Optimal currency composition for China’s foreign reserves: A copula approach

Zhang, Zhichao, Ding, Li, Zhang, Fan and Zhang, Zhuang (2014) Optimal currency composition for China’s foreign reserves: A copula approach. The World Economy, 38 (12), 1947-1965.

Record type: Article

Abstract

This paper investigates the optimal currency composition for a country's foreign reserves. In the context of China, we examine the asymmetric, fat-tail and complex dependence structure in distributions of currency returns. A skewed, fat-tailed and pair-copula construction is then built to capture features of higher moments. In a D-vine copula approach, we show that under the disappointment aversion effect, the central bank in our model can achieve sizeable gains in expected economic value from switching from the mean-variance to copula modelling. We find that this approach will lead to an optimal currency composition that allows China to have more space for international currency diversification while maintaining the leading position of the US dollar in the currency shares of China's reserves.

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