Diversification Effect of Gold as an Asset Class in Foreign Exchange Reserve Portfolio, Evidence from Sri Lanka

Foreign Exchange Reserves of the countries play a major role in managing exchange rate and monetary policy, particularly in emerging countries as Sri Lanka. Therefore, it is important to manage foreign exchange reserves in an open and transparent manner with clear objectives of what is going to be achieved. For a country like Sri Lanka the main objective would be the safety of the assets since it is difficult to absorb substantial risks in managing foreign exchange reserves due to relative lower size compared to its exposure to external sector of the economy. When it comes to gold as an assets class is considered to safe-haven assets due to its nature of higher return in times of crisis and inflationary periods. The objective of this study is to explore the diversification impact of gold on foreign exchange reserves in Sri Lanka for the period from 2007 to 2023. To explore the impact of diversification, correlation between gold and existing foreign exchange reserves and additional excess return per unit of risk provide with the inclusion of gold into the portfolio were used to analyze the possible diversification impact. The results showed that there is an increase in excess return with the addition of 1% to 5% of gold as a percentage of total foreign exchange reserves, while correlation of gold with existing portfolio was less than 0.5 indicating diversification impact. Further, the Sharpe ratio was also seen increasing when the gold composition in foreign exchange reserve portfolio was increased. It was found that gold can be considered as an asset class which help diversification for foreign exchange reserves of Sri Lanka, even though the same are managed in very conservatively.