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Vysoká škola ekonomická v Praze
Fakulta financí a účetnictví
katedra bankovnictví a pojišťovnictví
DIPLOMOVÁ PRÁCE
2022 Marharyta Onykiienko
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Vysoká škola ekonomická v Praze
Fakulta financí a účetnictví
katedra bankovnictví a pojišťovnictví
studijní obor: Finanční inženýrství
Fundamentální a technická analýza vývoje cen zlata
Autorka diplomové práce: Marharyta Onykiienko
Vedoucí diplomové práce: Ing.Milan Fičura, Ph.D
Rok obhajoby: 2022
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Čestné prohlášení
Prohlašuji, že jsem diplomovou práci na téma „Fundamentální a technická analýza vývoje cen zlata“ vypracovala samostatně a veškerou použitou literaturu a další prameny jsem řádně označila a uvedla v přiloženém seznamu.
V Praze dne
...
Marharyta Onykiienko
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AcknowledgementsFirst and foremost, I am extremely grateful to my supervisor, Ing. Minal Fičura, Ph.D.
for his patience and invaluable advice during work on my master thesis. I would also
like to thank my colleague and friend, Mrg.Vojtěch Nedvěd for his constant support
on R software, statistics, and econometrics.
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Abstract
Precious metals in general, and gold in particular, are one of the popular assets on the financial market. However, a comprehensive understanding of the gold prices is still missing. Despite the popularity of trying to find the drivers that could be used for estimating and predicting the price of gold, the available research does not offer a full understanding. This thesis aims to contribute to the discussion on the gold prices by identifying potential drivers and by applying a set of econometric models used for predicting futures gold returns. To fulfill this aim, the following models have been estimated: ARIMA, ARIMAX, VAR, and VECM. To compare the results, an opposite approach – technical analysis –was applied. From the set of methods, following the next indicators were used: MACD, RSI, CCI, and Stochastic momentum index.
The performance of both approaches was assessed using investment strategy in a comparison with, which will be compared with the random trading. This thesis contributes to the discussion on gold prices by first, examining the importance of selected factors using various econometric methods and second, by comparing two of the common approaches in order to achieve maximum profit.
Key words: gold, gold futures, fundamental analysis, technical analysis, ARIMA, ARIMAX, VAR, VECM, MACD, RSI, Stochastic momentum index, CCI.
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Abstrakt
Vzácné kovy, zejmená zlato, jsou populární investiční instrumenty na finančním trhu.
Doposud se však nepodařilo ukázat všechny prediktory spojené s jeho cenou. Hlavním cílem teto práce je tak přispět k diskuse zaměřené na studium potencionálních faktorů ovlivňujících cenu zlata. Tyto faktory by pak mohly být využity k přesnějším predikcím budoucího vývoje ceny, s tím spojenou vyšši ziskovosti investičních strategií. Ke studiu kauzálních vztahů byly aplikovány následující ekonometrické modely: ARIMA, ARIMAX, VAR, VECM. Dále byla provedená technická analýza zaměřená na skupinu technických indikatorů, ze kterých bylo zvoleno: MACD, RSI, CCI and Stochastic momentum index. Uspěšnost vybraných modelů byla porovnána pomocí jednotné invertiční strategie, přičemž výchozi strategií bylo náhodné obchodování. Hlávním přínosem této diplomové práce je studium efektů vybrané skupiny prediktorů, ukázání úspěšnosti ekonometrických modelů na nich postavených a v neposlední řadě porovnání výnosnosi ekonometrického přístupu a technické analýzy.
Kličová slova: zlato, futures na zlato, fundamentální analýza, technická analýza, ARIMA, ARIMAX, VAR, VECM, MACD, RSI, Stochastic momentum index, CCI
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Table of Contents
Introduction ... 9
1.COMMODITY TRADING ... 11
2. GOLD MARKET ... 18
2.1 Gold as a product ... 18
2.2 Gold as an asset ... 23
2.3 Gold markets ... 25
2.4 Advantages and disadvantages of gold as an asset ... 26
3.THEORY OF FUNDAMENTAL ANALYSIS ... 28
3.1 The main concept of fundamental analysis ... 28
3.2 External factors ... 29
3.3 Theory behind the methods used in fundamental analysis ... 33
3.3.1 Regression analysis ... 34
3.3.2 Time series analysis ... 35
4.THEORY OF TECHNICAL ANALYSIS ... 44
4.1 The main concept of technical analysis ... 44
4.2 Graphical analysis ... 45
4.3 Technical indicators ... 46
4.3.1 Moving average convergence divergence (MACD) ... 47
4.3.2 Relative strength index (RSI) ... 48
4.3.3 Stochastic oscillator (SO) ... 49
4.3.4 Commodity channel index (CCI) ... 50
5.PRACTICAL IMPLEMENTATION OF THE THEORETICAL KNOWLEDGE 52
5.1 Fundamental analysis ... 525.1.1 Data preparation and general assumptions ... 52
5.1.2 Regression analysis ... 54
5.1.3 Time series analysis ... 57
5.1.4 Comparison of the results ... 74
5.2 Technical analysis ... 79
5.2.1 Introduction ... 79
5.2.2. Simple and exponential moving averages ... 80
5.2.3. Moving averages convergence divergence (MACD) ... 84
5.2.4. Relative strength index (RSI) ... 85
5.2.5. Stochastic momentum index (SMI)... 87
5.2.6. Commodity channel index (CCI) ... 89
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5.2.7. Comparison of the results ... 90
Conclusion ... 94
Sources ... 96
Books ... 96
Journal articles and reports ... 97
Technical documentation ... 99
Website portals ... 99
Tables ... 100
Figures ... 101
Equations ... 103
Acronyms ... 105
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Introduction
Since the dawn of ancient civilizations, gold has been perceived as a symbol of power and stability. Being widely spread across the nations, it became a commonly accepted measurement of the value, which in terms of trading means money. Although its uniqueness could not meet the requirements of the market, it became a store of value and its concepts persisted. “Safe heaven” became a synonym of gold especially in times of uncertainty, which is proved by the variety of the derived instruments, suggested on the market. This formed the main objective of this master thesis: to contribute to the discussion about identifying and utilizing potential drivers of the gold price that can be used for profitable trading. To fulfill this objective, the work is divided into several sections.
The first chapter is dedicated to the overall concept of the commodity market: its objective, diversity of the assets and investment instruments with their potential benefits, that make them attractive to investors, and the drawbacks, that should be taken into consideration.
Having set the scene, we will dive into the uniqueness of the gold market from an industrial and investment perspective, which will be described in the second chapter.
The third chapter is dedicated to the theory of fundamental analysis, which propagandizes the idea of intrinsic value and uses a variety of methods for its identification.
It is assumed that there are exogenous factors that can have an impact on the price of an asset, particularly gold in our case. Hence, identifying those relationships can help in predicting the future prices of an asset. From the majority of the factors, that have been a subject of discussion in the numerous scientific papers, a set of exogenous factors have been chosen. They can be categorized into several groups: macroeconomic factors, like expected inflation, federal fund rate; stock market, which is represented by industrial index S&P 500, dollar index and the volatility index (VIX), which is used as a measure of uncertainty; positions of the major participants on the market, taken from the COT report, and other commodities: silver, crude oil, silver, platinum, natural gas. To estimate the nature of those relationships in this work, we will focus on two main approaches: regression and time series analysis. Both of them assume a linear relationship between the object of the study and chosen exogenous factors. Time series analysis, however, incorporates the concept of time which is important in financial analysis.
The fourth chapter is aimed to present the basics of technical analysis, its main differences, and methods, that are still popular despite being constantly criticized. Graphical analysis, as one of the major branches, is believed to be highly subjective, therefore we will focus on analyzing technical indicators, which is a mathematical calculation based on the historical price that can be used for predicting the further evolution of the price. The choice of
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the indicators depends on the chosen asset, but for the purpose of gold we will focus on four main indicators, that are believed to lead to a profitable strategy on the commodity market:
MACD, which is built on the combination of the moving averages; RSI, stochastic momentum index and CCI, which form a group of oscillators, that have different characteristics, hence can provide complementary or controversial signals.
The effectiveness of the chosen methods, described in the third and fourth parts will be tested on real data by applying a simple trading strategy. The profitability of the strategy compared to the exposed risk will be an indirect measure of the efficiency of the method and will be assessed by a set of chosen measures. In conclusion, we will discuss the limitations of the suggested methods and will suggest potential areas of improvements, that can be implemented for better results.
The main benefit of this work can be seen as the contribution to the major discussion about the existence of the relationship between the prices of gold and a set of chosen exogenous factors, modeled with the help of chosen econometric models and its practical implementation on the real data set in comparison to the concept of technical trading.
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1.COMMODITY TRADING
Despite the common belief that our century is highly technological, and commodities would never be as recognized as they used to be, commodity trading is still highly popular among investors, offering desired income compared to the risk of the outstanding position. In economic terms, commodities are raw materials (natural resources or agricultural products), that have full or partial but substantial fungibility
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nd can be used for personal consumption or further production1. With the first mention from the dawning of the 16th century, the history of commodity trading is much longer than the history of the financial money market. It all began with barter or natural trade. It kept evolving over time, profiting from the advantages of the commodity market and creating advanced methods for trading in order to minimize the result of negative consequences for trader’s profit.Commodities have two specific characteristics: real material nature, which allows physical delivery, and fungibility, which means that market does not differentiate the assets based on the producer, taking them as equivalent or nearly so. This feature takes the power from any kind of personal preferences and makes the forces of demand and supply the main drivers of the market price. The item, that is the object of the trade, is not determined on the individual level, on category level and its quality can be measured according to the standards, formulas, instructions etc. The decisive factor becomes its quantitative side, like price, quantity, or volume of the certain type.
The spectrum of commodity classification is wide, depending on source and further usage. For the purpose of this work, we would stop on the following one, which names three major categories with the following sub-groups:
- agricultural (also known as soft commodities) is a product of farming for consumption or further processing. It can be spitted into subcategories:
▪ consumption products or soft markets: sugar, cocoa, coffee, etc.,
▪ grains, such as soybeans, soybean oil, rice, oats, and corn,
▪ animals that become food, such as live cattle and pork (called lean hogs),
▪ raw materials, such as cotton and lumber
- energy, including crude oil, RBOB (reformulated blendstock for oxygenate blending) gasoline, natural gas, heating oil. This type of commodity greatly differs
1 https://en.wikipedia.org/wiki/Commodity
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from those listed above, as the storage is becoming more complicated (therefore, costly) and are better to be consumed as soon as possible after production.
- metals (or hard commodities), such as gold, copper, silver, and platinum, etc. 2 Although commodities are different in nature and potentially served for different purposes, they are gathered under one umbrella - commodity market, sharing the same concept, principles, and objective, ways of trading, and prince formation. Commodity marker can be defined as a physical or virtual centralized marketplace for buying, selling, and trading raw or primary products between producers and consumers of commodity products (James, 2016). It gives an opportunity for a massive scale commodity exchange throughout the world. The development of exchanges and financial instruments brought it to a brand-new level of complexity, providing with a wider range of opportunities for investors’ return and higher security for counterparties.3
The initial idea of trading market in general, and commodity market specifically as a physical place, where trade with following physical delivery took place, has gradually shifted to the concept of an instrument for price estimation. The price appears to be a product of consumers’ demand and producers’ supply. The main goal of the market becomes estimating the current price and ensuring certain prices for the future periods, where numerous deviations can emerge, starting from disproportion in demand-supply relation to speculation on future.
Talking about classification, it can be categorized from organizational, location, time perspectives, types of traded assets, the object of trade etc. From the organizational point of view, the commodity market does not differ from its stock alternatives. There are two main categories: organized (commodity exchanges) and decentralized also known as OTC (over the counter) markets. Classical exchange, as a type of organized market, is a legal entity that determines and enforces rules and procedures for trading standardized commodity contracts and related investments products4. OTC, on the other hand, refers more to the process of how securities are traded via broker-to-dealer networks as opposed to centralized exchanges. OTC can be more adaptive in order to meet customer needs, which brings flexibility but is conditional on higher riskiness.
As OTC is more about network systems, split by location is more about centralized exchanges. Despite lower representation of traded stock units, investors have access to about 50 major commodity markets worldwide, where the total volume of financial transactions
2 https://www.thebalance.com/what-are-commodities-3306236
3 https://rb.gy/geyiug
4 https://www.investopedia.com/terms/c/commoditiesexchange.asp
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significantly outreaches the volume of physical commodities that are traded. The main commodity exchanges 5, grouped by the continent are:
- Europe
o London Metal Exchange – futures market of contracts on precious metals6 o Climax - Netherlands – an exchange with the main focus on commodities
(energy and environmental) - USA
o Chicago Mercantile Exchange – market of derivatives
o New York Mercantile Exchange – commodity futures exchange - Asia
o Dubai Mercantile Exchange – energy futures exchange
o Zhengzhou Commodity Exchange – futures exchange for agricultural and chemical commodities
o Multi Commodity Exchange
o Tokyo Commodity Exchange – non-profit organization, focusing on regularization and control of the derivative contracts
o Singapore Exchange Limited o Australian Securities Exchange
Just to go back to classification, according to timing trading market can be divided into spot and future. Spot market assumes trading for immediate delivery. Future, on the contrary, assumes trades, that lock the price and conditions at the current time for delivery on a specific date in the future. As it turned out, from the perspective of commodity trading, future market significantly exceeds spot market, as it is used as a way of hedging for both counterparties.
In this work commodities in general and gold specifically is taken as a tool for investment, this brings up the following classification according to the object of trade:
physical, meaning the object of the investment is tangible asset (physical commodity), and financial, where the object of interest is certain financial instrument, which give you the right to own an asset under certain conditions, but not the asset itself. There are several reasons for investing in physical commodity. Even though the risk of price decrease still persists, and the ownership of physical asset is associated with further expenses, negative correlation between the prices on physical commodities and financial assets (like stocks, bonds etc) gives investors an opportunity for diversification by reducing systematic risk. At the same time, limited
5 https://indiafreenotes.com/commodity-exchanges-regional-national-international/
6 https://en.wikipedia.org/wiki/London_Metal_Exchange
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variability of physical commodities opposes the vide majority of financial instruments used for commodity trades, which meets all potential investors’ needs. Among all possible ways of investing, that are used on commodity market, future contract is the leading form of financial instruments. It is a type of financial derivatives in a form of standardized legal agreement, traded on exchanges, to facilitate the trade of a particular asset for a predetermined price at a specified time in the future 7. Cash settlement is performed on daily basis, reflecting daily profit and losses. The whole process of trade is ensured by clearing house. Compared to the physical trade, making a deal of futures contract is less capital requiring with lower transactional costs. In most of the cases, there is no physical delivery following the deal, which leads to zero carrying cost. Not to forget about an opportunity to trade on margin, which means using larger amount of money than is actually available on the account. This all gives investor an opportunity to open more position, benefiting from the economy of scale, thereby increasing potential profit (Hull, 2017).
The main disadvantage of the example described above is that it is dependent on one particular commodity. For the purpose of diversification commodity ETFs were created.
Commodity ETF is an exchanged-traded fund, invested in physical commodities or in commodities financial instruments. The price of ETF is derived from the price of underlying commodity or commodity indexes. Investment in ETF does not assume the ownership of commodity itself, but a set of contracts, backed by the commodity, which reduces investor’s expenses 8 .
Following the topic of financial derivatives, option is one of the next favorable choices among investors. Option is a financial instrument, which offers the opportunity to buy or sell the underlying asset at some point in time for estimated price. Unlike futures, option is an opportunity, not an obligation, which makes it more flexible. There are two main classes of options: plain vanilla, which is an option in its classical definition, and exotic, which is a hybrid security that can be customized in terms of structure, expiration date, price etc. Both types are traded are widely used for commodities, on exchanges or OTC market, depending on the instrument type involved.
The mentioned categories of investment opportunities include physical asset itself or financial instrument, that is derived from the price of an asset. The second subgroup would include securities of commodity producing companies. On one hand, the price of the stock depends on the price of commodity that is producing. But the rules of security investments
7 https://www.investopedia.com/terms/f/futurescontract.asp
8 https://www.investopedia.com/terms/c/commodity-etf.asp
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should also be taken into consideration, as the object of trade becomes a stock (or other securities, derived from stocks). This subcategory can be spitted into:
- individual securities, which includes standalone shares of commodity producing companies. If the produced commodity rises in price, the company increases its revenue and profit,
- instruments of collective investment, like mutual funds or exchange traded funds (ETFs). Collective investment is perceived to be more conservative, which enables individuals to trade with limited available capital on hand and at the same time their investments are exposed towards lower risk. This is possible by the definition of mutual funds, which is a type of financial vehicle, that is operated by professional money manager, and consists of numerous securities (stocks, bonds, and other assets, etc.) purchased on collected financial sources from individual investors. This combination of security instruments is chosen the way, that forms diversified portfolio with lower systematic risk. The negative side of mutual funds, like administrative costs and limited right to influence the investment process, was partially solved on ETFs. ETFs have been mentioned earlier, but in this paragraph, they are taken with their classical definition, as a basket of securities, that trade on exchange like a stock. Compared to mutual funds, ETFs tend to be more cost - effective and liquid and are more transparent in terms of investment plans due to the fact that their strategy is available to public (compared to mutual fonds).
- investment certificated (IC), which is last but not least in this subgroup. IC is a type of debt security, that obliges its issuer to pay to investor the defined amount of money, derived from the price of underlying asset at the time of maturity. The issuer is usually a bank or other financial institution. It is a generally believed, that IC is less costly than mutual fonds.
The choice of propriate way of investment is function of available capital, level of risk aversion, cost of alternatives, hurdle rate and, what is the most important component, the goal of investment. This leads to the main question, which is identifying main advantages and potential pitfalls of investing in commodities that cam make them more attractive for potential investors. Among main advantages are:
1. Diversification. History shows that there was a negative correlation between commodity and stock prices: where the prices of stocks were hitting the bottom, commodities were on the top and vice versa. In addition, it was proved, that political and social chaos only push commodity prices higher. That leads to a
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conclusion, that genuine diversification will not be completed without commodity in portfolio.
2. Potential returns. Individual commodity prices can vary as a result of several factors, such as supply – demand relation, inflation, variance of exchange rates and general economic situation. The increasing tempo of global infrastructure growth and numerous emerging massive projects have greatly influenced commodity prices, which lead to the further impact on companies in related industries. Commodity prices can rise even when the economy is stuck in reverse.
3. Potential hedge against inflation. From historical data, it was estimated that despite being more volatile than other comparing investments, commodities have been performing better in a period of high inflation, outpacing the inflation (Rogers, 2008).
The mentioned advantages should be interpreted with all potential risks that can have an impact on the commodity price. It is hard to say that the risks, listed below, are special only for the commodity market. There can be some qualities, particular for a specific market or product, but overall, they can be perceived as universal. Among them are:
1. Flat risk. Flat price is the absolute price level of a commodity. Although it is highly dependent on the industry and type of commodity that is being analyzed, commodity prices can be significantly affected by world events: political, economic, ecological changes, social and natural events. As a result of this correlation, prices of commodities or derived financial instruments are more volatile than prices of securities. It goes without saying that higher risk brings higher reward. History shows that during tough economical periods, commodity prices were pushed up, gaining abnormal profit for their investors. But there is another side, which proves, that not only that the price of the commodity can equal zero, but it can reach negative numbers (negative prices of crude oil at the beginning of 2020) due to the cost of carry (storage, insurance, etc.).
2. Basic risk. Basis is the difference between the spot and the future price of the commodity being hedged. The price difference appears due to discrepancy between the characteristics of the hedging instrument and the physical commodity being hedged. It generally arises from changes in the economics of transformation during the life of hedge, and despite being less volatile, there is still a risk of large loses.
3. Credit risk. This describes the risk that the counterparty would not be able to perform under contract terms. This type of risk is not special for commodity market, but is exposed to additional factors (ecological, natural), that can be specific for commodity
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trading. Those factors expand the group of operational risk, which is potential failure of some operational process.
4. Market and funding liquidity risk. Those types of risks are correlated, as the decline of one inevitably causes the decline of the other. Commodity market is believed to be liquid enough to reduce this type of risk to the minimum where possible. However, liquidity can vary randomly and substantially, which can lead to significant cost for the market participants.
5. Currency, political, legal (reputational) risks. Although those risks have to be a subject of risk management in every business by default, commodities are produced and partially consumed in countries, where the rule of law is no applicable to the whole extend, which destabilize the market, creating unequal conditions for market participants. In addition, commodities can be sometimes perceived as environmental hazards, which make the producers and consumers the subject to legal sanction if the environmental damage was done. Even if the absence of damage was proved, the reputational damage as a by-product of the process can be powerful (Rogers, 2008).
With all the advantages and potential drawbacks of commodity investment, it is clear, that investor can benefit from including commodities into their portfolio. However, that should be performed under clear understanding of special characteristics for various commodity types and their potential added value. For the purpose of this work, we have chosen gold. We would try to get acquainted with gold from the investor perspective and identify the benefit of adding gold to the investment portfolio.
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2. GOLD MARKET
2.1 Gold as a product
According to the definition, gold is a chemical element known as Aurum (symbol Au) 9, which has one of the higher atomic numbers among elements that naturally occur. It is a bright, reddish yellow, extremely heavy (2.5 times heavier than iron) and relatively rare precious metal. It’s a bit of a contradictory element due its two characteristics. On the one hand, it is one of the least reactive chemical elements, which means that it cannot be influenced by other elements, therefore is indestructible. That is why it does not lose its value despite the condition where it is stored, which is true both for raw materials and final products. On the other hand, it is dense, soft, malleable, and ductile metal, with temperature and electricity conductance, allowing gold to be easily processed. This leads to the conclusion that despite being resistant to any kind of damage from the outside, it can be easily processed and modified. This makes it widely used in numerous of industries, among which are:
- medicine. Gold nanoparticles became a part of diagnostic equipment, that help detect diseases at the earliest stages possible, and implantable electronics, which are not rejected by the human body and open up the whole new spectrum of potential application. Moreover, gold-based drugs have been developed for illnesses like rheumatoid arthritis, and, possibly, cancer treatment. Their effectiveness has not been completely proved, but the intermediate results show a positive trend.
- engineering and aerospace. Its resistant against electromagnetic radiation, which is harmful, is used in protective equipment for people and equipment. Besides, using gold in architecture makes it more cost-effective and eco-friendlier by lowering energy costs and carbon emissions.
- environment. Gold nanoparticles are used for development of product to solve the global problem of groundwater contamination by breaking down the contaminants into component parts, therefore simplifying the process of cleansing.
- new technologies. Most of the modern devices would not be able to meet all of the customers’ requirements without golden parts, which are used in all possible functional parts: from contacts though data storage technologies to visual
9 https://en.wikipedia.org/wiki/Gold
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displays10.
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t is not a surprise that all of the gadgets we are using on daily basis contain some golden elements.- monetary system. If we go back to the dawn of history, any kind of trading relationship started with the natural exchange (goods were exchanged for goods).
But the main drawback of this kind of relationship was its inability to measure the value of the good that was exchanged in a fair way and to find the corresponding good that would be equal in “price” and needed to the “seller”. This is where metals (gold and silver) stepped in as a unified measure and generally accepted payment method. This was the dawn of money as a concept. The main benefits of metals that were used were its endurance and convenience. Besides, it brought the power of supply and demand into the market: if the market supply was higher, the surplus was stored as treasure, keeping its intrinsic value as a metal. The same worked in the reverse way. As a result, the market was easily returned to equilibrium. The rapid growth of trading led to the deficit of metal raw materials.
The amount of the money on the market was unable to facilitate the number of transactions that were taken. This created a condition for a new system to emerge, which replaced metal money with paper equivalents. It was obligatory to keep the golden standard, linked currency (paper money) directly to the price of gold. A fixed price of gold was set that determined the value of the currency and limited amount of metal equivalents for bad extra emission of paper money. This was a necessary step, as physically, paper money is not worth anything, compared to metal money that was used earlier. Economic situation though led to reality, where that obligation was violated, and currency was issued without being backed by gold. It was 1971, when the Bretton Woods system collapsed, bringing to the end the link between currencies and gold. From that point in time, any role of gold in the monetary system is highly questionable (Revenda, Mandel, Kodera, Musílek, Dvořak, 2012).
Last but not least, it appeals to be visual pleasing for people all over centuries. It is believed that it was one of the first metals that attracted human’s attention and was considered as a symbol of richness and power (Studýnka, 2014). This was mostly due to its preciousness.
According to the statistics, published by the World Gold council, only 197,5K tons of gold has been mined throughout history 11 (compared to data from Statista, that about 4.2B metric tons
10 https://www.gold.org/about-gold/gold-demand/sectors-of-demand/uses-of-gold
11 https://www.gold.org/about-gold/gold-supply/gold-mining/how-much-gold
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of crude oil have been mined for 2020) 12. Two-thirds of the mentioned amount has been mined since 1950 and is still in use in one form or another because of its endurance.
As a raw material, it can be found in a form of grains, nuggets, or flakes, or alloyed with silver. The whole process starts with extracting ore from the deposit using blasting and drilling. Next step is separating metals, which is done by crushing and following leaching with the help of chemical reactions. The residuary product is formed into doré bars for later purification and refining 13.
A
lthough gold mining is a global business, operated on every continent (except Antarctica), the distribution of the places where the gold can be found (mostly mines of different types and scale) is extremely uneven. According to the data, provided by the Word Gold Council, annual total volume of gold mined is fluctuating around 3K tonnes. Three leaders in gold mining industry for 2020 are Africa (931 tonnes), Asia (610.4 tonnes) and a group of countries, called Commonwealth of Independent states, which includes Russia, Uzbekistan, Kazakhstan etc (557.4 tonnes). At the end of the range is Europe with the lowest numbers of gold mined (35.1 tonnes). The whole range can be seen on the graph below.Figure 1. Production volumes of gold for 2019-2020 by continent (in tonnes) Source: own processing based on https://www.gold.org/goldhub/data/historical-mine-production
At the country level the distribution is slightly different. The biggest producer is China, and in 2020 it is responsible for 11% of the global production, showing a slight decline (around 5%) compared to 2019. Russia (mostly its Asian part) and Australia are sharing the second place as the amount of gold produced is almost at the same level. What is interesting
12 https://www.statista.com/statistics/265229/global-oil-production-in-million-metric-
tons/#:~:text=In%202020%2C%20global%20crude%20oil,where%20this%20is%20recovered%20separately).
13 https://www.gold.org/about-gold/gold-supply/how-gold-is-mined
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is that those two mentioned countries belong to the minor group of gold miners that kept increasing trend in 2020 despite pandemic situation.
Figure 2. Production volumes of gold for 2019-2020 by country (in tonnes)
Source: own processing based on https://www.gold.org/goldhub/data/historical-mine-production
If we look at the graph of total gold supply, presented by WGC, it is clear that mining provides only a part of total gold demand. The other source comes from recycling. By general definition, recycled is gold, that was exchanged for money by consumers and was reprocessed. The biggest part (around 90%) comes from jewelry and the remaining part is provided by technologies. The difference between those sources is the speed of reaction to the gold price changes recycled gold is highly dependent on the economic situation and quickly reacts to any kind of shocks on the market, while gold producers require some time to adapt their prices.
This can be seen on the graph: decreasing price of gold is reflected in decreasing amount of gold recycled and vise versa.
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Figure 3. Quarterly supply of gold from 2010 to 2021
Source: https://www.gold.org/goldhub/data/gold-supply-and-demand-statistics
On the demand side, the two main consumers of gold supplied are jewelry and investment industries. Their proportion is conditioned by the price of gold: increasing price provokes higher demand from the investors price, which results in drop on jewelry market. The demand from the Central Bank side shows a cyclical trend with an increase in two quarters of 2021.
This was provoked by the unstable pandemic year or 2020, which motivated some of the central banks to increase their gold reserves as “a safe-haven asset and as a store of value”14. Technological sector though is represented to a lesser, but constant extend (less than 10% of the total demand).
Figure 4. Quarterly demand of gold from 2010 to 2021
Source: https://www.gold.org/goldhub/data/gold-supply-and-demand-statistics
14 https://www.gold.org/goldhub/research/gold-demand-trends/gold-demand-trends-q1-2021/central-banks
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2.2 Gold as an asset
As a part of the commodity market, gold offers numerous products that you can invest in. Investors on the gold market can decide to choose the form of real commodity as an investment instrument, which is gold in its physical form, enabling investors to store it, sell, trade, use as collateral etc. The second option is financial instruments, backed by gold. Let’s get a closer look at the advantages and disadvantages of both.
First and foremost, not any kind of gold can be accepted as an investment. It should meet certain criteria in terms of purity, weight, form etc. Due to its natural softness, gold is used with some harder metals (like copper) to produce alloy. The proportion of precise metals, resp. gold is measured in karats, where 24 indicates the pure gold. Physical gold can be bought in the form of jewelry, numismatic coins, and gold bullion (in the form of bars or coins).
Unlike numismatic coins and jewelry, which can be influenced by design, rarity, brand, personal preferences, gold bullion can be considered as the most direct way of investing in gold due to the fact that the price of the bullion is derived from the price of gold as raw material.
Key concern for investors becomes storage and security, which should be thought up front.
Interestingly, the way of storage has an impact on the liquidity of the instrument: private storage leads to lower liquidity, as the trade of such an instrument is related to higher costs, like quality check, which are not required if gold is stored in financial institutions or professional depositories. This led to the hybrid way of investment - gold account, offered by bullion banks. The gold is purchased on behalf of the customer and is physically attributed to the account in a case of allocated account, which is equivalent to the physical ownership.
Customer gets a gold certificate as a prof. Bank is not allowed to use it in its business, which provides an extra level of security for investors, but is responsible for storage and security. If the account is unallocated, the gold may be lent, which provides bank with an extra income but deprive the customer of the security in case of insolvency 15. Although it was mentioned that there is no credit risk of the counterparty, there is a risk of bad-quality instrument, provided by the supplier, which increases the importance of supplier check 16.
The other group is formed by the financial instruments, which are backed by gold. The prevalent form is futures contracts, and likewise other commodities, they are settled in cash without further delivery, which eliminates extra expenses followed from the delivery.
However, some costs like initial and maintenance margin, are still required. The market of futures contracts is relatively liquid, but it is barely available for private investors due to
15 https://www.gold.org/what-we-do/investing-gold/how-buy-gold/allocated-accounts
16 https://jrotbart.com/gold-councils-investing-in-gold/
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relatively high required investment amounts. Gold futures, compared to other commodities, are always in contango, which means that the future price is higher than the spot price and provides negative rolling return. This leads to the conclusion, that in order to profit, investor should sell furfures before the settlement (Demidova-Menzel, Heidorn, 2007).
With the high demand on financial instruments backed by gold, there have emerged further derived products, used by advanced traders. One of them is Contracts for Difference (CFD)17. According to the definition by Investopedia, it is an arrangement, made in financial derivatives trading where the difference in the settlement between the open and the closing trade prices is cash-settled. Basically, the mechanism looks like: if the closing price is higher than the opening price, the seller will pay the buyer the difference, and vise versa. This OTC product allows traders to get all the benefits of owning a security without any responsibilities that the physical ownership of the asset can bring - instead of buying or selling physical gold, a trader can simply speculate on whether the price of gold would increase or decrease. Besides, leveraging a principle of margin trade allows investor to gain greater exposure for the initial capital. These advantages come with the weak industry regulation: as OTC product, it is highly dependent on broker’s credibility
. A
lthough being forbidden in some countries (like the USA), the market of CFD is rapidly growing 18. By 2026 it is projected to reach 1618.2 mil USD from 1 475mil USD in 2020 19.Except already mentioned options for commodity trading like ETFs and mutual funds, new products keep emerging in order to meet customer needs. One of them is Xetra-Gold 20. By the definition, it is German law governed bearer note, a zero-bond perpetual, which is backed by the physical gold. If the product is terminated (or, as it is specified in the documentation, exercised), one gram of gold per product is delivered on the relevant redemption date. In case that physical delivery is not possible, cash payment is provided instead. The benefits and risks of this product align with the numerous advantages and disadvantages, that are provided by financial instruments. However, there are specific characteristics that make the difference. There is one extra layer of credit risk included: by the definition, the underlying gold is kept in custody by Clearstream Banking AG on issuer’s behalf and is exposed to the risk of loss. In case this risk is materialized, the issuer would not be able to meet its obligations. On the bright sight, compared to futures, there is no negative roll return 21.
17 https://www.investopedia.com/articles/stocks/09/trade-a-cfd.asp
18 https://corporatefinanceinstitute.com/resources/knowledge/finance/contract-for-difference-cfd/
19 https://www.ktvn.com/story/44238454/cfd-market-size-2021-industry-growth-prospects-cagr-89-business-participation-price- analysis-research-with-development-trends-key-manufacturers
20 https://www.xetra-gold.com/en/product/
21 The difference between shorter dated, closer to maturity commodity contracts and longer dated contract/
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From the indirect investment perspective, there are two options available to traders.
Investment in stocks of mining companies is one of it. In this case, the financial state of company indirectly depends on gold prices, however, as most of the companies produce more than just gold, investor can benefit from the expending production. Thus, solving the problem of no growth potential of physical investment. The profit and stock price, consequently, can be influenced by numerous other factors, like the quality of management or/and decisions made, interest rates, wages etc. That is why investor should pay attention on the way the company is running the business: mining costs, existing mine portfolio and following expansions. The initial idea of those companies, stepping into the market, is security against unexpended changes of the gold price. This gives investors opportunity to benefit from the increasing price (in case the price of the gold is growing) and collecting the dividends from the stock. It should also be taken into consideration that the price of such stocks is more volatile than the stock price and complementary factors should also be considered (expected price of gold, mining costs, etc. (Demidova-Menzel, Heidorn, 2007)
Least but not last are streaming and royalty companies, which are profiting from providing miners with cash up front for the right to buy gold and other metals from specific miners at reduced prices in the future. This is a kind of intermediary that is get paid in gold avoiding all potential downsides of physically mining gold and running a mine with is extra valuable at the time of price falling.
2.3 Gold markets
Although gold, as an investment instrument, is demanded on all trading markets, there are several hubs, or centers, that are believed to be playing a crucial role in gold turnover.
London OTC market, US futures market (COMEX) and the Chinese market, which primarily stands for Shanghai Gold Exchange (SGE) and Shanghai Future Market – those players make more than 90% of global trading volumes, leaving around10% to smaller distributed secondary markets.
70% of the total volume of gold traded belongs to London OTC, which historically was believed to be the heart of the gold system. It is mainly focused on physical trades. Despite some pros (favorable time zone location and infrastructure), starting from 2015 it keeps losing its relative share. The main reason is delayed modernization and structural changes, which are planned to be changed with the initiative from WGC.
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COMEX, as a division of the Chicago Merchandise Exchange, is the primary derivative market. It has become an important player in the price formation process: the trades are concentrated on nearest dates, which comes up as an approximation for spot prices. It has a huge impact on Asian market growth due to the increasing share of transactions.
The Chinese market, Shanghai Gold Exchange, is the largest purely physical spot exchange in the world. It was the initiator of the Gold Price Benchmark, which gave power to China as the gold price-setter. Physical trades on SGE are complemented with the derivative trades on SFM, although those exchanges are functioning independently.
The chain of important centers includes Dubai, India, Japan, Singapore and Hong Kong, which are key players for serving local demands in regional trading hubs 22.
2.4 Advantages and disadvantages of gold as an asset
With all the opportunities and ways of investing gold offers, it is worth to go through the be advantages and disadvantages of adding it to the portfolio. Both physical investments and securities will be considered. From investor’s perspective, it is crucial to have gold among other assets because:
- its concept of value keeping. Even though the concept of intrinsic value is being argued, the intrinsic value of gold does not change even if the price increases or decreases. Besides, it is perceived to be “virtually indestructible”, which means
“it cannot be hacked or erased”, according to Charles Stevens, COO of Bullion Box Subscriptions 23,
- its high liquidity. The market of gold is highly liquid which enables quick conversion of gold into cash,
- relatively small amount of the initial investment required, primarily for physical investment,
- opportunity for diversification due to negative or low correlation with other trading instruments,
- the absence of connection with any monetary authority, which ensures protection against currency depreciation and inflation. Gold is believed to be a “safe island”
during the periods of high inflation and following currency rate changes.
The disadvantages that should not be neglected are:
22 https://www.gold.org/what-we-do/gold-market-structure/global-gold-market
23 https://www.businessinsider.com/how-to-invest-in-gold
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- storage and security cost, that lowers the profit of the investment. It is primarily connected to the physical investment and could be eliminated by choosing another available option,
- higher purchase price (due to additional fees applied, like commission, transaction fee, that are added on top of the traded price) or, in case of securities, margin fees, that should be paid in order to keep the investment,
- the absence of capital yield from physical investment, compared to securities, which means that investor cannot collect returns during the life of investment in the form of dividends,
- systematic risk. It arises from the investment in gold mining companies, which performance is influenced by the political and economic conditions in its native country,
- marker and credit risk as the basic risks on financial market. They are present in all kinds of investments, and gold is not an exception.
To sum up, it is relatively obvious that gold is a good candidate and should be considered to be added to the portfolio. The form of the investment and size though depends on individual preferences and expectations. The popularity of gold grows in time of economic instability and future uncertainty, but in general, gold as a part of portfolio makes sense anytime – at least as an instrument of diversification.
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3.THEORY OF FUNDAMENTAL ANALYSIS
3.1 The main concept of fundamental analysis
Fundamental analysis is based on the idea that specific economic and financial factors can estimate the intrinsic value (“fair price”) of the security, which can be compared with the actual price on the market for further investment decisions. Its main opponents are technical analysis, which will be described later in this work, and efficient market hypothesis (or EFH).
Although EFH will not be covered in this work, it is worth mentioning its main idea: the market price fully reflects all available information and excess return is impossible, which basically leads to the conclusion that the market price equals intrinsic value.
Talking about “fair price”, the hypothesis is based on two major assumptions:
1. the current price does not fully reflect the value of the security-based on publicly available data.
2. In the long run, the market will reflect the fundamentals. But the definition of “long- run” is not clear and can vary from one day to year.
The main complication of the fundamental analysis is factor selection, which should not be straightforward for assets. Generally, all the factors can be formed into two major groups:
quantitative, which relates to the information that can be defined and measured in numbers, and qualitative, which relates to the standard or nature of something 24. Qualitative factors are highly subjective and for the further analysis performed in this work, only quantitative factors are taken into consideration. However, it should be mentioned that some of the factors, despite having an impact, cannot be measured. This makes the value of intrinsic value, under consumption that it exists, biased.
The concept of fundamental analysis was the area for studying in multiple papers.
Numerous works were devoted to analyzing and modeling the relationship between gold and other factors, from commodities to interest rates. For example, in their working paper Narayan P.K, Naryan S. and Zheng X. (2010) tried to prove that there is a relationship between gold and crude oil, which can be used for predicting price for both commodities. Their correlation was proved on the time interval from 1995 to
2
009, therefore results can be seen as positive.The study from Bechmanm (2015) describes that the impact of exchange rates on gold prices is differently distributed in time and is highly dependent on chosen currency. The other
24 https://www.investopedia.com/terms/f/fundamentalanalysis.asp
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example, working paper by Worthington and Pahlavi (2007) was dedicated to testing whether gold is the right asset for hedging by analyzing the long-term relationship between gold and CPI, or consumer price index in the USA. The same positive result, meaning that gold effectiveness against inflation was proved in follow-up papers by Wang, Lee and Thi
(
2011).More complex overview of the relevant literature can be found in the survey “The financial economics of gold”, published in 2015 by A. O’Connor, Brian M. Lucey, Jonathan A. Batten and Dirk G. Baur.
3.2 External factors
Having defined the concept of fundamental analysis, I am going to switch to the factors that we believe can have an impact on gold price. It should be mentioned that the nature of the relationship is out of the scope of this work and will not be investigated in detail. We will focus on the impact of those factors on predictive power of the model, that will be used for predictions. The selection of the factors was based on the research of similar works that have been conducted and some common assumptions from the theory of economics. However, it was limited by the availability of the data therefore some factors that could potentially have an impact were not included in this the work. For example, cryptocurrencies. There is an assumption that there can be a relationship between the price of Bitcoin (or other cryptocurrencies) and the price of gold, but the relatively short history of Bitcoin would drastically reduce our main dataset, therefore we were forced to abandon it as a factor.
As a proxy of the global economy, the USA market was chosen. Data were downloaded from different resources: the portal of the Federal reserve bank of St. Louis 25 , Reuters Portal 26 and Yahoo finance 27. Instead of using spot prices, for the purposes of this work gold futures prices were taken, which are believed to be less “noisy” and suitable for modeling. Timelines for gold prices were obtained from Reuters terminal. The final set of the variables was chosen from July 2006 to September 2021 on the weekly frequency with the further split into train (2006-2016) and test sets (2017-2021). For the subsequent testing in the practical part, we have chosen eleven factors.
25 https://fred.stlouisfed.org/
26 https://www.reutersagency.com/en/
27 https://finance.yahoo.com/
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Among them are:1. Inflation
As for now, the literature has disputable opinions about the relationship between inflation and gold prices. Some works state that there is positive correlation between gold and percentage change in USA consumer price index (CPI), which is believed to be an approximate measure of inflation, having not only short-term relationship, but long-term either. This, however, was not observed on the word market. The increasing inflation provokes prices to go up, which leads to the increasing demand and, consequently, increasing prices of gold. It also proves that gold can be used as a hedging instrument against inflation. On the other hand, there is a second opinion, that negative correlation between gold, stating that increasing inflation leads to decreasing demand in gold, therefore causes price going down. The logic behind this opinion is based on the assumption that high inflation leads to the general decrease of purchasing power and gold is no exception. (Levin, Wright, 2006) Those two confrontational opinions should be checked. However, unlike most of the papers that utilize real inflation, we will use breakeven inflation. This is the spread between the nominal yield on the fixed rate investment and the real yield on the inflation-linked investment of similar maturity and credit quality28. In our case, it is the difference between 5-Year Treasury Constant Maturity Securities and 5-Year Treasury Inflation-Indexed Constant Maturity Securities, which is participants' market expectation about inflation for the upcoming 5 years. The main reason why expected inflation is used instead of reported inflation is time delay: real inflation rate is reported with a certain lag, which can cause biased results. Data was obtained from the portal of Federal reserve bank of St. Louis 29. The line chart of the expected inflation and gold futures from 2006 till 2021 can be found in the appendix A.
2. S&P 500
Stocks and commodities, especially precious metals, are the most popular assets among investors, which are used in combination for better diversification. From the very beginning, stocks were believed to be a certain predictor for future economic trends. Due to the constantly expanding size of the stock market, more common practice is to use aggregated index, like S&P 500. Empirical evidence shows that the prices of S&P 500 and gold have opposite trends, indicating the presence of negative correlation. It has a logical explanation: if the stock market
28 inflation-linked.com/breakeven.html
29 https://fred.stlouisfed.org/series/T5YIE#0
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is getting more volatile, investors are looking for less riskier investments, even being willing to accept lower income. With the wide range of available indexes, we would use S&P500, which is believed to be a benchmark for investors due to the fact that it incorporates 500 large- cap companies across different industries and provides a complex overview of the economy30 (Ralescu, Zhang, 2019). Weekly data was obtained from Reuters Portal. The line chart of prices of S&P500 and gold futures for studied interval can be found in appendix A.
3. Federal funds rate
Federal fund rate is one of the macroeconomic tools for the purpose of regulation is an interest rate in USA but with the analogue in every country. Used for money balance adjustment, it is also a powerful tool for overall macroeconomic correction: either boosting or slowing down the business cycle. From investor’s perspective, it is a great measure of opportunity cost of holding the particular asset (cost of carry), including gold. By common sense, it is assumed that gold and interest rates are negatively correlated: growing interest rates makes financial investments more attractive, leading to the decrease in gold demand. The same happens the opposite way: lower interest rates lead to the increasing demand in gold. However, there is the other side, that should not be disregarded: there is a mutual relationship between interest rates and inflation rate, which is believed to be causing an increase in gold prices. This co-dependent relationship is supposed to be checked in this work. For further analysis US federal funds rate will be taken as a proxy for the money system 31. The line chart of the federal funds rate and gold futures prices can be found in appendix A.
4. VIX
Gold is believed to be a “safe heaven” asset, that can keep the value of wealth during turbulent times. In order to prove or reject this hypothesis, we will check if there is any dependency between the “level of uncertainty in society” and gold price. As the measure of uncertainty level, we choose VIX, or volatility index. VIX is a forward-looking indicator, that represents 30-day volatility of S&P 500 index by using SPX options as an input. Higher VIX reflects more fluctuating investors’ expectations about the market and vice versa. Although it is believed to have some limitations, like incomplete overview of all potential sources of uncertainty (like politics), we are willing to accept is as a proxy for further modeling. Weekly data was downloaded from Reuters. The combined graph of the VIX and gold futures prices can be found in appendix A.
30 https://www.investopedia.com/ask/answers/041315/what-are-pros-and-cons-using-sp-500-
benchmark.asp#:~:text=The%20central%20advantage%20of%20using,health%20of%20the%20United%20States.
31 https://www.macrotrends.net/2015/fed-funds-rate-historical-chart
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5. COT reportCommitment of Traders (COT) report is the weekly report released by Commodity Futures Trading Commission (CFTC). It is American governmental organization who is in charge of regulation and control on the US derivative market. The report provides overview of all the deals between all marker participants in order to ensure transparent, fair and competitive economic environment. On the high level, we can split market participants into two groups:
hedgers, whose main priority is to secure their interest against market fluctuation (producers, for example) and speculators, whose main interest is instant profit. Surprisingly, COT report has not been examined and tested before on possible correlation between commodity price in general and precious metals price in particular. We assume that there supposed to be a dependency between the price of gold and the number of open positions by market participants.
The whole report is above the scope of this work, so we would limit it to the total amount of short and long positions of producers (as hedgers) and money makers (as speculators). Weekly data is obtained from the aggregated COT report, provided by NASDAQ 32. Line charts, which are aimed to show total volume of taken positions for money makers and producers can be found in appendix A.
6. Dollar index/ Dollar to EURO exchange rate
The connection between gold price and different exchange rates have been examined and proved in various papers for the past decade. We would like to prove it as well. There is a wide range of currencies that can have an impact on gold, therefore we have decided to include two factors. One of them is Dollar index (DXY) as a measure of value of the US dollar to a basket of foreign currencies, believed to be the currencies of US trade partners: Euro, Japanese yen, Pounding sterling, Canadian dollar, Swedish krona, and Swiss franc in unequal decreasing proportion. The other one is pure US Dollar to Euro exchange rate, assuming that Euro is the second most tradable currency in the world 33. Historical weekly data of Dollar index 34 and US Dollar to Euro exchange rate 35 was obtained from the portal the portal of Federal reserve bank of St. Louis. We would check which factor performs better and it will be included in the model. From the line charts in the appendix A, it is seen that dollar to euro exchange rate changes in totally opposite direction that gold price, suggesting the negative correlation between them. DXY, or dollar index is relatively stable compared to the gold price changes.
32 https://data.nasdaq.com/data/CFTC/088691_FO_ALL-commitment-of-traders-gold-cmx-futures-and-options-088691
33 https://www.investopedia.com/trading/most-tradable-currencies/
34 https://fred.stlouisfed.org/series/DEXUSEU
35 https://fred.stlouisfed.org/series/DTWEXBGS
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This can be caused by the opposite direction of the relationship between currencies, that are included in dollar index, and gold prices.
7. Other commodities.
The relationship between gold and other commodities have been a subject for discussion. To prove or reject this hypothesis, we are including the following commodities:
- Energy sector: crude oil 36 and natural gas 37. It is believed to be a direct relationship between crude oil and gold, at a first glance, different commodities even though the one does not necessarily impact the other. Different papers provide different opinions, and it is unclear whether they are correlated or just exposed to the same risk, therefore are changing in the same direction. To prove or reject the hypothesis of a possible relationship, we would include crude oil as a factor. On the contrary, being similar to crude oil as a source of energy, natural gas was not tested for potential impact on the gold price. We assume that there can be a relationship between real gold and “new gold” as natural gas is being called nowadays and if there is a reason that it is not included in any studies.
- Precious metals: silver 38 and platinum39. Silver was chosen due to the fact that its relationship (long-term and short-term) was studied in different papers, despite the fact that its strength varies during history. Platinum, on the other hand, was not mentioned in studies, despite having similar characteristics to gold. Thus, we would try to test if there is a relationship and whether it can be used.
The line charts for the trend of the listed factors compared to the golf futures can be found in appendix A.
3.3 Theory behind the methods used in fundamental analysis
The majority of the methods that can be used for modeling of the relationship between factor(s) and target greatly varies and highly depends on the purpose. The econometric view prioritizes the idea of discovering and explaining the relationship between X and Y. This, however, is not always possible, and this is where machine learning algorithms become more successful. Their main focus is to make predictions tolerating the fact that some of the
36 https://finance.yahoo.com/quote/CL=F?p=CL=F&.tsrc=fin-srch
37 https://finance.yahoo.com/quote/NG=F?p=NG=F&.tsrc=fin-srch
38 https://finance.yahoo.com/quote/SI=F?p=SI=F&.tsrc=fin-srch
39 https://finance.yahoo.com/quote/PL=F?p=PL=F&.tsrc=fin-srch
