Does country background risk matter to the strategic asset allocation of sovereign wealth funds

Abstract On the basis of background risk theory (Gollier 2001), this paper discusses the country background assets of sovereign wealth funds (SWFs), establishes the optimal strategic asset allocation model with consideration for background risk, and proves that the rebalanced weight of each asset is negatively correlated with the covariance of background assets and financial assets. Considering both the national foreign currency reserve assets and future payment obligations of international import goods as background risk, this paper uses China's SWF as a sample, partitions global equity markets according to MSCI country and industry indices, utilizes market implied expected return and market models to estimate the expected return of those investable assets, and finally determines the optimal strategic asset allocation of SWFs. The theoretical modeling methods in this paper can be extended to solve SWFs' asset allocation problems with non-tradable assets and to help optimize the portfolio allocation decisions of individual investors with heterogeneous background risks.