This paper sets out an analytical framework for optimal asset allocation of sovereign wealth, based on the theory of contingent claims analysis applied to the sovereigns economic balance sheet. A country solves an asset-liability management problem involving its sources of income and its expenditures. We derive analytically the optimal asset allocation of sovereign wealth, taking explicit account of all sources of risks affecting the sovereigns balance sheet. The optimal composition of sovereign wealth should involve a performance-seeking portfolio and three hedging demand terms for the variability of the fiscal surplus and external and domestic debt. A real-life application of our model in the case of Chile shows that its sovereign investment is under-diversified.
