Sovereign Wealth Funds: Reserve Funds

  1. Reserve funds. These are designed to earn returns on excess foreign reserves held by central banks. Typically, foreign exchange reserves held by central banks are low-yielding assets relative to the yields offered by bonds issued by central banks that make up their liabilities. Reserve funds aim to reduce this negative cost of carry through boosting returns on reserves.

I’m having a tough time wrapping my head around this specifically. Can anyone explain better?

Thanks!

Northwestern Zamborania has huge natural deposits of tantalum, along with the world’s most highly prized orchids, licorice, and peat moss. Their economy relies on exports of these items to Japan, Great Britain, and Australia, creating a huge trade imbalance, with local producers holding large quantities of JPY, GBP, and AUD. The Zamboranian government buys up the foreign currencies from these local producers, then invests those reserves; they set up the Northwestern Zamboranian Universal Reserve Fund (NZURF, pronounced “enzurf”) to manage the investments. To buy the foreign currency from the producers, the Zamboranian central bank prints money: Zamboranian guandices (singular: guandex, NZG). To prevent the increased money supply from causing inflation, the central bank issues NZG-denominated bonds, taking the excess (i.e., newly minted) money out of circulation. The NZURF’s job is to invest the reserves to produce returns that will cover the interest payments on those bonds, and maintain the purchasing power of the JPY/GBP/AUD portfolio.

Part of that return comes from selling NZURF flags and coffee mugs. They’re all the rage.