Special Drawing Rights

SDR is an international reserve asset, created by the IMF in 1969 to supplement the existing official reserves of member countries

The risk-return properties of SDR-denominated investments

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As a basket currency, the SDR derives its exchange value from the exchange rates of its constituent currencies; currently the SDR is comprised of the U.S. dollar, the euro, the pound sterling and the Japanese yen. In this section, we present an analysis of the investment properties of the SDR, emphasizing its stability, to illustrate the potential benefits of SDR-denominated fixed income instruments in comparison to instruments denominated in the individual currencies within the SDR basket. The analysis covers the period from January 1999, when the euro was introduced, through June 2009. Over this period, we consider hypothetical investments in short-term fixed income instruments, from the perspective of investors that use each of the component securities and the SDR as the base currency.

 

The analysis evaluates the alternatives of investing in shortterm instruments denominated in the local base currency, in the three other component currencies, and in the SDR itself. The total nominal returns to an investment strategy would consist of interest income accrued in the investment currency in which the instrument is denominated and exchange rate gains or losses in converting between the base currencies and investing currency. For each investor of a given base currency, the streams of total returns of each of the investment strategies are simulated and contrasted against each other, in terms of average returns, volatility of returns and reward per unit of risk. The bilateral exchange rates used are monthly closing rates as reported by Reuters, obtained from Datastream.

 

The investment instruments are assumed to be short-term government securities that currently constitute the SDR interest rate basket as well as an instrument denominated in SDRs which pays the SDR market interest rate.4 We use market yields on three-month U.S. Treasury bills, three-month U.K. Treasury bills, the three-month Eurepo rate and three-month Japanese Financing bills, all obtained from Datastream. SDR interest rates are determined weekly as a weighted average of the yields on the securities in the SDR basket. The data on market interest rates on SDR are available on a monthly frequency, reported at mid-month, in the IMF’s International Finance Series via Datastream.

 

The principal attraction of an SDR-based financial instrument, as for any other basket instruments, lies in the superior stability of returns it is capable of providing due to the diversification of currency risk, as well as in its convenience and cost advantage. The SDR serves as a convenient risk diversifier, because as a basket its value is based on component instruments that are imperfectly correlated with each other. As the total returns from such investment include both the currency gains/losses and the interest income in the investment currency, the SDR risk-reduction property accrues from both currency returns and interest income

 

From the exchange risk perspective, the SDR’s stability primarily results from the fact that exchange rate shifts among the currencies in the SDR basket tend to offset one another, depending on the degree of correlations among the component currencies. To the extent that movements in the exchange rates of the currencies within the basket are not perfectly positively correlated, changes in the value of one currency could be partially offset by smaller changes, if the correlations are positive, or by opposite changes in the values of the remaining currencies. As movements in the exchange rates of currencies in the SDR basket are not perfectly correlated, the volatility of the SDR’s value in terms of any one of the component currencies (e.g., the U.S dollar) would be less than the average of the volatilities of the values of all the other SDR-component currencies in terms of that particular currency. Similarly, the SDR’s interest rate is a weighted average of the nominal interest rates of the constituent currencies. Table 1 presents the pair-wise correlation coefficients of changes in the exchange rates, expressed in terms of the SDR and of the component currencies in the SDR basket, as well as the correlations in changes in the interest rates of the currencies. (Partner: Essensys, market leader in Executive Interim Management)