Abstract

In this paper, we propose a gold price index that enables market participants to separate the change in the ‘intrinsic’ value of gold from changes in global exchange rates. The index is a geometrically weighted average of the price of gold denominated in different currencies, with weights that are proportional to the market power of each country in the global gold market. Market power is defined as the impact that a change in a country’s exchange rate has on the price of gold expressed in other currencies. We use principal components analysis to reduce the set of global exchange rates to four currency ‘blocs’ representing the U.S. dollar, the euro, the commodity currencies and the Asian currencies, respectively. We estimate the weight of each currency bloc in the index in an error correction framework using a broad set of variables to control for the unobserved intrinsic value. We show that the resulting index is less volatile than the USD price of gold and, in contrast with the USD price of gold, has a strong negative relationship with global equities and a strong positive relationship with the VIX index, both of which underline the role of gold as a safe haven asset.

Introduction

The market for gold is one of the largest and most liquid in the world, surpassed only by the major currency pairs in terms of daily turnover.1 The price of gold, like that of many commodities, is conventionally quoted in USD. However, gold is not exclusively a US asset and so the return from an investment in gold, when calculated using the quoted USD price, conflates the change in the value of gold with the change in the value of the USD. To illustrate this point, consider the change in the gold price between 30 March 2015 and 18 May 2015. The USD price rose from 1185.79 USD per ounce to 1228.05 USD per ounce, an increase of 3.56 percent. But to a UK investor, the price of gold fell from 800.99 GBP per ounce to 783.00 GBP per ounce, a decrease of 2.25 percent. The discrepancy arises because the USD depreciated against the GBP by more than the price of gold increased in USD terms. In this paper, we develop a gold price index, which when used to compute returns, reflects changes in the intrinsic value of gold independently of concurrent changes in global exchange rates. As an illustration of the use the index, we are able to establish that over the period described above, the intrinsic value of gold decreased by 0.54%, and that the remaining changes in the price of gold in USD (+3.02%) and GBP (-1.31%) were due solely to exchange rate effects.