Hi folks,
This is the question:
The correct answer is A.
The answer key explains it this way:
"A country always needs FX reserves for global trade and for paying its foreign
currency debt.
In this example, the BoC invests the USD in very liquid but low yielding U.S. Treasuries. The BoC finances its purchase of USD by printing CAD currency. However, flooding the Canadian market with more CAD currency can cause inflationary pressures, therefore, answer choice B is incorrect.
The BoC counters those inflationary pressures by issuing monetary stabilization bonds to “absorb” the excess CAD currency. The stabilization bonds are issued at a higher yield than the yield received from the U.S. Treasury investments. That results in a cost called “negative carry” (e.g., issue debt at higher yield, invest at lower yield), therefore, answer choice C is incorrect.
The BoC periodically determines and updates how much in USD currency it needs in its FX reserves. Excess FX reserves not needed can then be transferred to a reserve fund and invested in riskier, higher yielding assets to offset the negative carry, therefore, answer choice A is correct"
I have a few questions linked to the text in bold:
- How do we know BoC invests the USD in very liquid but low yielding U.S. Treasuries?
- How do we know the BoC finances its purchase of USD by printing CAD currency?
- How do we know the BoC counters inflationary pressures by issuing monetary stabilization bonds to “absorb” the excess CAD currency?
- How do we know the stabilization bonds are issued at a higher yield than the yield received from the U.S. Treasury investments?
I have these questions because the question doesn’t seem to mention it. Are we just supposed to know the working mechanics of reserve funds?
Thanks!