Causality and volatility patterns between gold prices and exchange rates
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.
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