Use of Gold in Financial Risk Hedge

What the paper says

Introduction Commodities very often are added to a diversified market portfolio to protect investors and firms from tail risk events. Recently, this trend is amplified by institutions that hold large positions in commodity futures for hedging purposes and by banks that have to comply with the new liquidity and risk management requirements. This development is known as the financialization of commodity markets. Historically, it has been shown that commodities, like gold, serve as a safe haven in times of market turmoil. (1) When the stock market plummets, gold prices increase, making a diversified investor immune to recession. The hedging feature of gold is reflected in the reduction of a portfolio's Value at Risk (VaR), as well as in a low correlation of gold with the stock market index. Prior research has looked at the ability of gold to act as a safe haven or a hedge in times of extreme market volatility. However, the literature in this area focuses on precious metals and not as much on their Exchange-Traded Funds (ETFs) or on gold mining companies. I extend the analysis to include both ETFs and the stocks of gold mining companies. Investors and hedgers alike will find the results of this paper to be of interest. In particular, I show that gold ETFs and gold mining stocks can serve as safe havens during market turmoil. (2) This paper finds that for the period of 2004 to 2012 gold acted both as a safe haven and a diversifier. These two novel findings suggest that gold ETFs and gold mining stocks serve as a safe haven in market turmoil. Gold mining stocks are strongly correlated with the market factor during the normal market conditions, but they do show diversification benefits in the turbulent investment climate. This noteworthy finding is consistent with the notion that gold mining companies stocks act as a call option on the price of gold. The moneyness of this call option changes in periods of market stress, making gold mining stocks act more like gold and less like a typical equity. This paper takes a look at prior research that has been done in relation to gold as a portfolio diversifier and adds a new dimension to the topic. My research contributes to the prior literature in three distinct ways. First, the paper estimates gold price as a function of the Fama-French (1993) benchmark factors and not just a stock index or a bond index, as others have done. Second, this research considers Exchange-Traded Funds that are linked to gold price as an alternative to gold holdings. The results suggest that gold ETFs are independent of the market index, have low betas and can serve as a diversification tool. Third, the paper checks whether the gold mining stocks have the same underlying factors as gold itself. The last hypothesis holds in the events of high market volatility and low equity returns. The results are robust to different model specifications. The current paper touches upon several aspects of the literatures discussed. Section 2 conducts a review of the relevant literature. Section 3 examines the sample and methodology employed in the paper. Section 4 discusses the empirical findings for gold, ETFs and the Gold Mining Index in a normal investment climate. Section 5 analyzes the safe haven quality of gold bullions, ETFs and mining stocks during the periods of high market volatility and low market returns. Section 6 concludes. Literature Review The critical step in evaluating any financial risk management strategy is to correctly measure the underlying risk exposure after the hedge. This research is closely related to prior literature on commodity hedging and portfolio diversification. In particular, gold can be used as a risk management vehicle and as an instrument for capital preservation. First of all, gold increases portfolio diversification through its low correlation, on average 0.1, to other assets (World Gold Council [WGC] 2013). In addition, gold reduces portfolio losses during tail-risk events. …