Eesti Pank's foreign exchange reserve management principles

The purpose of Eesti Pank's foreign exchange reserve (FER) and the key management principle

The primary goal of Eesti Pank's FER is to safeguard the stability of the Estonian kroon. The FER must exceed Eesti Pank's liabilities, i.e. the total sum of kroons issued by Eesti Pank. In addition, the task of the FER is to guarantee additional funds necessary for the independent operational functioning of Eesti Pank as the central bank. The key principle behind the management of the FER is to maintain the value and liquidity of the reserve assets while earning optimum income from investments within the established risk limits. The size of the FER and the income earned on it is measured in Estonian kroons.

The decision-making process concerning the management of Eesti Pank's FER

The FER is managed by the Financial Markets Department of Eesti Pank. The strategic decisions associated with the field are made on two different management levels:

The head of every respective level is responsible within their competence for the content and implementation of decisions and for guaranteeing that the decisions made by them are in accordance with higher-level decisions.

In the management of the FER the competence of Governor of Eesti Pank includes:

     approval of the decision-making competence related to the management of the FER;
     approval of the principles on managing the financial risks concerning the management of the FER;
     approval of the currencies, financial markets and financial instruments allowed for the management of the FER;

The Monetary Policy Committee endorses the benchmark portfolio of the FER. The decisions made concerning the FER benchmark portfolio are reviewed when necessary but not less frequently than once a year. The limits across risk classes by which the actual investment portfolio may deviate from the benchmark portfolio are approved by Head of the Financial Markets Department.

Risk limits are established on the basis of the foreign exchange net reserve.

The principles of managing financial risks related to investing Eesti Pank's FER

Of the financial risks accompanying the management of Eesti Pank's foreign exchange reserve the currency risk, interest rate risk, credit risk and liquidity risk are regulated. When possible, risks are estimated with the risk variable VAR and limited with regard to the benchmark portfolio.

VAR (Value at risk) is a risk measurement based on variability, which is based on the RiskMetrics© principles and the data acquired by that method. Those financial risks that cannot be measured with the VAR method are limited through volume or another parameter.

The benchmark portfolio against which the limitation of the risk level is performed is theoretical, i.e. actually a non-existing benchmark portfolio that indicates the general risk tolerance of Eesti Pank and based on which the risk level of the actual investment portfolio is measured. Financial assets in the benchmark portfolio are selected so that these would ensure the preservation of the FER over the period of one year, i.e., would make sure the return on investment of the reserves would not be negative. This means that upon checking the preservation of the FER at one-year intervals, the value of the reserves has remained the same or has increased with a 95% probability.

Thus, the benchmark portfolio is the best passive investment alternative which serves as a basis for the measurement of the actual investment portfolio's yield, i.e. profitability. All in all, the benchmark portfolio for Eesti Pank's FER management serves as a basis for the measurement of the actual investment portfolio's risk level as well as profitability.