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Executive Summary

Why is gold different from other assets? An empirical investigation

Executive Summary
By Colin Lawrence
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The lack of correlation between returns on gold and those on financial assets such as equities has become widely established. This research tested the argument that the fundamental reason for this lack of correlation is that returns on gold are not correlated to economic activity whereas returns on mainstream financial assets are. Other commodities, which are generally thought to be correlated with economic activity, were also tested.

A number of different relationships were examined to show that returns on gold are independent of the business cycle. Using both static and dynamic analysis this study examined to what extent there is a relationship between economic variables and (i) financial indices (ii) commodities and (iii) gold.

Using the gold price and US macroeconomic and financial market quarterly data from January 1975 to December 2001, the following conclusions were reached:
  • There is no statistically significant correlation between returns on gold and changes in macroeconomic variables such as GDP, inflation and interest rates;
  • Returns on financial assets such as the Dow Jones Industrial Average Index, Standard & Poor's 500 index and 10-year US government bonds are correlated with changes in macroeconomic variables;
  • Changes in macroeconomic variables have a much stronger impact on other commodities (such as aluminium, oil and zinc) than they do on gold; and
  • Returns on gold are less correlated with returns on equity and bond indices than are returns on other commodities.
These results support the notion that gold may be an effective portfolio diversifier.

It is thought that the reasons which set gold apart from other commodities stem from three crucial attributes of gold: it is fungible, indestructible and, most importantly, the inventory of above-ground stocks of gold is enormous relative to the supply flow. This last attribute means that a sudden surge in gold demand can be quickly and easily met through sales of existing holdings of gold jewellery or other products (either to fund new purchases or for cash), in this way increasing the amount of gold recovered from scrap. It may also be met through the mechanism of the gold leasing market allied to the trading of gold bullion Over-the-Counter. The potential for gold to be highly liquid and responsive to price changes is seen as its critical difference from other commodities.

Although returns on gold may be correlated with those on other commodities, it is thought that the strength of this relationship depends on the extent to which each commodity shares the crucial attributes of gold, particularly that of high liquidity. Further study is, however, required to isolate the effect of liquidity variation of different commodities.

1 The author is Honorary Visiting Professor of Risk Management, Faculty of Finance, Cass Business School, London and Managing Partner, LA Risk and Financial Ltd., a consulting firm.

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