP’s
for deterioration in the rating and
therefore in the credit so as to avoid anticipatory price deterioration. In the case of commercial
paper, the risks are almost entirely default risks as opposed to price deterioration, given the short
term nature of this market. The role of the internal analysts is to determine that the borrower is of
superior credit quality (as also indicated by the quality ratings provided by the rating agencies) and
has sufficient liquidity in the event of a credit event to be able to pay their maturing debt if access to
re-funding resources is compromised. A liquidity squeeze caused by limited access to refunding is
a risk of purchasing unsecured commercial paper, and is a risk that should be explicitly evaluated
by internal credit analysts in the event that commercial paper is permitted in the investment
universe.

With regard to other money market instruments traditionally eligible for inclusion in Liquidity
tranches, time deposits should also come under some scrutiny. Paradoxically, although time
deposits are generally regarded as Liquidity instruments and although they have little risk of loss
(other than bank credit risk), deposits technically are not convertible into cash prior to maturity so,
strictly speaking, have amongst the least liquidity of many fixed income instruments. Liquidity is
therefore very limited in a portfolio of time deposits with an average maturity of anything longer than
a week. Ironically this is typically the investment of first choice for the liquidity portfolios of many
Central Banks. A further issue that is common within the liquidity component of reserves is the
investment of cash on deposit with local banks. It is not unheard of for crises to occur within the
domestic banking system that have an impact on the currency, thereby leading to a drawdown on
reserves. We therefore, as a policy, would not advocate the investment of reserves in local banks
as this subjects the reserves to the same type of risks that they are there to protect against. In the

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case of Canada, we note that this is provided for in the EFA policy guidelines which, prudently,
explicitly prohibit investing any part of the EFA in the local Canadian banking system.

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Marketability
Another way of looking at liquidity is to evaluate the ability to liquidate and, most critically, to
liquidate in times of stress. An argument could be made that all traded securities are liquid under
normal market conditions. However, market conditions are not always normal, and it is during those
times of abnormal behavior that a security’s true liquidity can be gauged. The most appropriate way
to evaluate a security’s liquidity is to determine the impact on the size of transactions that can be
executed and evaluate any change in spread, relative to normal market conditions, that an
unexpected market event can cause. From an economic perspective, most investors gauge
liquidity in terms of how much money will have to be forgone should they be required to sell a
security during an extraordinary event.

High quality government fixed income markets, which comprise the majority of the EFA, offer the
highest level of liquidity in terms of marketability. Portfolios can be liquidated within a short period
of time (the whole EFA can likely be liquidated in less than 3 days) and losses due to wide bid-offer
spreads or price mark-downs for size or immediate settlement will be minimal. US Treasury and
agency securities can normally settle T+1, but same day settlement is not unusual. Euro
denominated Government bonds are slightly less liquid and although they can be executed in
slightly smaller size in normal market conditions, it is our estimate that they can be liquidated in the
same size as US Treasuries in conditions of market stress. One key difference, however, is that
non-US government securities typically settle T+3, which means that in terms of accessibility of
cash, they are less liquid. Finally, sovereign and supranational euro- and global bonds which are
eligible instruments in the EFA and in the reserve assets of many Central Banks, while having
safety in terms of their credit rating, are among the less liquid (or least liquid) of investment grade
instruments. This should be a cautionary note against building sizeable positions in supranationals,
although the practical experience has been that it is often harder to build positions than liquidate in
sovereigns and supranationals as there is such great demand from Central Banks for this paper,
that it often exceeds the available supply.

FFTW has conducted an internal survey (Table 1 below) amongst members of our investment team
in order to evaluate the impact on spreads that an unexpected negative event is likely to have on
different asset classes.

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Table 1

On The Run Securities


Under Normal Market Conditions During Times of Market Stress
Max. Transaction Max. Transaction
Size w/out Impacting Bid/ Offer Size w/out Impacting Bid/ Offer
Maturity Market Price Spread Market Price Spread
US Treasuries
2 year 500mm 0.25/32 200mm .5/32
5 year 250mm 0.25-.5/32 100mm 1/32
10 year 200mm 0.5/32 75mm 1/32
30 year 100mm 1/32 20mm 4/32
Other Sovereigns
Germany 2 year 250mm 1.5 cents 100mm 3 cents
Germany 5 year 250mm 2 cents 100mm 4 cents
Germany 10 year 150mm 3 cents 75mm 5/6 cents
Japan 2 year JPY60bio 0.25-0.5bps JPY30bio 0.5-1bps
Japan 5 year JPY40bio 0.25-0.5bps JPY20bio 1bps
Japan 10 year JPY20bio 0.5bps JPY10bio 1bps

US Agencies
2 year 300mm 1/2 bps 200mm 1 bps
5 year 200mm 1- 2 bps 100mm 3 bps
10 year 100mm 1 - 2 bps 75mm 3 bps
30 year 50mm 2 - 3 bps 20mm 4 bps
Supernationals
2 year 50mm 3 bps 10mm 7 bps
5 year 25mm 3 bps 10mm 10 bps
10 year 25mm 5 bps 5mm 10 bps
30 year 25mm 5 bps 5mm 10 bps
Mtg. Pass-Through
15 year 100mm 0.5/32 10mm 6/32
30 year 250mm 0.5/32 10mm 4/32
ABS
Top Tier AAA 2 year 5-30mm 0.25/32 1-5mm 2/32
5 year 5-30mm 0.25/32 1-5mm 2/32
10 year 5-30mm 0.25/32 1-5mm 2/32
Second Tier AAA 2 year 5-10mm 0.50/32 1-5mm 4/32
5 year 5-10mm 0.50/32 1-5mm 4/32
10 year 5-10mm 0.50/32 1-5mm 4/32
Corporates
AAA 2 year 50mm 3 bps 10mm 10 bps
5 year 50mm 3 bps 10mm 10 bps
10 year 50mm 5 bps 5mm 10 bps
30 year 25mm 5 bps 5mm 10 bps
AA 2 year 50mm 3 bps 5mm 10 bps
5 year 50mm 5 bps 5mm 10 bps
10 year 25mm 5 bps 5mm 10 bps
30 year 25mm 5 bps 5mm 10 bps
A 2 year 25mm 5 bps 5mm 10 bps
5 year 25mm 5 bps 5mm 10 bps
10 year 25mm 5 bps 5mm 20 bps
30 year 25mm 5 bps 5mm 20 bps

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It should be noted that the eligible securities within the EFA are clearly the most liquid in terms of
size and bid-offer spreads, both in normal market conditions but particularly in extreme situations. It
is evident that Canada has adopted a conservative but also a very prudent approach to market
liquidity. A question that Canada may wish to address, however, is whether the highest level of
liquidity is required for the whole of the
EFA or whether there can be some
compromise on a part of the reserves.
LESS LIQUID
Liquidity has a cost so it is definitely
INVESTMENT
appropriate to maintain the highest
TRANCHE
level of liquidity in terms of
marketability and maturity in the HIGHLY LIQUID

Liquidity Tranche. However, it may INVESTMENT


TRANCHE
worth consideration to divide the
Investment Tranche into two
LIQUIDITY
categories a most liquid and a slightly
TRANCHE
less liquid category, in order to
generate a higher return on a portion
of the EFA (see diagram above). The less liquid investments would still be very liquid, in the
context of world markets, but would mean that the liquidity premium would not be forfeited on 100%
of the EFA, when the likelihood of 100% drawdown over a short period of time is relatively small.

Capital Preservation
Capital preservation is a key parameter for every Central Bank. The responsibility of the reserve
management department is to oversee the reserves and to ensure that they are available for use
and that the amount does not shrink and can potentially grow. This requires prudence,
conservatism, an understanding of the likely use of assets and an evaluation of the trade-off
between protecting the value of the reserve assets and growing the size of the reserves through
prudent investment. The assessment of what capital preservation means is very much dependent
on both the time frame in which the investment of the reserves are being evaluated and whether
the reserves are being viewed on an aggregate basis or whether each strategy/portfolio within the
reserves is being reviewed on an individual basis. The following analysis explains the difference in
these parameters, the appropriate risk level in each event and the type of benchmark that may be
the most suited to each circumstance. There are two types of risk uniformly taken by Central Bank
reserve managers, duration risk and non-base currency risk. Currency risk will always be a
component by the very nature of foreign currency reserves, duration, however, may or may not.

Exchange Fund Account 17


One of the key purposes of a benchmark is to reflect the neutral risk profile of the pool of assets, in
this case, of the EFA. The neutral risk profile, in turn should reflect the risk tolerance of the reserve
manager. While “neutral risk profile” can have many interpretations, we generally illustrate this by
stating that if the portfolio were to be indexed to the benchmark, the client should feel comfortable
with the portfolio returns over the chosen investment horizon, irrespective of market conditions over
that period. By portfolio we refer to those assets that may comprise the EFA and are neither
hedging nor hedged by liabilities. Unlike the EFA, most Central Banks have a designated
benchmark against which the assets are managed but, also unlike the EFA, as discussed before,
most Central Banks separate the assets from the liabilities and take little or no note of the cost of
the reserves. This means that, in order to have some sort of ‘risk compass’, most Central Banks
choose a benchmark as a measure of neutral risk, against which to manage the reserves.
However, taking into account our earlier definition of “neutral risk profile” and given the EFA’s risk
parameters, the Fund’s benchmark in this instance could be considered to be zero and therefore
risk free.

Despite the generally conservative nature of investments within the Central Bank community, the
EFA’s risk profile should be considered conservative by comparison. As will be discussed
throughout the next couple of pages, we have witnessed a change in the way that many Central
Banks allocate risk within international reserves portfolios as we see more Central Banks allocating
duration and credit risk within their portfolios.

It is not uncommon for Central Banks to be hesitant about making changes to an established
reserve management program, particularly when the objective is to increase the level of risk in
order to potentially increment return within the portfolio. We would anticipate that Canada has
similar concerns should the EFA’s current risk level be subject to review in the future.

For the purpose of this evaluation, we have outlined the process undertaken by FFTW to determine
the level of risk that we would consider appropriate for a Central Bank with Canada’s objectives
and will compare this with what we understand to be the norm within the Central Bank community.
We have focused on historic extremes as a determinant of the range of potential outcomes.
Generally we recommend evaluating market moves falling within two standard deviations of the
historic mean, with a focus on the downside returns. We do acknowledge, however, that the last
decade has presented a number of four (and greater) standard deviation events so chosen risk
levels should always be stress tested for the extreme events. While no-one likes returns in down
market periods, clients need to evaluate the impact of the different return outcomes to assess
which are tolerable and, most importantly, which are intolerable.

Exchange Fund Account 18


In order to gravitate towards the optimal balance between risk and potential return given the
individual requirements of most Central Banks, as outlined earlier, we have analyzed the history of
various fixed income asset classes in a number of different ways. Chart 1 below shows US Yield
Movements going back to 1980. The chart highlights the change in environment between the
1980’s, where yields averaged 10.36% and volatility was more extreme, and the period from 1990
onwards, in which the average yield was 5.11% and there has been considerably less volatility.

Chart 1 US Yield Movements, January 1980 to December 2005

19.75

16.00

12.25
Jan '80 - Dec '89
Yields, %

Average = 10.36

8.50

4.75
Jan '90 - Dec '05
Average = 5.11
3 month LIBOR
2Yr US Treasury
10Yr Treasury
80 '90 A
1.00
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Data Source: Bloomberg

To assist in identifying the risks attached to duration, the table below provides the risk/return
characteristics of US Treasury securities over the 26 year period ending December, 2005.

The table shows the risk and return history of the US Treasury market, broken down into maturity
buckets. The Period End Duration column is the duration as of December 2005. It should be noted,
however, that the duration of each index may have changed over the period under analysis as a
result of changes in market issuance patterns over the course of the period under review. The
mean return represents the average of the monthly rolling annual periods under review for 26
years. The volatility is the standard deviation of these rolling annual periods. The worst return
represents the worst rolling annual return and it should be noted that it may not necessarily have
taken place in a calendar year. Finally, the Sharpe ratio is calculated using 3 month LIBID as the
risk free rate, as this is the most common investment parameter and benchmark for the liquidity
component of Central Bank reserves.

Exchange Fund Account 19


Table 2

Period End Worst Annual # of Periods of


26 Years (1/80 - 12/05) Mean Return Standard Deviation Sharpe Ratio
Duration Return Negative Return
3 Mo LIBID 0.25 6.82 3.98 1.05 -

1-3 Treasury 1.73 8.03 4.74 (0.35) 2 0.25

3-5 Treasury 3.57 9.07 6.42 (2.74) 16 0.35

5-7 Treasury 4.55 9.69 7.76 (6.10) 26 0.37

7-10 Treasury 6.56 10.20 9.31 (8.06) 37 0.36

10+ Treasury 10.54 11.50 12.07 (12.09) 44 0.39

1-10 Treasury 3.36 8.67 5.90 (1.70) 11 0.31

Treasury Index 5.09 9.49 7.04 (4.48) 21 0.38

Source: Merrill Lynch & Bloomberg

In reviewing the above data, we can make the following observations. First, if positive return is the
major consideration (i.e. capital preservation), then history shows us that in this time frame the 1-3
year sector of the US Treasury market has had negative returns during only two annual periods
(the annual periods ending Feb 2005 and March 2005, when starting yields were at record lows).
This is important for two reasons:

(i) The period under review includes three rising rate cycles (1994, 1999 and 2004/5) so for US
Treasury returns, particularly in the short end of the market, it is a highly representative period
of analysis.

(ii) For many Central Banks, as well as Canada, the need for capital preservation over a one year
period is a key requirement of an investment strategy and the 1-3 year area of the yield curve is
a very commonly chosen neutral position (benchmark) among the more conservative Central
Banks throughout the world.

Table 3 below shows similar data to Table 2 above, but over the more representative (lower
volatility) period since 1990. It should be noted that the volatility is lower, the mean returns are
lower, but despite this, in the short end of the yield curve, the worst annual returns are unchanged.

Exchange Fund Account 20


Table 3

Period End Worst Annual # of Periods of


16 Years (1/90 - 12/05) Mean Return Standard Deviation Sharpe Ratio
Duration Return Negative Return

3 Mo LIBID 0.25 4.39 1.87 1.05 -

1-3 Treasury 1.73 5.85 3.11 (0.35) 2 0.47

3-5 Treasury 3.57 7.17 4.76 (2.74) 13 0.58

5-7 Treasury 4.55 7.83 5.61 (4.32) 17 0.61

7-10 Treasury 6.56 8.26 6.60 (7.41) 22 0.59

10+ Treasury 10.54 9.80 8.43 (11.58) 23 0.64

1-10 Treasury 3.36 6.52 4.05 (1.70) 11 0.52

Treasury Index 5.09 7.54 5.10 (4.48) 15 0.62


Source: Merrill Lynch Indices, FFTW Analysis. Duration shown as of December 2004
Periods of analysis: January 1990 to December 2005

The 1-3 year area of the curve, with a duration of around 1.75 years, therefore appears to be an
appropriate maximum duration level for a risk-averse investor seeking a low probability of negative
returns. It is one of the key duration targets within the Central Bank community and not only
provides a high probability of capital preservation, but also from an investment perspective includes
one of the most advantageous areas for beneficial yield curve roll down in a normal market
environment.

The current asset-liability management policy in Canada requires that the duration of the assets in
the EFA and the liabilities funding those assets be matched as close as possible. The objective is
to reduce the amount of interest rate risk to which the reserves are exposed at any given time. Any
deviation from a duration neutral position is, in most cases, the result of timing differences in the
reinvestment of maturities although modest and specific deviations from a neutral position are
permitted, based on the maturity of the asset being reinvested. This practice significantly deviates
from that of most Central Banks in so far as most don’t have the objective of completely eliminating
duration risk and, in fact, actually aim to take and actively manage the duration to which the reserve
program is exposed.

We would suggest that Canada consider reviewing the duration exposure within the current fund
structure. If Canada had an appetite to increase duration risk as a means of incrementing return,
the duration gap could be increased up to a level representative of the duration exposure suitable
for many other Central Bank with similar stated objectives. As discussed above in our analysis of
interest rate exposures, a typical duration gap could be up to 1.75yrs, which is the duration of a
typical 1-3 year Central Bank benchmark. As can be seen in Table 3, a 1-3 year US Treasury
benchmark only had 2 negative rolling one year return periods during the 16 years analyzed and
the worst return during that period was negative 35 basis points at a point in time when aggregate
yields were close to 1%. Two years of duration exposure has been a common target duration in

Exchange Fund Account 21


the Central Bank community and is often the first step for Central Banks looking to extend the
duration of reserve portfolios beyond money market parameters. In fact, FFTW is aware of at least
25 Central Banks around the world who have chosen a 1-3 year benchmark as an internal and/or
external benchmark.

The concept of a benchmark will be different for the EFA compared to typical Central Bank reserve
managers given that the assets are liability matched and therefore already have their own
benchmark in a sense. A discussion point will center around the implementation issues inherent in
assuming duration risk while operating within the liability matching framework, and will address the
potential for, and the need to avoid, residual yield curve risk. Increasing duration in an otherwise
liability-matched structure will necessitate some yield curve exposure in order to avoid leverage.
We have debated several options for establishing a benchmark for the EFA. The first is to establish
a benchmark structure to optimize the asset side while the hedging of liabilities in terms of duration
and currency will be managed as an overlay, a structure which would necessitate the use of futures
as eligible instruments in the guideline parameters. The second is to recognize the liabilities
themselves as a type of benchmark and limit taking off-benchmark duration exposures to non-
systematic positions or opportunistic, tactical duration exposures. The third approach is to assume
that the benchmark duration is zero thereby viewing returns in a total return concept, allowing both
overweight and underweight (long and short) positions using futures to manage the risk. This as a
concept, can of course be extended to other risks, such as currency through an overlay and even,
credit through swaps. A final alternative is to maintain the current duration matched structure but to
introduce different risks, such as the addition of new asset classes to enhance the yield spread
between the assets and the cost of funding (liabilities).

Each of the above structures has its own pros and cons. The first will require the use of derivatives,
and specifically the use of interest rate futures and interest rate swaps to manage the assets as an
overlay, a potential impediment to Canada as it is to many Central Banks. The issue with the
second approach is that one of the key requirements of a benchmark is its long term strategic
nature, so non-systematic duration risk assumes an alpha and not a beta approach to returns. We
believe that in an unconstrained world, a combination of these two approaches is appropriate. The
third option is one towards which the industry as a whole is turning as the concept of total return
management becomes both more recognized and more popular. The separation of beta
(benchmark or market returns) from alpha (excess returns) in a total return context allows the
industry to assume a cash-like benchmark but still generate excess returns while specifically
isolating and targeting the risks that they wish to assume. In the case of the EFA, the objective is
to generate excess returns (alpha) over the funding cost subject to the ability to preserve capital
and maintain liquidity needs.

Exchange Fund Account 22


Another way in which duration risk may be more effectively used, is to diversify the risks across
multiple markets. Currently the duration risks offset liabilities in three currencies: US Dollars, Euro
and Yen. The chart below illustrates the degree of correlation between the major bond markets
over the last 25 years.

17.5

Low 6/03
15.0
Yield Levels

USD 10 Yr 3.1%
12.5 JPY 10 Yr 0.4%
DEM 10 Yr 3.4%
UK 10 Yr 3.9%
10.0
Yields, %

7.5

5.0
10Yr Treasury

10Yr Japanese Treasury


2.5
10Yr German Treasury

10Yr UK Treasury

0.0
80

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Source: Bloomberg. As of February 28, 2006.

In addition, appendix 1 shows a correlation table of the major investment grade fixed income
markets and although correlations are relatively high between many markets, they are still less than
1.0 which indicates that a higher degree of diversification is achievable by adopting a broader set of
markets. An important point to note is that the decision to diversify market exposure can and should
be a separate decision from the currency allocation decision, which will be addressed later.

The eligibility of an increasing number of countries in global benchmarks has been steadily
evidenced as the smaller markets have developed and borrowing, and therefore liquidity within
markets, has increased. This would be an area for Canada to analyse further. By way of
comparison, many Central Banks that adopt a multi-currency approach in their reserves do so by
adopting a published multi-currency benchmark which includes 11 or more countries. The Citigroup
World Government Bond Index, the JP Morgan Global Bond Index and the Lehman Brothers
Global Aggregate Index are all multi-country indices currently used by Central Banks, and are often
custom-weighted to target specific country allocations or sub-components are used to target

Exchange Fund Account 23


preferred duration risk, such as a WGBI 1-3 year benchmark. The risk lowering benefit of country
diversification can be seen in Table 4 below.

Table 4

Period End Worst Annual # of Periods of


16 Years (1/90 - 12/05) Mean Return Std Dev Sharpe
Duration Return Negative Return

LIBID 0.25 4.39 1.87 1.05 - -

1-3 Treasuries 1.73 5.85 3.11 -0.35 2 0.47

1-5 Treasuries 2.37 6.26 3.67 -1.26 8 0.51

1-3 International Hedged 1.82 5.81 2.47 1.14 - 0.57

1-5 International Hedged 2.65 6.48 3.02 -0.56 2 0.69

International Hedged 6.04 8.03 4.33 -4.02 8 0.84

1-3 International Unhedged 1.82 6.29 8.60 -11.38 46 0.22

1-5 International Unhedged 2.65 6.75 8.70 -11.27 46 0.27

International Unhedged 6.04 8.45 8.95 -9.70 37 0.45

Treasury Index 5.09 7.54 5.10 -4.48 15 0.62

Finally, we will assess the currency breakdown of the EFA. The currency allocation is currently a
combination of US Dollars, Euro and to a small extent Japanese. The currency exposure is
determined as a neutral position and the allocation around that neutral position remain very limited.
In assessing the decision process behind the currency breakdown of reserves, there appeared to
be scope for further evaluation of the currency mix. The allocation of the non-base currencies
represents the single largest contribution to risk in a reserve portfolio and is a decision that lends
itself to a quantitative determination that we suggest includes:

(i) An assessment of the correlation of each currency and combination of currencies


relative to the home currency (the Canadian Dollar). This will intrinsically include the
impact on the currency due to trade patterns as well as non-trade flows and influences.

(ii) An estimate of the likely use of a given currency for intervention purposes.

(iii) An evaluation of the expected long term returns within each currency.

We would suggest conducting this analysis using long term (10 and 20+ year) data histories to fully
assess the long term historic relationships between the optimal currency mix for the reserves and
the Canadian Dollar as the neutral currency decision is a long term strategic decision and one
which we would expect and recommend be changed only infrequently. While the US Dollar, Euro
and Japanese Yen are the main reserve currencies, we suggest that this analysis be broadened to
include other currencies to allow a degree of diversification which can be expected to reduce the
overall risk attributable to the currency mix. It should be noted, however, that the three eligible
currencies are the most liquid in the world and that through introducing other less liquid currencies,

Exchange Fund Account 24


depending upon the size of the intended neutral allocation, the liquidity requirement of the EFA may
be compromised.

Finally, having evaluated other risks, we can turn to an evaluation of different asset classes within
the fixed income universe as a means of generating incremental return

Return Enhancement

The challenge of managing a pool of assets against a zero or ‘cash’ neutral position is to identify
strategies which outperform cash while not exposing the portfolio to capital depreciation during
periods of rising yields. In our experience, the objectives of low volatility or enhanced cash
investment returns may be achieved by seeking incremental yield in a diversified portfolio of low
volatility assets, thereby achieving higher returns over cash while limiting additional risk.
Historically, returns achieved have typically paid the investor well for the additional risk taken, often
in the short term (1 year) and almost always in the long term (over a cycle). The chart below
summarises the strategies that are generally adopted to achieve different objectives.

Objective
Maintain Liquidity Maximise Returns

Liquidity: High Liquidity Lower Liquidity


Risk Level: Low Risk Higher Risk
Duration: 3 months 1.7 years 5.0 years
Credit: Government Agency, sovereign Corporates
Credit: AAA rating BBB Rating
Structure: Bullets ABS, CMO’s Mortgages
Country: US Global Hedged Global Unhedged
Portfolio: Money Market Short-Intermediate Broad Market
Benchmark: LIBOR 1-3 Yr US Treasury Global Aggregate

This section will focus upon the left side of the chart and will examine where and how far to move to
the right to achieve excess returns while not losing sight of the short term (annual) capital
preservation needs.

Return enhancement for conservative Central Banks can be divided into two categories: duration
and sector. Currency may also be used for return enhancement purposes, but within reserve
management, that tends to be for the more aggressive Central Banks. The more aggressive
Central Bank investors, with some exceptions, are either those who

Exchange Fund Account 25


(i) have little expectation of cash needs for intervention purposes such as the national
reserves of those Central Banks which form the European Monetary Union; or

(ii) Central Banks which have sizeable reserves and therefore the Investment and Excess
Wealth component may be invested more aggressively as the drawdown for intervention
needs is less likely given the sizeable cushion invested in lower volatility and more liquid
components. These would be categorized in the top two tiers in the diagram below.

• Multi-country and/or multi-currency


• Mortgage-Backed Securities
• Global Credit
• Global Aggregate
‘EXCESS’ • Alpha Transfer Strategies

• Longer Duration ≈ 5 Yrs


• Multi-Country
• Non-Base Currency Exposure
• High Quality Credit Sectors
INVESTMENT
• Duration < 2 Yrs
• US Treasuries and Agencies
• Sovereigns and Supranationals
INTERMEDIATE LIQUIDITY • Fixed and Floating Rate ABS

• Duration ≈ 3 months
• Treasury Bills
• Time Deposits
LIQUIDITY • Repos

While return enhancement is not a key objective of the EFA, the potential to increment return at low
levels of risk should not be ignored and is an area that we recommend Canada should consider
evaluating. The opportunity cost of holding the most liquid government securities translates into
forfeited income and while the purpose of reserves is not to make money, it is becoming
increasingly important to many Central Banks to enhance the return on reserves. Driven by the
search to find yield, Central Banks have continued to expand the universe of acceptable asset
classes included in their reserve management programs. Various surveys show that there is a
steady move away from the traditionally “safe” asset classes towards highly rated, liquid but higher
yielding investment opportunities. The RBS Reserve Management Trends – 2006 survey found
that over the past year Central Banks are increasing their allocation to both “riskier” and “new”
assets. In response to the question “Which of the following ’new‘ asset classes is your Central
Bank currently invested in?”, over a third of survey respondents reported investing in ‘A’ rated
government securities. Almost half of the Central Banks surveyed are introducing “new” asset
classes and one quarter of those surveyed are introducing structured securities, namely ABS and
MBS.

Exchange Fund Account 26


Exchange Fund Account 27
Table 5

Number of
Asset Class
Central Banks
Governments bonds (AA) 36
Governments bonds (A) 18
Governments bonds (BBB) 6
Governments (below BBB) 4
Corporate bonds (above BBB) 10
Corporate bonds (below BBB) 2
Agency paper 32
Asset-backed bonds 12
Mortgage-backed bonds 12
Index-linked bonds 12
Equities 4
Hedge Funds 0
Property 0
Alternative investment 4
Source: Central Bank Publications

The outcome, above, shows that moving down the credit curve in terms of rating has been the most
popular option and moving into non-government sectors has been the second option. Alternatives,
equities and corporate bonds are also included in the asset mix for some reserve managers, but
this is a much smaller component and limited to the more aggressive investors.

A second source also supports this finding. The UBS Central Bank Survey that includes the results
of more than 50 respondents shows a steady increase in the percentage of Central Banks that
approve Mortgage Backed Security and Asset Backed Security (MBS/ABS) allocations. The survey
is somewhat similar but shows the progression of moves into new asset classes over the past eight
years, which tells a very important story and indicates the trend among reserve managers.

Exchange Fund Account 28


Trends in Approved Asset Classes: 1998 to 2005
(% of central banks which have approved the asset class)

Asset Class 2005 2004 2003 2002 2001 2000 1999 1998
US Agencies 82 76 78 75 71 62 68 54
Supranationals 74 63 62 60 62 54 63 60
Sovereign Eurobonds 60 60 58 58 61 60 66 66
Sovereign Globals 54 50 56 54 52 44 50 34
Pfandbriefes 48 44 38 35 37 34 28 12
Bank Debt 41 21 24 21 26 20 16 4
MBS/ABS 39 39 27 22 17 19 12 2
Corporates 38 38 32 28 22 20 15 10
Landesbank Debt 37 33 27 30 30 32 28 12
Yankee Bonds 19 12 14 16 22 28 12 18
TIPS 16 9 na na na na na na
Local Government 14 12 14 16 16 18 18 8
Canadian Provinces 9 10 10 8 9 10 10 12
Equities 5 3 2 na na na na na

Source: UBS Central Bank Surveys, 1998-2005

Relevant points to note from the above survey are that the proportion of correspondents investing
in non-Treasury sectors has increased steadily over the years suggesting that return is becoming
increasingly important. Furthermore allocations to structured securities such as Mortgage Backed
Securities (MBS) and Asset Backed Securities (ABS) have increased dramatically, as the
percentage approving these structured securities has grown from 2% to 39%, surpassed only by
allocations to bank debt. MBS and ABS are clearly identified as sectors of interest and relevance to
Central Bank reserve managers, in terms of their risk and return characteristics as well as in
qualitative terms such as their rating, the collateralized nature of the asset classes and the relative
protection from headline risk. Another point to note from the above is the reduction in the number of
Central Banks allocating to sovereigns. Part of this is likely due to availability, but the lower liquidity
of this sector is also a relevant factor behind this statistic.

The objective of most yield enhancement strategies undertaken by Central Banks is to introduce
credit spreads into what would otherwise be a government portfolio by investing in either structured
securities or unsecured corporate securities. Taking into account the objectives and risk tolerance
both of Canada, and of most Central Banks, we would not recommend the inclusion of unsecured
corporate debt. This introduces headline risk, company preference issues and at the extreme, the
potential for accusations of conflict of interest between the corporate world and the Central Bank.

An area we would strongly favor for inclusion in the EFA, and one that is supported by the surveys
above in terms of eligibility and appropriateness, is the introduction of spread through investments
in structured (collateralized) securities. We recommend considering diversifying some government
risk into high quality Asset Backed Securities and low volatility, short duration, prepayment stable
US Mortgage Backed Security structures such as Collateralised Mortgage Obligation Floating Rate
Notes (‘CMO floaters’), Planned Amortisation Class (PAC) CMOs and Adjustable Rate Mortgages

Exchange Fund Account 29


(ARMs). Both these sectors generally offer high credit ratings, fully collateralized US agency debt
in the case of US Mortgage Backed Securities, and superior yields to government securities while
offering low volatility of relative returns. Our recommendation focuses on generating incremental
yield above a stated benchmark through investing in Floating Rate and Fixed Rate Asset Backed
Securities. In this case the benchmark may be considered to be the current government asset
structure of the EFA. Value would be derived from the higher yields generally available in these
instruments relative to government debt, as well as potential additional return through the active
management of security selection and sector allocation across and within the different ABS sub-
sectors. The high quality (AAA and AA) sectors and those in which many Central Banks invest are:
home equity loans (HEL), credit card receivables, auto loans, and student loans. The following
provides details of the ABS market in terms of size, liquidity and incremental yield as this is an area
in which a number of Central Banks invest, Central Banks whose only other investments are those
similar to the eligible instruments currently approved in the EFA.

The US ABS market offers broad diversification in terms of sub-sectors, issuers, rating and
geography. As issuance has grown, liquidity in the asset class continues to improve. Chart 2
illustrates the increased issuance and shows the growth of different sectors of the ABS market.

Chart 2

ABS Issuance
Historical Yearly Public Issuance: 1992 - 2005
1,000

900 Home Equity Loans Credit Cards


Autos Manufactured Housing
800 Student Other

700

600
Billions $

500

400

300

200

100

0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Asset backed securities provide a means of adding incremental yield relative to US Treasuries and
deposit rates (LIBID), while at the same time maintaining a high credit quality and a high degree of
liquidity. The yield spread is largely to compensate the invester for structural risk, or the risk of

Exchange Fund Account 30


cash flow volatility, and to a less extent to compensate for the credit of the servicer. All of these
risks can be carefully monitored, controlled and managed within the context of an overall portfolio.

For duration-sensitive investors, investing in high quality floating rate ABS benchmarked to one
month or three month LIBOR would be an ideal option. However, the Bank of Canada should also
consider taking advantage of investment opportunities in fixed rate ABS. Fixed rate instruments
are an investment option for the EFA as the fund is allowed to maintain absolute duration as long
as it is offset by the liability exposure, thus yielding little net duration exposure to the reserves.

In the following table, we have compared the 1-3 year sector of the ABS market over the 12 year
period ending December 2005 to US Treasuries, US Agencies and US corporate bonds (1994 is
the first year in which accurate index data became available for ABS). All non-government asset
classes represented in the table have generated substantial excess returns at volatility levels only
marginally above those of US Treasuries. Corporate bonds offer superior risk/return characteristics
but asset-backed securities, which are largely AAA-rated (we would in any event recommend
restricting a Central Bank portfolio to AAA-rated issues) have earned a substantial incremental
yield relative to US Treasuries, a comparable return to corporates yet are significantly more liquid.
Finally, as noted earlier, this asset class is much more acceptable to the Central Bank community
given the general aversion to the headline risk associated with corporate bonds.

Table 6

Period End Standard Worst Annual # of Periods of


12 Years (1/94 - 12/05) Mean Return Sharpe Ratio
Duration Deviation Return Negative Return

3 mo LIBID 0.25 4.26 1.89 1.05 - -

Treasury Index 1-3 yr 1.73 5.28 2.75 (0.35) 2 0.37

Agency Index 1-3 yr 1.77 5.57 2.74 (0.06) 1 0.48

Corporate Index 1-3Yr 1.80 6.20 2.69 0.25 - 0.72

AAA/AA Rated Corporates 1-3 Yr 1.79 6.07 2.91 (0.14) 1 0.62

AAA/AA & A Rated Corporates 1-3 Yr 1.79 6.15 2.84 0.01 - 0.67

BBB Rated Corporates 1-3Yr 1.82 6.27 2.77 0.62 - 0.72

AAA/AA Rated ABS 1-3Yr 1.83 6.01 2.90 0.03 - 0.60

Corporate Index & AAA/AA ABS 1-3Yr 1.80 6.18 2.69 0.23 - 0.71

AAA/AA & A Rated Corporates & AAA/AA ABS 1-3 Yr 1.79 6.13 2.84 0.01 - 0.66

Source: Merrill Lynch/ Citigroup Indices, FFTW Analysis


Period of analysis: January 1994 to December 2005

The impact on the EFA of adding ABS into the asset allocation would be to lower the risk of the
aggregate portfolio, achieved by introducing diversification but with a similarly low volatility asset
class as US Treasuries, and to increase the return potential primarily through yield enhancement.
The table above shows that the historical annualized return increment of Asset Backed Securities
over US Treasuries over the past 12 years has been 73 basis points for comparable volatility. 73

Exchange Fund Account 31


basis points translates into US$ 7,300,000 additional income for every US$ 1 billion allocated to the
asset class. The forfeited return relative to US agencies is 44bps, or US$ 4,400,000 in additional
income for every US$ 1 billion allocated to ABS and not agencies. These are sizeable forfeitures
for Canada and deserve additional consideration as to whether the current conservative allocation
to G3 governments, agencies, sovereigns and supranationals could be broadened for the purposes
of increasing return potential.

Liquidity in Asset Backed Security Market


Outstanding US Bond Market Debt
as of December 31, 2005
ABS are a highly liquid and growing sector of the
Asset-Backed
fixed income universe. The chart to the right 8%

depicts the breakdown of the total US Bond Mortgage-Related Municipal


23% 9%
Market by sector. The US ABS market has now
grown to approximately US $1.8 trillion, close to
50% of the size of the US Treasury market and Money Market
14%
just a little less than the size of the US Federal
Agency market. The chart below shows the
Corporate
annual growth of the Asset Backed Securities Federal Agency
20%
10%
sector and clearly illustrates the steady growth in
new issuance of Asset Backed Securities. Treasury
16%

ABS Issuance Statistics


Historical Yearly Public Issuance: 1992-2005
1,200

1,000

800
Billions $

600

400

200

0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Source: Bond Market Association, Bloomberg

In terms of bid/offer spreads, high quality ABS issues trade, as stated in our spread survey earlier,
on a spread of less than one thirty second. This allows for a high degree of liquidity in terms of
liquidation or sales, with the main impediment being that of sourcing suitable new issues for

Exchange Fund Account 32


reinvestment or purchases. Asset Backed Securities generally trade T+3 settlement so have the
same settlement characteristics as the Euro denominated government securities already permitted
in the portfolio. Although current spreads provide little indication of incremental return potential, the
table below provides an indication of the incremental yield currently offered by this asset class.
Table 7
Floating Rate Spreads as of May 1, 2006
Sector Rating Benchmark Avg Life (years) Current Spread (bps)
Auto AAA 1 Mo LIBOR 1 (1)
AAA 1 Mo LIBOR 2 0
AAA 1 Mo LIBOR 3 1
Auto (Non-prime) AAA 1 Mo LIBOR 1 2
AAA 1 Mo LIBOR 2 3
AAA 1 Mo LIBOR 3 5
Credit Card AAA 1 Mo LIBOR 1 (3)
AAA 1 Mo LIBOR 2 (2)
AAA 1 Mo LIBOR 3 (1)
AAA 1 Mo LIBOR 5 3
AAA 1 Mo LIBOR 7 5
AAA 1 Mo LIBOR 10 9
A 1 Mo LIBOR 5 11
BBB 1 Mo LIBOR 5 25
Home Equity AAA 1 Mo LIBOR 1 6
AAA 1 Mo LIBOR 2 11
AAA 1 Mo LIBOR 3 16
AA 1 Mo LIBOR 5 32
A 1 Mo LIBOR 5 44
BBB 1 Mo LIBOR 5 115
Student Loans AAA 3 Mo LIBOR 1 (2)
AAA 3 Mo LIBOR 2 (1)
AAA 3 Mo LIBOR 3 0
AAA 3 Mo LIBOR 5 5
AAA 3 Mo LIBOR 7 8
Benchmark Avg Life (years) Current Value
1 Month LIBOR 1 Month 5.04%
3 Month LIBOR 3 Month 5.13%

Source: Bank of America Securities, LLC and FFTW as of May 1, 2006

Spreads have tightened substantially in recent years as the ABS market has grown, become more
liquid and also more mainstream, This mean that the incremental return above LIBOR is now quite
limited. However, the asset class still offers incremental return relative to Government debt and
should be evaluated for inclusion in a longer term context and particularly to potentially prepare for
future investment should spreads become more attractive.
Active management of Asset Backed Securities within the context of the EFA should generally
revolve around the following three fundamentals:
ABS exposure is duration and yield curve neutral. The sector decision is a separate
decision from duration and yield curve.

Exchange Fund Account 33


Relative value opportunities exist across a diversified portfolio of ABS.
Sophisticated analytics are essential to assessing value and controlling risk.

There are two main sources of added value in managing Asset Backed Securities. The first is the
incremental yield derived from these securities. The second is the value derived from managing
sub-sectors within the ABS universe and then selecting specific issues within those sub-sectors.
The different sub-sector opportunities within the ABS market include fixed and floating rate notes
across home equity loans, credit card receivables, auto loans and student loans. The security
selection process should seek to determine whether the investor will receive adequate
compensation for the identified risks of a particular security.

Exchange Fund Account 34


CONCLUSION

• We would identify the management of Canada’s reserves as being among the more
conservatively managed within the Central Bank community.

• The EFA is managed prudently and with full regard for the key objectives to ensure liquidity and
capital preservation. Subject to the achievement of these goals, return becomes a tertiary
consideration. However, Canada have historically managed to contribute to the public purse
through the excess return earned above the funding costs of the EFA.

• The reserve management structure is unusual in so far as liabilities are matched against
assets, whereas more usually (though not necessarily a superior structure) assets are
managed against a benchmark and are evaluated in the context of the benchmark and not
against a cost of funding.

• The excess return earned over funding in 2005 was 9bps while simultaneously ensuring
liquidity and capital preservation relative to the liabilities – the key objectives of the EFA.

• Liquidity is very high in all investments within the EFA. We suggest reviewing the need for the
highest level of liquidity for the aggregate reserves and suggest that the cost of the liquidity
premium may be lowered by reducing liquidity marginally within a component of the reserves.

• A trend we have observed in recent years is the more aggressive investment of reserves by
many Central Banks as the need for return becomes an objective of increasing importance.

• We suggest a point for consideration might to be to move the management of the EFA from the
Liquidity strata closer to the top of the Intermediate Liquidity layer on the triangle of reserves,
an increase in risk with the objective of increasing return.

• Other suggestions which lead to an increase in risk to potentially increase the additional return
earned over funding include evaluating adding duration to the assets, focusing around the two
year duration area, an area that is commonly chosen as a duration target / benchmark for
Central Banks moving away from the Liquidity tranche for the first time.

• Another recommendation is to consider evaluating non-government sectors and specifically to


consider introducing ABS and low volatility MBS structures to introduce incremental yield at a
comparable level of volatility to the current Treasury and Agency allocation.

Exchange Fund Account 35


• The currency allocation is a large component of the volatility of the reserves and we
recommend a quantitative analysis of the current allocation to ensure that the breakdown is
appropriate.

• We further suggest consideration be given to increasing the number of currencies held in the
EFA to provide a more diverse and lower risk portfolio of assets

Exchange Fund Account 36


Appendix 1

Correlation Matrix
April 30, 2000 to April 30, 2006

CORRELATIONS Australia Austria Belgium Canada Denmark Finland France Germany Greece Ireland Italy Japan Netherlands Norway Poland Portugal Spain Singapore Sweden Switzerland U.S. U.K.
Australia Tsy 1.00 0.79 0.79 0.75 0.77 0.81 0.79 0.79 0.79 0.80 0.75 0.26 0.80 0.67 0.42 0.80 0.79 0.57 0.75 0.74 0.74 0.78
Austria Tsy 0.79 1.00 1.00 0.82 0.98 0.98 1.00 1.00 0.98 0.99 0.99 0.29 1.00 0.80 0.50 0.99 1.00 0.63 0.90 0.86 0.83 0.85
Belgium Tsy 0.79 1.00 1.00 0.82 0.98 0.99 1.00 1.00 0.98 0.99 0.99 0.30 1.00 0.80 0.50 1.00 1.00 0.64 0.90 0.85 0.84 0.85
Canada Tsy 0.75 0.82 0.82 1.00 0.80 0.82 0.82 0.83 0.80 0.82 0.82 0.19 0.83 0.67 0.44 0.81 0.82 0.53 0.77 0.70 0.87 0.74
Denmark Tsy 0.77 0.98 0.98 0.80 1.00 0.97 0.98 0.98 0.96 0.97 0.97 0.27 0.98 0.79 0.50 0.97 0.98 0.64 0.90 0.86 0.83 0.82
Finland Tsy 0.81 0.98 0.99 0.82 0.97 1.00 0.98 0.98 0.97 0.99 0.96 0.29 0.98 0.80 0.48 0.99 0.98 0.66 0.90 0.85 0.85 0.83
France Tsy 0.79 1.00 1.00 0.82 0.98 0.98 1.00 1.00 0.98 0.99 0.99 0.29 1.00 0.80 0.50 0.99 1.00 0.62 0.90 0.86 0.83 0.86
Germany Tsy 0.79 1.00 1.00 0.83 0.98 0.98 1.00 1.00 0.98 0.99 0.99 0.27 1.00 0.80 0.49 0.99 1.00 0.62 0.91 0.86 0.84 0.86
Greece Tsy 0.79 0.98 0.98 0.80 0.96 0.97 0.98 0.98 1.00 0.97 0.97 0.29 0.98 0.78 0.51 0.98 0.98 0.66 0.89 0.85 0.83 0.85
Ireland Tsy 0.80 0.99 0.99 0.82 0.97 0.99 0.99 0.99 0.97 1.00 0.98 0.28 0.99 0.80 0.47 0.99 0.99 0.63 0.92 0.85 0.83 0.86
Italy Tsy 0.75 0.99 0.99 0.82 0.97 0.96 0.99 0.99 0.97 0.98 1.00 0.28 0.99 0.79 0.51 0.97 0.99 0.61 0.89 0.85 0.81 0.83
Japan Tsy 0.26 0.29 0.30 0.19 0.27 0.29 0.29 0.27 0.29 0.28 0.28 1.00 0.28 0.22 0.14 0.29 0.29 0.39 0.26 0.30 0.19 0.22
Netherlands Tsy 0.80 1.00 1.00 0.83 0.98 0.98 1.00 1.00 0.98 0.99 0.99 0.28 1.00 0.80 0.50 0.99 1.00 0.63 0.90 0.86 0.84 0.86
Norway Tsy 0.67 0.80 0.80 0.67 0.79 0.80 0.80 0.80 0.78 0.80 0.79 0.22 0.80 1.00 0.43 0.80 0.80 0.47 0.75 0.63 0.66 0.70
Poland Tsy 0.42 0.50 0.50 0.44 0.50 0.48 0.50 0.49 0.51 0.47 0.51 0.14 0.50 0.43 1.00 0.50 0.50 0.40 0.45 0.41 0.41 0.50
Portugal Tsy 0.80 0.99 1.00 0.81 0.97 0.99 0.99 0.99 0.98 0.99 0.97 0.29 0.99 0.80 0.50 1.00 0.99 0.65 0.90 0.85 0.83 0.84
Spain Tsy 0.79 1.00 1.00 0.82 0.98 0.98 1.00 1.00 0.98 0.99 0.99 0.29 1.00 0.80 0.50 0.99 1.00 0.63 0.90 0.85 0.83 0.85
Singapore Tsy 0.57 0.63 0.64 0.53 0.64 0.66 0.62 0.62 0.66 0.63 0.61 0.39 0.63 0.47 0.40 0.65 0.63 1.00 0.58 0.61 0.62 0.56
Sweden Tsy 0.75 0.90 0.90 0.77 0.90 0.90 0.90 0.91 0.89 0.92 0.89 0.26 0.90 0.75 0.45 0.90 0.90 0.58 1.00 0.77 0.74 0.79
Switzerland Tsy 0.74 0.86 0.85 0.70 0.86 0.85 0.86 0.86 0.85 0.85 0.85 0.30 0.86 0.63 0.41 0.85 0.85 0.61 0.77 1.00 0.70 0.68
U.S. Tsy 0.74 0.83 0.84 0.87 0.83 0.85 0.83 0.84 0.83 0.83 0.81 0.19 0.84 0.66 0.41 0.83 0.83 0.62 0.74 0.70 1.00 0.75
U.K. Tsy 0.78 0.85 0.85 0.74 0.82 0.83 0.86 0.86 0.85 0.86 0.83 0.22 0.86 0.70 0.50 0.84 0.85 0.56 0.79 0.68 0.75 1.00

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