In this week’s commentary we present a simple methodology for measuring the amount of risk aversion in gold markets. This measure of risk aversion (which we define below) compares the variability of observed gold prices versus the variability that can be implied from gold option prices. The volatility of gold prices is the *actual measured variability* of gold prices over a given period of time while the volatility implied from option prices is the *expected variability* of gold prices in the future that is inferred from the quoted prices of gold options. Because the expected future variability of gold can be estimated from market prices as a risk measure it effectively embeds information about investors’ expectations of future movements in the price of gold as well as their appetite for holding gold.

The most common method for calculating gold price volatility is to calculate the standard deviation of daily gold price returns and this measure is typically called the historical volatility. Implied volatility on the other hand is simply calculated from the quoted prices of gold options on option markets.

Volatility Risk Premium = Risk Aversion

Although there are several methods to estimate the volatility risk premium, a method often used subtracts historical volatility from implied volatility – in other words it subtracts the *actual *amount of observed variability in gold prices from the *expected *variability in gold prices that can be implied from gold option prices. This difference can be thought of as a measure of the level of risk aversion in gold markets – in effect it is the compensation that an investor requires for bearing risk related to potential sharp changes in future market volatility. When the gold volatility risk premium is positive i.e. the implied volatility is higher than the historical volatility, this implies that investors expect the future variability of gold prices to be *higher* than the recent historical variability. Similarly when the gold volatility risk premium is negative i.e. the implied volatility is lower than the historical volatility, this implies that investors expect the future variability of gold prices to be *lower* than the recent historical variability.

“Expect” is a key word here because of course market forecasts are just that – a forecast not a guarantee – but at any given point in time, the gold volatility risk premium is a useful indicator of the amount of risk aversion in gold markets. The higher the risk premium, the stronger the signal that markets are expecting actual market variability in the *future* to be higher than market variability in the *past*.

In the chart below we plot the volatility risk premium in the dollar gold market over the last 10 years. The blue and red lines show the 3 month (65 business days) actual and expected variability in gold prices respectively while the green line shows the difference between the two series. A positive difference indicates a positive volatility risk premium i.e. the market expects variability in gold prices over the next 65 days to be *higher *than variability in gold prices over the most recent 65 days. Finally the yellow line plotted on the right hand axis shows the gold price in dollars as a frame of reference.

- The most interesting pattern we can perhaps observe in the chart is the
*positive*relationship between the level of risk aversion (the gold volatility risk premium) and the gold price which is the opposite of what would typically be observed in other asset classes where a negative relationship would be more common. In the chart below spikes in the level of risk aversion above +10% were always accompanied with strong increases in the price of gold.