​Summary: 

The average level of the Bank of Israel's foreign exchange reserves during 2004 was about $26 billion. The reserves are managed in accordance with the Bank of Israel Law, 1954 and the legal interpretations of the Law, as well as a set of rules which reflect the character of the Bank and the functions of the foreign exchange reserves. Accordingly, the reserves are invested in foreign currency denominated bonds either issued or fully guaranteed by foreign governments and in foreign currency deposits with foreign banks abroad. As part of the management of reserves, the Bank is permitted to carry out transactions with commercial and investment banks outside of Israel and to use financial derivatives, such as futures contracts, on the condition that the underlying asset is one that the Bank is permitted to hold. The Bank is also permitted to carry out transactions in foreign currency with a limited number of local entities such as the government and banking institutions. 

The functions of the foreign exchange reserves have changed over the years as a result of changes in the macroeconomic environment, which includes monetary and exchange rate policy. Currently, there are two categories of functions: 1Possible uses of the reserves, i.e. the possibility of selling them (in exchange for shekels) or lending them, with the main use being the sale of foreign exchange to the government for the servicing of its debt; and 2Benefits to the economy arising from the fact that the State of Israel possesses a particular quantity of foreign exchange reserves. The primary benefits are the reduction of the probability of a crisis in Israel's foreign exchange market and the improvement in Israel's international financial standing. The functions of the reserves serve as a basis both for determining their desired size and for defining the investment policy according to which they are managed.

The management of the reserves portfolio, in accordance with the investment policy derived from the functions of the reserves, is anchored to a hypothetical benchmark portfolio. The composition of the benchmark portfolio is determined by rules which govern its currency composition, its duration in each currency, the types of assets included within it and the dispersion of these assets along the yield curve. The management of the reserves portfolio relative to a benchmark fulfills three functions: the benchmark portfolio serves as a "risk-free portfolio"; the yield on the benchmark portfolio provides a basis for evaluating the yield on the invested reserves; and the restrictions on permitted deviations from the benchmark define the degrees of freedom for the active management of the reserves portfolio (which relate primarily to currency risk and that part of interest-rate risk measured by duration). 
The holding period yield of the reserves in terms of a numeraire was 1.7 percent in 2004 as compared to 2.2 percent in the previous year. This yield reflects low yields-to-maturity during 2004 in the capital markets in which the reserves are invested, in addition to capital losses as a result of the increase in yields-to-maturity during the year. The holding period yield in shekel terms was 1.8 percent for the year in comparison to -1.3 percent in 2003. This reflected the weakening of the shekel against the non-dollar currencies in which the reserves are invested which was approximately offset by its strengthening against the dollar. 

This year the holding period yield on the reserves was higher than the benchmark yield by 3basis points, a difference which reflects the contribution of the management of the portfolio. The yield on the reserves is determined to a large extent by the composition of the benchmark in view of the relatively small magnitude of deviations from the benchmark. It is these deviations which account for the managed risk of the portfolio. In recent years, a significant amount of effort has been invested in choosing an allocation of assets in the portfolio different from that of the benchmark and in selecting assets not included in the benchmark reserves portfolio. In contrast, the extent of the positions in duration and currency management has been reduced in accordance with the policy of reducing exposure in these areas. 

The contribution of the decisions regarding the selection of assets, which accounts for part of the yield spread against the benchmark, was 9 basis points this year. Most of this contribution was a result of the investment in Eurobonds (about 6 basis points) and GNMA mortgage-backed securities (about one basis point) and securities-lending activity (about 2 basis points). The contribution of currency management contributed about 2 basis points while that of interest rate risk management (duration and dispersion) was a negative 6 basis points. 

The exposure of the reserves to the banking system averaged 19 percent of the total reserves in 2004. A large proportion of the exposure was utilized in securities lending, an activity with a very short investment horizon. Some of the exposure reflects the investment in fixed-term deposits in order to benefit from higher yields relative to government bonds with the same maturity (the TED spread). This exposure was managed according to a set of rules and quotas which play a central role in the credit risk management of the portfolio. 
The reserves have a high level of liquidity which is a measure of that portion of the portfolio which can be quickly realized without a loss in value. About 85 percent of the reserves portfolio is invested in highly liquid investments while the rest is invested in assets with lower liquidity. In view of the objectives in holding reserves, the level of liquidity appears to be adequate. The high level of liquidity is dictated by the Bank of Israel Law and the investment policy derived from the spirit of that law, which call for a conservative approach to the management of financial risk, and by considerations of profitability which have led in recent years to only partial exploitation of the degrees of freedom to invest in less liquid assets.
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1 A glossary of terms used in this chapter can be found in Appendix 1.1. The first use of a glossary term in the main text is marked in italics. Various aspects of the management of foreign exchange reserves are discussed in the first chapters of previous issues of the Annual Report of the Foreign Currency Department. These reports can be found on the Bank of Israel site: www.bankisrael.gov.il.
2 The average level of reserves in this report is calculated on the basis of the daily balances of reserves assessed at their full market value. All the holding period yields in this report are expressed in terms of a numeraire unless otherwise specified. 
3 According to the Law, it is permissible for the Bank to hold gold as foreign reserves but this has not been done for several years since it is not considered economically worthwhile. 
 

Chapter 1: Investment of the Foreign Exchange Reserves - PDF File