Abstract
Starting from the constraints and incentives that cause countries to issue debt in foreign currency, this paper provides an overview of policy approaches for choosing the optimal currency structure of sovereign foreign‐currency debt. The objective of sovereign debt managers generally includes both risk and cost minimisation, while constraints to foreign‐currency debt allocation originate in the parameters of the domestic macroeconomy, the shocks it faces and the initial conditions. Overall, the main parameters that drive the solutions for optimal currency allocation of foreign‐currency debt are the covariances of macrovariables with exchange rates and the variances of different exchange rates. Both the covariances and the exchange rate volatility can be deceptive when a fixed exchange rate regime is maintained, however. To adequately capture the expected covariances in the context of managed exchange rate regimes, we suggest that sovereign debt managers work with equilibrium instead of actual exchange rates. For the same reason and because the estimates of relative exchange rate variances should be forward looking, we suggest using synchronisation indicators in the policy analysis to better capture the underlying drivers of exchange rate volatility across currencies. Copyright © 2010 John Wiley & Sons, Ltd.