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.
- The simplest way to think about this relationship is to first consider gold’s role as a diversifying and defensive asset in most investor’s portfolio. Investor’s have historically sought to hold gold during periods when there have been sharp jumps in risk aversion and when equity markets typically move lower. But as the variability of equity prices has risen, the variability in gold prices has also been pushed up as excess demand for gold has come into the market from investors looking for defensive assets. The rise in variability in gold prices has in turn pushed up the expected future variability in gold prices as implied from option prices causing the risk aversion level in gold markets to rise. Overall this should be seen a benefit to holding gold as it reaffirms its defensive qualities during periods of rising risk aversion in other asset markets, notably equity markets.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.
Source: Bloomberg LP; Treesdale Partners calculations; past performance is no guarantee of future performance.
- The sharp fall in risk aversion in October 2013 where the indicator dipped to -10% coincided with a period of strongly rising equity prices and sharply lower gold prices as the desire to hold defensive assets, in particular gold, fell out of favor and saw the gold price retreat rapidly from its $1800 high.
- The average volatility risk premium over the 10 years has been +1.5%. By way of comparison the average for the S&P 500 index over the same 10 year period is 1.1% (Source: Bloomberg LP) which is of similar magnitude as in the gold market. An detailed discussion for the persistence of the risk premium over long periods of time is beyond the scope of this paper but it does speak to the extent to which investors’ expectations of future market variability impacts the pricing of risky assets
- The most recent three month period has seen the level of risk aversion jump to the current 5.4% level as the rise in global equity markets has stalled and bond yields have tumbled. The rise in the gold volatility risk premium is indicating that investors are pricing in the potential for a significant rise in future market variability and gold may be a beneficiary of this rise in risk aversion as investors once again look to gold as a defensive asset to improve the diversification of their portfolios. This should be supportive for gold prices in the short term.