THE ROLE OF GOLD IN FINANCIAL INVESTMENT: MALAYSIAN PERSPECTIVE

Below are the excerpts from the working paper that I worked together with lead author Prof. Mansor Hj Ibrahim. The paper is summarized and most of the technical parts are removed to provide an easy reading, the paper was also presented in the 2nd Langkawi International Finance and Economics Seminar which was held in 2010. The full copy of the paper could be found on the net, with the proceedings published by esharianomics.com.......a.h.baharom

THE ROLE OF GOLD IN FINANCIAL INVESTMENT: MALAYSIAN PERSPECTIVE

Mansor H. Ibrahim
A. H. Baharom

Over the last two decades, the international financial markets have experienced a series of financial crises and turbulence in different parts of the world. Among them include the Mexican crisis in 1994, the Asian financial crisis in 1997/1998, the Russian crisis in 1998, Brazilian crisis in 1999, the Argentine financial crisis in 2001/2002 and most recently the US subprime crisis in 2007 and Greece’s financial crisis in 2009. In all cases, these crises resulted in drastic drop and excessive volatility in the stock markets of the crisis-originating countries. The national markets of other economies suffered as well through the “contagion” effect. These adverse financial shocks brought substantial costs to the crisis-affected countries as the shocks were translated into banking distress and economic slumps. As an example, the 1997/1998 Asian crisis brought the market index of Thailand, the crisis-originating country, to nosedive from a peak of 1410.33 points in January 1996 to 214.53 in August 1998. Other regional markets particularly Indonesia, Malaysia, and the Philippines nosedived as well, observing their market prices to shred by more than half over roughly the same periods. These shocks were then propagated to the real sector. The growth rates of Indonesia, Malaysia, the Philippines and Thailand in 1997 were respectively 4.7%, 7.3%, 5.2% and -1.7%. In 1998, these figures dropped drastically for all countries to -13.1% (Indonesia), -7.4% (Malaysia), -0.6% (Philippines) and -10.2% (Thailand).

The recurring heightened volatility in the stock markets is normally viewed to impose substantial risk to stock investment. Existing studies on stock market risk have a predominant focus on characterizing the risk using GARCH-type models and whether the risk can be diversified through international diversification. The risk dynamics have been examined for not only developed markets, which occupy majority of studies, but also to emerging markets as far as Lithuania (Teresienė, 2009). Studies on the benefits of international diversification tend to suggest increasing interactions among national markets and their interactions are more intense during crisis episodes and accordingly limit the benefits of diversifying away financial risks originating from a specific market (Lee and Kim, 1993; Arshanapalli and Doukas, 1993; and Meric and Meric (1997). These studies thus highlight the need to identify other types of financial assets as a protection against this risk.and Greece’s financial crisis in 2009. In all cases, these crises resulted in drastic drop and excessive volatility in the stock markets of the crisis-originating countries.

The national markets of other economies suffered as well through the “contagion” effect. These adverse financial shocks brought substantial costs to the crisis-affected countries as the shocks were translated into banking distress and economic slumps.The crisis episodes seem to conjure up the image of gold as an alternative investment asset or an important part of assets in financial portfolios. The emerging interest in gold in times of crises perhaps stems from its historical use as a medium of exchange and standard of value and its stable purchasing power over times. In light of these, few studies have raised an empirical inquiry as to whether gold can at least diversify portfolio risk or at best provide a safe haven. Notable among these studies are recent works by Capie et al. (2005), Hillier et al. (2006) and Baur and Lucey (2010).

Capie et al. (2006) examined whether gold serves as a hedge against fluctuations in sterling-dollar and yen-dollar rates and arrive at a conclusion that gold possesses the exchange rate hedge property. However, they also note that the extent of hedging tends to vary over time. Baur and Lucey (2010) estimate the relations between U.S., U. K. and German stock and bond returns and gold returns. They document evidence for the hedging role of gold. Moreover, gold also provides a safe haven in extreme market conditions.

The present paper attempts to contribute to this line of research by examining the role of gold in financial investment from an emerging market perspective, Malaysia. We focus on the emerging Malaysian market since it is the emerging markets that frequently exhibit volatile market movements relative to the advanced markets and, in Malaysia, the importance of gold was strongly voiced during the Asian crisis. In the analysis, we assess whether gold investment can provide diversifying role, hedging role or safe haven role for stock market investors as recently defined by Baur and Lucey (2010), which is based on correlations between gold returns and stock market returns. Simply stated, gold is said to provide a diversifying role if its return is positively but less than perfectly correlated with stock market return. Gold serves as a hedge if its return is independent from or negatively correlated with the stock return. Finally, if this hedging characteristic of gold investment also prevails during periods of market turmoil or stress, the gold is considered to be a safe haven.

In the analysis, we look at the relation between domestic gold and stock market returns within a regression framework. Based on daily data from August 2001 to March 2010, our analysis covers both full sample and two equally-divided sub-samples. The latter is implemented such that we can roughly address possible changing relations between gold and stock returns in the recent period marked by heightened volatility during years surrounding the US subprime crisis. The heightened volatility of financial markets sparked by a series of financial crises in different parts of the world has raised serious concern over stock investment risk and,consequently, necessitates the need to identify alternative financial assets that can ameliorate investment portfolio risk. In light of this, we empirically investigate whether gold can serve as a diversification, a hedge, or a safe haven asset for the case of Malaysia. We look at the issue from Malaysia’s investment perspective by estimating the relations between gold and stock returns using daily domestic gold and stock market data from August 2001 to March 2010.

In general, we find gold to serve as a diversification asset. The analysis also reveals two important findings. First, during periods of extreme market conditions, the relations between gold and stock market returns tend to be stronger. This signals the weakened diversification benefit of gold investment during period of large market downturns. And second, based on two equally-divided sub-samples, gold is found to provide a hedge against stock market risk and a safe haven during extreme stock market downturns during the first sub-sample. However, these properties of gold tend to disappear during recent years. Thus, the investment role of gold has been degraded to be a diversification asset. Again, the diversification benefit seems weakened during extreme market conditions. In short, the investment role of gold is time-varying. Probably, in the case of Malaysia, the degradation of gold from a hedge or safe haven asset to a diversification asset over recent years is due to the prolonged volatility of the market during years surrounding the sub-prime crisis.