My colleagues and I finished an academic paper on the volatility sensitivity of precious metals to news and to their own past volatility. We also examined the volatility spillover from one metal to another. The four precious metals we examined are: gold, silver, platinum and palladium. We also explored their volatility sensitivity to the dollar/euro exchange rate in the presence of monetary policy as represented by the federal funds rate. In an MBA student classroom exercise on the historical correlations between the gold price and a group of dollar exchange rates and indices including dollar/euro, dollar/pound, dollar/yen, exchange rate index-broad and exchange rate index-major, the students found that the dollar/euro exchange rate has the highest correlation (0.86) with the gold price over the daily period 1999-2009. Therefore, we chose the dollar/ euro as the preferred exchange rate measure to use in our models. The results of the estimated models are then used to calculate hedge ratios and optimal portfolio weights.
Here is a summary of the findings of this paper.
- Upon examining the historical volatility of the four models over the daily period 1999-2007, we found that silver is the most volatile while gold is the least volatile. Gold is not as highly sensitive as the others because its demand or production is a small fraction of its above-ground supplly. Therefore, it doesn't exhibit high volatility to shocks. This is not the case with silver, platinum and palladium.
- The historical data also implies that the highest contemporaneous return correlation is between the two cousins platinum and palladium (0.47) followed by the correlation between gold and silver (0.37).
The results of the estimated models suggest that:
- If you want to buy gold, buy silver. If you want to sell gold, sell silver.
- Gold and palladium are more sensitive to news in the short run than silver and platinum.
- Silver and platinum are more sensitive to past volatility than gold and palladium.
- The hedge is least effective when silver is hedged by platinum.
- Hedging is very costly if silver and gold were hedged by the value of the dollar relative to euro.
- It is more effective to hedge gold with palladium than with sliver and platinum. The models suggest that lower the return correlation betweenany two precious metals, the more effective the hedge is and vice versa.
- U.S. dollar volatility affects gold’s volatility much more than it affects the volatilities of other precious metals.
- Restrictive monetary policy that exhibits its self in raising the federal funds rate has differential volatility impacts on the precious metals, though leading to higher volatility of the precious metals. Gold shows the greatest response.
- Tightening monetary policy by the Federal Reserve derceases the volatility of the dollat/euro exchange rate.
The paper can be accessed at:
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