A volatility-based approach to gold as a safe haven: can it explain the abnormalities in gold returns during periods of extreme financial adversity?

Maria Alberta Oliveira,Carlos Santos

doi:10.21511/imfi.13(3-1).2016.06

Maria Alberta Oliveira, Carlos Santos

Open Access

https://doi.org/10.21511/imfi.13(3-1).2016.06

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Abstract

In this paper, the authors provide an explanation of the abnormal behavior of gold returns between the 1st of January 2008 and the 31st of December 2013. The authors suggest a behavioral finance foundation to the fact that gold returns exceed those of a wide range of other assets over this period. The approach rests on the safe haven (SH) motif for flights to gold during heavy financial stress periods. The prevailing Baur-Lucey-McDermott paradigm on gold as a SH is shown to be insufficient, as it ignores the roles of volatility and risk preferences. The auhors suggest a formal SH definition, recovering those elements from behavioral finance. Contrary to the previous paradigm, the approach is data-consistent, in the sample period. The authors find that gold is a SH for all stock markets considered, some exchange rates, and even Euro Area sovereign bonds (including German bunds). They estimate the SH risk premium in all cases. The authors find that investors perceive the distinction between good and bad volatility, and that they do not ask for excess returns when gold volatility is high for SH reasons. This is consistent with the literature on the low frequency of idiosyncratic shocks in the gold market. Furthermore, the authors find evidence that, in a period of high financial uncertainty, fund managers building portfolios consisting only of gold might be acting rationally, contrary to the finance common sense for normal periods. In fact, in the sample period, gold is even strictly dominant in mean-variance terms, when compared to equity. Keywords: safe haven, gold, euro debt crisis, risk preferences, fund management. JEL Classification: C22, C58, G01, G11, G15

Highlights

The financial crisis of 2008-09 and the Euro Area (EA) sovereign debt crisis have spurred renewed interest on the topic of safe haven (SH) assets
The burden of the crisis is clear for stock markets: on average, compound yearly losses were 37.78% for the ATHEX and 7.87% for the EURONEXT100, while yearly gains were as low as 0.32%, for the FTSE100, 2.9% for the S&P500, and 4% for the DAX30
Results of GARCH-X (1,1) model with mean equation of gold returns depending on stock markets volatility

Summary

Introduction

The financial crisis of 2008-09 and the Euro Area (EA) sovereign debt crisis have spurred renewed interest on the topic of safe haven (SH) assets. The usual positive skewness in the distribution of gold returns is not found in this period, suggesting that gold would not provide downside protection in a portfolio, contrary to what had been argued, inter alia, in Lucey et al (2006) and Lucey (2011). In this period, gold is not strictly dominated, in mean-variance terms, by any of a wide range of financial assets, and its volatility is lower than that of several stock markets. The claim that investors holding only gold would be worse off than those holding just equity (e.g., Flavin et al, 2014)

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