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?
I can share my 2c about this, as your questions my comments:
Central banks around the world purchase or sell USD (mostly) to stabilize their exchange rate, so their USD holdings are invested (obviously) in very liquid and low yielding US treasuries as they are the least risky (virtually 0 risk) and the most liquid worldwide. In other words, BoC won’t speculate or trade for profit, or put at risk its foreign reserves.
If you want to increase ur USD holdings, where does the BoC get the money from? Ask the goverment for funds? I mean the national treasury (from tax collection). It is not possible, at least not for the sole intention of purchasing and holding foreign currency, the goverment would never lend the BoC some CAD to buy USD. The real life mechanism is that the BoC “prints” CAD from the thin air and then purchase the USD. That is why central banks exists in first place, to be able to print fiduciary money from the “nothing”. You would ask then, why not print 100 Trillion CAD and make all canadians millionares… yeah, it depends on the country abilitiy to create wealth (to produce goods and services). Here is where the IS-LM model takes place, depending on the levels of Investment (I) and Savings (S) of the country, the central bank can create Money supply (M) at specific Liquidity preferences (L). So central banks revisit their IS-LM models periodically to assess if they are able to print more money or withdraw money from the economy. The equilibrium provides the best level of inflation, GDP growth, and employment.
If BoC printed CAD from the thin air as we saw in point 2, then they can coordinate with the goverment for new debt issuance and thus those CAD in excess be “absorved” or “withdrawn” from the economy as investors buying those bonds will use their CAD holdings and thus those CAD funds are no longer currency inside the economy. Depending on the country, the “national bonds” or soverign debt can be issued by the central banks themselves or only from the goverments.
Assuming easy capital flows for Canada (and it is, canada is a very open country in terms of capital flows), canadian investors would prefer US treasuries over canadian treasuries unless canadian treasuries yield more risk-adjusted than US treasuries. If BoC wants its stabilization bonds to be bought (CAD denominated), then they have to “pay” more.
CFA journey is based on theory and practice so some real life knowledge is also needed, there is no magical book or course that teaches everything, some things need to come from our background or experience.
