Causality and volatility patterns between gold prices and exchange rates

https://doi.org/10.1016/j.najef.2015.09.015Get rights and content

Highlights

  • We examine the volatility transmission between gold prices and exchange rates.

  • Our results point to a specific role of the US dollar.

  • Volatility of dollar exchange rates results in hedging functions of gold prices.

Abstract

This paper provides a new perspective on the link between gold prices and exchange rates. Based on gold prices denominated in five different currencies and the related bilateral exchange rates, we put causalities and short-run volatility transmission under closer scrutiny. We provide evidence that the identification of a strong hedge function of gold requires an explicit modeling of the volatility component. For all currencies, exchange rate depreciations initially have a negative impact on the gold price after one day which turns out to be positive after two days in most of the cases. Contrary to previous studies, our results point to a specific role of the dollar in the context of gold-exchange rate relationships: volatility of dollar exchange rates more frequently results in strong hedging functions of gold prices. Furthermore, the gold price denominated in the US dollar tends to increase after a depreciation of the dollar.

Introduction

A long-established relationship between gold prices and dollar depreciations is based on the law of one price: if gold is denominated in US dollar, dollar depreciations coincide with increasing gold prices in order to eliminate arbitrage opportunities. This identity has been established by Beckers and Soenen (1984) and Sjaastad and Scacciallani (1996) among others. Studies by Capie, Mills, and Wood (2005) and Sjaastad (2008) confirm this finding for different dollar exchange rates with the latter study also identifying a causality from dollar movements to the price of gold denominated in different currencies.

In this vein, the present paper contributes to the literature in three different ways: firstly, we focus on volatility transmission between the gold prices denominated in different currencies and bilateral exchange rates as a novel issue. This is important since both gold and exchange rates are (1) traded at a high frequency and (2) linked to each other through hedge or safe haven features which are related to periods of volatility (Ciner, Gurdgiev, & Lucey, 2013). Secondly, we pay specific attention to the issue of causality, allowing for spillover effects in both directions. The literature is notably silent when it comes to a clarification of the causality issue between gold prices and exchange rates. Considering that exchange rates and gold prices are asset prices, it is reasonable to assume that causalities can go into both directions.3 Finally, we investigate whether a special pattern for the US dollar can be identified if several gold prices and exchange rates are considered. Pukthuanthong and Roll (2011) have recently shown that the price of gold can be associated with currency depreciation not only for the US dollar but also for other currencies. While they focus on a correlation analysis and Granger causality tests, we investigate whether volatility spillover effects offer a specific role for the United States. To analyze these questions, we estimate a GARCH-in-mean SVAR model in the tradition of Elder (2003) which allows us to estimate the parameters of interest in an internally consistent fashion.

The remainder of this paper is organized as follows: We briefly turn to a review of the most relevant literature in Section 2 before proceeding with a description of our data in Section 3 and of our methodology in Section 4. Section 5 presents our results and Section 6 concludes.

Section snippets

Review of the literature

Taking into account the large body of literature on gold prices and exchange rates, we only elaborate on a few selected studies in the following review. Early studies by Capie et al. (2005) and Sjaastad (2008) have examined the hedge property of gold with respect to changes of the US dollar and have shown that dollar exchange rates and gold prices are inversely related with the latter study also identifying a causality from dollar movements to the price of gold denominated in different

Data

Our sample period covers data from January 1979 to June 2013 on a daily basis. Data on gold prices and bilateral exchange rates is taken from the World Gold Council and Thomson Reuters Datastream, respectively. Gold prices are denominated in the US dollar, British pound sterling, euro, Japanese yen, and Indian rupee5

Empirical framework

One focus of our study is to analyze the volatility spillover effect between gold prices and exchange rates, therefore we apply a framework in the tradition of Elder (2003) which allows us to estimate the parameters of interest in an internally consistent fashion. This approach is based on a structural vector autoregression (SVAR) that is modified to accommodate GARCH-in-mean errors. We use the conditional standard deviation of the one-step-ahead forecast error as our measure of volatility (

Empirical results

Our empirical findings can be classified into four categories: The impact of gold price volatility and gold price changes on exchange rate changes and the reversed causalities from exchange rates to gold prices. The latter causality has been frequently analyzed in the context of hedge or safe haven functions of gold without incorporating an explicit modeling of volatility shocks. Gold is said to be a weak or strong hedge if it is uncorrelated or negatively correlated with exchange rates on

Conclusions

Previous research has established a link between gold prices and currency depreciations based on the law of one price without accounting for volatility transmission. Using daily data and explicitly allowing for volatility spillovers, we do not find clear evidence for such a relationship over the very short-run. Exchange rate depreciations have a negative impact on the gold price measured in different currencies after one day which partly turns out to be positive after two days.

Contrary to

Acknowledgements

Thanks for valuable comments are due to two anonymous reviewers and the participants of the 12th Annual EEFS Conference, Berlin/Germany.

References (29)

  • S. Johansen

    Statistical analysis of cointegration vectors

    Journal of Economic Dynamics and Control

    (1988)
  • M. Joy

    Gold and the US dollar: Hedge or haven?

    Finance Research Letters

    (2011)
  • K. Pukthuanthong et al.

    Gold and the dollar (and the euro, pound, and yen)

    Journal of Banking & Finance

    (2011)
  • J.C. Reboredo

    Is gold a safe haven or a hedge for the US dollar? Implications for risk management

    Journal of Banking & Finance

    (2013)
  • Cited by (42)

    • Dynamic spillovers and linkages between gold, crude oil, S&P 500, and other economic and financial variables. Evidence from the USA

      2022, North American Journal of Economics and Finance
      Citation Excerpt :

      Furthermore, Sui et al. (2021) focusing on three different economies (Turkey, USA, and Peru) using quantile-on-quantile regression (QQR) and quantile-on-quantile correlation (QQCOR) models, displayed a hedging aspect of gold against currency movements under specific macroeconomic conditions and dollarization levels. While, Baur (2011), Reboredo (2013b), and Beckmann et al. (2015) through the use of VAR and GARCH models, and Lin et al. (2016) through wavelet analysis, find that the US dollar dominates the gold market, and conclude that the volatility of dollar rates are turning gold into a strong hedge with respect to the movements of its labelled denominator currency. Giannellis and Koukouritakis (2019) studying the G7 countries and by using a two-regime Panel Smooth Transition Regression model, showed that hedging by gold against exchange rate risk appears mainly in times of economic turmoil.

    View all citing articles on Scopus
    1

    Tel.: +49 201 183 3215; fax: +49 201 183 4181.

    2

    Tel.: +44 20 70400258.

    View full text