An analysis of the volatility of precious metals - Free Essay Example

The article on commodities has focused on price co-movements and their roles in conveying information about the macroeconomic. The gold and silver are those precious metals that mainly focused by the existing research. The previous research do not examine precious metals shock and volatility cross effects, therefore there is a main weakness if one considers such applications as hedging. There are three objective of study this article. The board objective of study this article is to analyze the conditional volatility and the correlation dependency and interdependency for the four major precious metal, they are gold, silver, palladium and platinum. Besides that, the second objective is to analyze the volatility feedback causes between the US dollar exchange and the four precious metal. The writer expect that the metal volatility will be higher if the US dollar is weaker. And the third objective is to derive the implications of the approximate results on variances and covariances for set up optimal portfolio designs and hedging strategies. 2.Review of the Literature The research of industrial is more ample on analyze their co-movement and the information transmissions if compare illustrating their volatility and correlation dependency and interdependence. According to McKenzie et al. (2001), that the asymmetric effects are not present and the model did not provide an adequate explanation of the data. Tully and Lucey(2007) agreed that the exchange rate is the main macroeconomic variable that will impact the golds volatility, however few other macroeconomic variable had an impact. Besides that, Batten and Lucey (2007) using intraday (high frequency) and interday data in order to analyze the gold futures contracts volatility that traded on the Chicago Board of Trade. Garman and Klass (1980) have analyze the volatility properties of the future returns by the univariate GARCH model and the alternative nonparametric Garman-Klass volatility range statistic. Furthermore, That palladium, platinum, copper and gold futures have chaotic str uctures is agree by Yang and Brorsen (1993). The volatility in the prices of nine non-oil commodities, such as gold and silver, to volatility in oil prices have compared by Plourde and Watkins (1998). 3. Data Description From January 4, 1999 until November 5, 2007, we investigated the four main precious commodity closing spot prices ,exchange rate of U.S. dollar and the federal funds rate. The COMEX in New York have traded the gold (GOLD), silver (SILV), palladium (PALL), and platinum (PLAT) and their entire price are measured in US dollars per troy ounce. Since the precious metals, specially gold, are susceptible to geopolitical crises. The precious metal are dissimilar with the oil grades, the statistics has show that the precious metals are not belong to one great pool. Based on the coefficient of variation, if compare with all precious metals prices, the gold price has the lowest historical volatility, in contract palladium price has the highest historical volatility because of the palladiums supply is relatively small. The above-ground supply of gold is more than 10% of its annual demand and production. The gold has an monetary component and it is not used oftentimes in exchange market, the refore the volatility of the gold price is low. Besides that, Gold is known to have notoriously extended bear markets, in opposite silver price is more commodity-driven than gold as its monetary element was gradually phased out. The statistics for the metals returns normally follow those for their prices. Palladium return has the highest historical volatility, it is followed by silver , in adverse gold return has the lowest if compare with the four metals. When the market is up, silver is performs better than gold, however when then market is down the silver does worse. In term of historical return means, the precious metal that highest average return is platinum, followed by silver, in contrary gold and palladium have the lowest averages in return. The historical return correlation between palladium and platinum is the highest compare with all precious metals and it is positive, followed by the correlation between returns of gold and silver. In opposite, the lowest correla tion is between gold and palladium and it is positive. There is a distinct strong correlation between gold and platinum. The change in the federal funds rate has a inverse correlation with those precious metals, same as the exchange rate. 4.Methodology We used the VARMA-GARCH model in order to concentrate on interdependence of conditional variance and correlation among the precious metals and the exchange rate. Furthermore, we have using vary types of GARCH models to analyze the hedging strategies for the bullion market. Besides that , we also have used Multivariate Dynamic Conditional Correlation GARCH model (DCC-MGARCH) in order to use it to inspect on the dynamics of the first model. 5.Empirical Results 5.1. Model I(VATMA-GARCH): The Four Precious Metals This VARMA-GARFCH Model 1 is for focus on the four precious metal in presence of geopolitics. Own shock volatility The different precious metals have vary degree of news sensitivity. The four precious metal have separated into two groups because of the news-oriented result: the gold and palladium are dropped into the high news-sensitivity group, and the silver and platinum have dropped into the low news-sensitivity group. The gold is very sensitive to news, it is because gold is the most concerned metal by the traders and policy makers. In contrast, the platinum has the lowest shock sensitivity, maybe is because it is expensive. The investor who are favor volatility should focus on the first group, and those who are more disfavor volatility should be concentrate in second group. Own volatility dependency The result have reflex that the precious metals are normally more impact by common fundamental factors than by shock. The silver and platinum are placed in the high volatility sensitivity group, in opposite gold and palladium are in the low volatility sensitivity group. The gold is comparatively less sensitive to macroeconomic variable in long run, due to its large supply of above-ground. The silver is more influenced by macroeconomic factors than gold, therefore silver is more commodity-driven then gold. If investors added the gold into the portfolio, it is possible to increase the volatility in short term but not in long term, because of its short run sensitivity to news. In contrast , in long term due to its long run above-ground supply may smoothes the fluctuations. Short-run shock interdependency The cross shock effects among all four precious metals are limited, due to the precious metal are not belong to one great pool. When there is shocks to palladium, the platinum volatility will be cool off, it is maybe because of they both are substitutes in industrial production. If there are a shock to the gold, the gold will impact positively to the silver. Furthermore, gold and silver are also used in jewelry industry, therefore the investment portfolios of gold and silver can be a safe havens. Long-run volatility interdependency The long-run cross shock affects of cross past volatility are significant to all precious metals. Gold metal is the most sensitive to long-run volatility interdependence with respect to other metal. Gold have the strongest cross volatility spillover affect on those on those other metals, it is because of the gold are used in jewelry industry and it is a part of international reserve, in contrast, other metals are used in substantially in industrial uses. The strong interdependence with gold is maybe is due to its vast above-ground supply and the gold is close relationship with the dollar. Besides that, gold are most being concerned by those traders. Silver and platinums past volatilities are offset each others current volatility, that mean they are negatively impact by common fundamental factors. Therefore, silver and platinum may not be included in a portfolio that are purposes to reducing volatility in long run. Geopolitics Those metals are sensitive to the geopolitical events, such as the 2003 Iraq war was slightly elevated the mean returns of both gold and silver as a result of flight to safety, in opposite, platinum and palladium are not show the same flight to safety in the war. Silver was responded positively to this war, while platinum and palladium are responded negatively in the long run. That mean traders of those metals are hedge diverse against volatility caused by geopolitics. Constant condition correlations (CCC) All the CCC between those precious metals return are positive. The highest CCC is between the platinum and palladium, the two metals are also used in the same industries. The second highest CCC is between the gold and silver, and both metals are the most diffusely traded among the precious metals. Besides that, both metals are also used in jewelry. In contrast, the lowest CCC is between the gold and palladium, gold is the mopt traded metal, while palladium are the least traded metal. 5.2. Model II (Expanded VARMA-GARCH): Precious Metals and Exchange Rate The expanded volatility system has included the exchange rate of dollar and the precious metals, exclude palladium. Palladium is excluded is because of three reasons. First, it have a very small annual production if compare to gold and silver. Second, it is not widely traded in the world. Lastly, it is because the VARMA-GARCH did not converge when palladium was added to other three metals. Gold is a metal that highly sensi tive monetary policy and the change in the exchange rate. The gold and the platinum are the highest in this cross exchange rate volatility, that mean that there are economic fundamental factors are related to the exchange rate volatility that intensify the volatility of precious metals. Gold has the strongest cross reversal impact, while silver and platinum have lower but also similar effect. Besides that, golds past volatility have intensify the exchange rate volatility. The gold and US dollar are integral part of international foreign reserve of central bank, gold is also first safe haven for US dollar. Those monetary policy makers are think about the gold is a harbinger of inflation. The 2003 Iraq war have impact on the both metal returns and volatility significantly. The silvers average return is the most affected, while the platinum return is impacted the least. Besides that, the war have increase the volatility of the three precious metals as well as US dollar volatility. T he gold volatility is affected most, while the platinum is the least. FRR as a monetary policy variable in the system decrease the metal volatility, it is because of the metal-to-metal volatility are modified by the metal-to-exchange rate volatility despite the strong volatility to the exchange rate from those metals. 5.3. Model III (VARMA-DCC): The Four Precious Metals This Model III is to justify on the dynamics of the Model I. 5.4. Model IV (Expanded VARMA-DCC): Precious Metals and Exchange Rate The restricting the shock and the volatility spillovers are do not impact the own shock effect much, however it have mixed effects on the own volatility spillovers. Besides that, the Model IV is to justify on the dynamics of the Model II. 6. Implications for Portfolio Designs and Hedging Strategies There are example for constructing a optimal portfolio and hedging strategic for precious metals. The first example is follows Kroner and Ng (1998) by a portfolio that can reducing the risk but did not lowering the expected return of the portfolio. For example, there are a suggestion that optimal holding gold by holding portfolio that include gold and silver, the portfolio of gold in one dollar should be 81cents for gold, and 19 cents for silvers. This optimal portfolio weight advise that traders should hold more gold than silver and also other precious metals in order to reduce the risk without reducing the expected return, because the CCC of the gold and silver are the second highest. Besides that, they also suggest that investors should hold more platinum than silver ,should be 40% for platinum and 60% for silver in their portfolio. It is because these two metals are not highly correlated. Furthermore, when come to platinum and palladium, the optimal portfolio should be 83% for platinum and 17% for palladium in favor of the exotic metal over the dull one, it is because platinum and palladium are the highest correlation among four precious metals. Besides that, in purpose of set a optimal portfolio, we also can follow example that given by Kroner and Sultan (1993) about risk minimizing hedge ratios and put it for our precious metals. In purpose of minimize the risk, a long position of one dollar is taken in a precious metal should be also hedged by a short position in another precious. According the research, the values of hedge ratio for those precious metals are lower than those for stock market. By using this strategy, one dollar buy in gold should be shorted by about 19 cents of silver. This result have show that it is more effective to hedge long gold positions by shorting palladium, it is because gold and palladium are the lowest CCC among all the pairs of precious metals. In contrast, the least effective strategy to hedge is hedging long platinum position and also to short palladium, it is because the CCC between platinum and palladium are the highest if compare with any other pairs of precious metals. That mean results show that hedging is more effective when the long position in a precious metal and hedge with short position in another precious metal that is not closely related to the first one precious metal. Besides that, there are optimal portfolio weight and hedging ratios for the three metals exclude palladium and also exchange rate in presence of monetary policy and geopolitics are given. The portfolio gold/dollar has the highest weight for the gold if compare with the three other precious metals, in adverse the silver/dollar portfolio has the lowest weight. It is because the gold is considered as the safest haven against fluctuations in the dollar, while the silver does not have enough variation benefit, such as gold and platinum. 7. Conclusions