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Foreign Exchange Reserves

Foreign assets held by the central bank of a certain country

What are Foreign Exchange Reserves?

Foreign exchange reserves refer to foreign assets held by the central bank of a certain country. Foreign assets comprise assets that are not denominated in the domestic currency of the country. For example, US government bonds held by the Bank of Japan are foreign assets for Japan.

 

Foreign Exchange Reserves

 

For most central banks (or central monetary authority), foreign exchange reserves consist of foreign currency (cash) that generates no income and foreign government bonds (fixed income instruments) that generate income in the form of interest payments. Foreign assets generate income in foreign currency. For example, US government bonds pay interest in US dollars, and Japanese government bonds pay interest in Japanese yen.

 

Summary:

  • Foreign exchange reserves refer to foreign assets held by the central bank of a certain country. Foreign assets comprise assets that are not denominated in the domestic currency of the country.
  • All income generated by a foreign asset is in terms of foreign currency. For example, US Government bonds pay interest in US dollars, and Japanese Government bonds pay interest in Japanese yen.
  • The two most popular foreign assets are US dollar-denominated assets and euro-denominated assets. About 61.5% of all foreign exchange reserves are held in US dollars, and 26.2% of all foreign exchange reserves are held in euros.

 

The US Dollar and Foreign Exchange Reserves

The US dollar is the de-facto global currency and is used for the majority of international transactions. In fact, most international transactions use the US dollar even if the United States is not one of the transacting parties. In addition, most commodity markets (such as crude oil and gold) use the US dollar.

One of the reasons the US dollar is viewed as a global currency is because the USA is home to well-developed financial markets and strong legal and political institutions. As a result, the US dollar is a relatively stable currency. It means that transacting parties don’t need to worry about the value of their payments fluctuating wildly.

In addition, holders of US government bonds don’t need to worry about the US government defaulting on interest payments on the bonds. The US dollar is also widely used for cross-border investments. Almost 58% of all international loans made by banks are made using the US currency.

 

Composition of Foreign Exchange Reserves

The two most popular foreign assets are US dollar-denominated assets and euro-denominated assets. Similar to the US dollar, the euro offers its holders access to a large common market (the Eurozone area) that consists of well-developed legal and political institutions.

According to the Bank for International Settlements (BIS), 63% of all foreign exchange trading in 2010 was done using either the US dollar or the euro. Of the 63%, around 42% of the trading was done using US dollars, and about 21% was done using euros. The next most-traded foreign currency was the Japanese yen, which was used for around 10% of all foreign exchange trading. (Source)

 

Related Readings

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Calculating Foreign Exchange Spread
  • FX Rates – Currencies
  • Gross National Product
  • Triangular Arbitrage Opportunity

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