“Long run relationship and volatility between Gold, Exchange Rate

and Crude Oil”

A PROJECT STUDY SUBMITTED IN PARTIAL FULFILLMENT

FOR THE REQUIREMENT OF THE TWO YEAR
POST GRADUATE DIPLOMA IN MANAGEMENT -
GENERAL (2019-2021)

BY
Yash Jain
133/2019

Synopsis

SUBMITTED TO
INSTITUTE MENTOR – Dr. Sweta Agarwal

LAL BAHADUR SHASTRI INSTITUTE OF MANAGEMENT,

DELHI
 LAL BAHADUR SHASTRI INSTITUTE OF MANAGEMENT, DELHI

Date……………

CERTIFICATE

This is to certify that the present study is based on my original research work and my indebtedness
to others’ works, publications, etc. wherever cited in this study has been duly acknowledged at
appropriate places. This work has not been submitted either in part or in full for the award of any
diploma or degree in any university/ Institute and is now being submitted for evaluation in partial
fulfillment for the requirement of the Two-year Full Time Post-Graduate Diploma in Management.

_____________________________

Signature of the Student

(Name & Roll No. of the student)

The student consulted / did not consult me while doing this Final Research Project.

Extent of Plagiarism: ________%

Prof. ______________

Faculty Guide
 DECLARATION

I hereby declare, to the best of my knowledge and ability that my work on the Final Research
Project title Long run relationship & volatility between gold, exchange rate and crude oil is
a genuine research work undertaken by me in partial fulfilment of the requirement for the award
of Post Graduate Diploma in Management (PGDM) – General.

This is a record of my original work done under the guidance of Dr. Sweta Agarwal. I declare to
the best of my knowledge; no part of this report has been submitted elsewhere previously for
award of a degree.

Yash Jain

PGDM General

(133/2019)

LBSIM
 ACKNOWLEDGEMENT

Behind every achievement lies an unfathomable sea of gratitude to those who have extended
their support and without whom it would ever have come into existence. To them I lay the words
of gratitude.

I have received help from many individuals as I went through to prepare for this report and it
gives me immense pleasure to thank them. My deepest gratitude to Dr. Sweta Agarwal, my
faculty guide at Lal Bahadur Shastri Institute of Management for her support and for providing
valuable information, which helped me to complete this project successfully. Despite her busy
schedule, she took some time out to enrich me with his knowledge. I sincerely thank her for
imparting me with the trends, sentiments and overall knowledge of commodities which helped
me to decipher many doubts during my study.

Last but not the least; I would like to thank my friends at LBSIM for guiding me to successfully
completion of the report.
 Table of Content

Introduction...............................................................................................................................1
Literature Review .....................................................................................................................3
Research Objectives..................................................................................................................5
Data Description and Research Methodology...........................................................................6
Data Analysis and Findings.....................................................................................................10
Stationarity ..................................................................................................................12
Optimum Lag Length...................................................................................................16
Johansen Cointegration Test ........................................................................................17
Vector Autoregression (VAR)......................................................................................19
Diagonal VECH ...........................................................................................................21
Conclusions...............................................................................................................................23
References.................................................................................................................................24
 List of Figures

Sr. No. Description

1 Graph of trend in Crude Oil Prices
2 Graph of trend in Gold Prices
3 Graph of trend in Exchange Rate Prices
4 Graph of stationarity of Crude Oil Prices
5 Graph of stationarity of Gold Prices
6 Graph of stationarity of Exchange Rate Prices
 Introduction

A commodity is a basic good used in commerce that is interchangeable with other goods of the
same type. Traditional examples of commodities include grains, gold, beef, oil, and natural gas.

For investors, commodities can be an important way to diversify their portfolio beyond traditional
securities. Because the prices of commodities tend to move in opposition to stocks, some investors
also rely on commodities during periods of market volatility.

In the past, commodities trading required significant amounts of time, money, and expertise, and
was primarily limited to professional traders. Today, there are more options for participating in the
commodity markets.

The purpose of this study is to look at the connection between gold prices, exchange rate prices
and Brent crude oil prices. For this reason, crude oil prices were viewed as energy sector
representation.

Then again, concerning valuable metal, we used gold prices. The study was directed utilizing every
day information for the period 2008–2020. The investigation varies from similar studies done in
the past on the grounds that it uses diverse exogenous factors and the timespan under evaluation.

As exogenous and endogenous factors vary, the connection between the factors contrasts also.
Also, on the off chance that we utilize diverse timeframes and time arrangement (day by day, week
by week, month to month or every year), the outcomes may fluctuate as needs be.

The pattern in global economy's market interconnectivity can likewise be found in the commodity
sector with its most representative- gold and oil.

Gold, the valuable metal and oil being the most traded crude material, plays a significant part in
molding the economy.

The primary connection among gold and oil has begun in history, when Middle East producers
required gold in trade for crude oil. In 1933 Saudi Arabia's original oil concession could only be

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traded in gold. Due to numerous authentic occasions, the gold and oil markets went through
colossal turn of events and there was no longer a huge relationship between these two commodities.

The point of the hypothetical and quantitative data review is analysis of the long run relationship
among gold and oil prices and exchange rate. To understand the long run connection between these
asset classes, it is imperative to check for co-integration. Hence the research gives a light on
relationship between these asset classes. For this reason, different statistical and econometric tools
are used.

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 Literature Review

Hsiao-FenChang, Liang-ChouHuang and Ming-ChinChin conducted examination, which inspects

the relationships of oil price, gold price and the NT dollar versus U.S. dollar exchange rate during
2007/09/03–2011/12/28. Johansen co-interaction test, VAR model, Granger causality test, impulse
response analysis, and variance deterioration strategy was used to explain the interactive
relationship among the three variable. These tests and models show that the oil value, gold cost
and conversion standard remain extensively autonomous from each other, which infers
policymakers ought to think about the detachment of vitality and money related arrangements.

Mongi Arfaoui and Aymen Ben Rejeb motivation behind this paper was to analyze, in a global
point of view, the oil, gold, US dollar and stock prices interdependencies and to distinguish
immediately direct and indirect linkages among them. A strategy dependent on concurrent
conditions framework was used to recognize direct and indirect linkages for the period 1995-2015.
The outcomes show noteworthy connections between all business sectors. The author found a
negative relation among oil and stock prices but oil prices is significantly and positively influenced
by gold and USD. Oil prices are also influenced by oil future prices and by Chinese oil gross
imports. Gold rate is concerned by changes in oil, USD and stock markets. The US dollar is
adversely influenced by stock market and significantly by oil and gold prices. Indirect effects
always exist which confirm the presence of global interdependencies and involve the
financialization process of commodity markets.

Wang and Chueh (2013) dealt with the long-term and short-term dynamic interactions among oil
prices, interest rates, gold prices and the U.S. dollar. The study employed the threshold
cointegration model and the threshold error correction model for analysis covering the period
between 2 January 1989 and 20 December 2007. It was seen that in short term, gold prices and
crude oil prices were related positively. Moreover, it was determined that while the crude oil had
a positive effect on gold futures prices, interest rates had a negative effect on futures prices.

Based on daily and quarterly data, Apergis (2014) analyzed whether there was any correlation
between gold prices and real foreign exchange rates and nominal Australian dollar/U.S. dollar
for the time period between 2000 and 2012 through the VECM model (vector error correction

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model). It was concluded that gold prices could be used for estimating Australian dollar/U.S.
dollar foreign exchange rates.

Beckmann and Czudaj (2013) analyzed long term and short-term relationships between the U.S.
consumer price index, the nominal effective foreign exchange rate, oil and gold. The results of a
cointegrated VAR showed that oil and gold were two important commodities and they had
significantly different economic effects, and that gold and oil distributions were positively
correlated with U.S. consumer prices.

Souček (2013) conducted a study to reveal the acting together of capital movements, gold futures
markets (short position) and crude oil. The results showed that there is a negative reaction to
sudden shocks in interest rates in other markets whereas there is a positive correlation between
demand for crude oil futures for hedging and stocks.

Topcu and Aksoy (2012) examined the short-term and long-term correlations between gold,
government debt securities, stocks, the consumer and the producer price index for the period
between 2003 and 2011 through regression, causality and cointegration analyses. The results of
the regression analysis indicated that return on investment in gold had a negative correlation with
stock returns but had a positive correlation with the producer price index.

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 Research Objective

 The objectives of this study is to understand the relationship between gold and crude prices
with exchange rate
 To analyze the extent of short term and long term relationship between these asset classes

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 Research Methodology

Data Sets:

1. Gold Prices
2. Brent Crude Prices
3. USD-INR Exchange Rate

Data Source: Bloomberg Terminal and other websites (yahoo finance)

Data Analysis Technique: MS Excel and E views

Data Sample: Daily price of all the three asset classes were taken for past 12 years (2008-20)

This study is done to find the long-term relationship between different asset classes namely: crude
oil, gold and exchange rate. Since the data is real time and is daily price of all the three assets, the
data is most probably subject to be non-stationary and asymmetric. Thus, various tests have been
employed using MS Excel and E-views.

Hypothesis Development: There are three different hypothesis sets used. First is the hypothesis
for testing the stationarity of the data. The second hypothesis is used for Johansen co-integration
test to test for long term relationship between the asset classes. The third and final hypothesis is
used to test for volatility in these asset classes.

Stationary Check:

Once the data is obtained, it is checked for unit root i.e. whether there is stationarity or not. In case
the data is not stationary, it is made stationary. This is done in order to make data more meaningful.
Underestimating the assumption of normal distribution may lead to type 1 and type 2 errors. In
order to increase the normality of the variables, to change measurement levels and to stabilize the
variance data, transformation can be conducted. Data can be transformed via taking the inverse,
logarithm or square root. Among these, taking the logarithm or log transformation are the most
widely used transformations. In case of these three-asset class, data is made stationary by taking
Log return of this data.

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In order to find whether the data is stationary or not, the test used with the help of E-views tool is
Unit Root Test. This test tells us whether a time series variable is non-stationary or possesses a
unit root. The hypothesis for this test is as below:

H null – The data has unit root i.e. the data is non-stationary

H alternative – The data is stationary

Here H null and H alternative are null and alternate hypothesis respectively. For null to be rejected
and data to be stationary, the required p-value should be less than 0.05.

Optimum Lag Length:

To this end, after the ADF stationary test was carried out, optimum lag selection was made for
these two models established by using the criteria of Akaike information criterion (AIC) and
Schwarz’ Bayesian Information Criterion (SBI).

Johansen Cointegration Test:

In view of the lag values determined, the Johansen co-integration test was conducted to determine
whether or not there was co-integration between the variables. A co-integration analysis is carried
out to determine whether the variables have a long-term relationship. Failure to integrate means
the lack of a long-term relationship between the variables concerned. The cointegration analysis
tests the null hypothesis suggesting that there is no co-integration with the co-integration existence.
Cointegration analyses employ eigenvalue and trace statistic values as test statistics. The co-
integration test determines the type of regression model (VAR or VECM) to be used. This test is
only valid when we are working with series that are known to be non-stationary, so we use level
data for Johansen cointegration tests. We may summarize the five deterministic trend cases
considered by Johansen as:

1. The level data have no deterministic trends and the cointegrating equations do not have
intercepts:

2. The level data have no deterministic trends and the cointegrating equations have intercepts:

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3. The level data have linear trends but the cointegrating equations have only intercepts:

4. The level data and the cointegrating equations have linear trends:

5. The level data have quadratic trends and the cointegrating equations have linear trends:

The hypothesis for this test is as below: HN – The asset classes have no co-integration among
them. HA – There is co-integration between these asset classes.

Vector Auto Regression (VAR):

Vector auto regression (VAR) models were introduced in 1980 to model the joint dynamics and
causal relations among a set of macroeconomic variables. VAR models are useful for forecasting.
Consider a univariate autoregressive model— for example,

AR (1) Yt = α + βYt–1+ Єt —which describes the dynamics of just one random variable Yt as a
linear function of its own past.

Diagonal VECH:

The first multivariate GARCH model was introduced in 1988, which is called VECH model. In
the VECH model, every conditional variance and covariance is a function of all lagged conditional
variances and covariances, as well as lagged squared returns and cross-products of returns. The
model can be expressed below:

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Where VECH (Ht) is an operator that stacks the columns of the lower triangular part of its
argument square matrix, Ht is the covariance matrix of the residuals, N presents the number of
variables, t is the index of the t th observation, c is a vector, Aj and Bj are parameter matrices and
 is an N 1 vector.

The diagonal elements of matrix A measures the influences from past squared innovations on the
current volatility (i.e. own-volatility shocks) while non-diagonal elements determine the
crossproduct effects of the lagged innovations on the current covolatility (i.e. cross-volatility
shocks). Similarly, the diagonal elements of matrix B determines the influences from past squared
volatilities on the current volatility (i.e. own-volatility spillovers) and non-diagonal elements
measure the cross-product effects of the lagged covolatilities on the current covolatility (i.e. cross-
volatility spillovers).

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 Data Analysis and Findings

Underestimated normal distribution assumptions can lead to type 1 and type 2 errors.
Transformation can be carried out to increase the normality of the variables, to change
measurement levels and to stabilize the variance data. Data can be converted by reversing,
logarithm or square root. Among them, the most commonly used transformations are the logarithm
or log transformation.

Data Collection

The asset classes used for this study is Brent crude oil, gold and exchange rate. The daily closing
price of every asset classes is taken from Bloomberg over a period of 12 years (2008-20). The
price movement of all the three asset classes are shown below.

For CRUDE OIL

10
 For GOLD

For Exchange Rate (INR)

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As we can see there is trend in data as well as data is not constant. We can also see that there is
seasonality in data. To remove trend, we used log returns. Log Returns make data constant. Even
after Log Returns if the trend isn’t removed we use 1st Differencing followed by 2nd differencing.

Stationary Check

The Stationary test results for all the three asset classes are given below:

For CRUDE OIL

12
For GOLD

13
For Exchange Rate (INR)

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Since the p-value is less than 0.05 for all the three asset classes, the data is stationary.

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Optimum Lag Length

This tells me that Lag 2 is the best for my model. As AIC is the lower one.

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Johansen Cointegration Test

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Since the trace statistic value is more than the 5% critical value, and the max statistics value is
more than the 5% critical value, the null hypothesis can be rejected. This result shows that there is
cointegration between gold prices, crude oil prices and exchange rate.

The dependent variable is crude oil, and the independent variable are exchange rate and gold
prices.

The positive coefficient of exchange rate and gold suggest that an increase in them will reduce the
oil price.

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VAR (Vector Auto Regression)

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Thus, based on VAR results, when exchange prices were taken as the independent variable the
two-period lag effect of the exchange prices were determined to be statistically significant at the
significance level of 1%.

When gold prices were taken as independent variables, the one-period lag effect of the exchange
rate prices and the two-period lag effects of exchange rate prices as well as one-period lag effect
of gold prices were determined to be statistically significant at the significance level of 1%.

AIC is lower than SC, so we chose AIC model.

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Diagonal VECH

Among the main objective of the study there is to study the effect of volatility spillover between
these asset classes.

Diagonal VECH is the statistical tool that we are going to use to study the effect of volatility
spillover.

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Here A terms are the ARCH terms and B terms are the GARCH terms. ARCH explains the past
shock and GARCH explains past volatility. In the table the arch terms are not significant and the
GARCH terms are significant.

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CONCLUSIONS

The price of gold, which has been considered a safe haven for some investors over the years, may
depend on many macroeconomic factors, such as crude oil prices, inflation rates, real exchange
rates, and interest rates, price of precious metals, consumer price index, gold reserves, stock indices
and future contracts.

At the first glance it seems that gold and crude prices depend on various national and international
macroeconomic variables, capital markets and the prices/returns of another commodity market
investment instruments. So, it is necessary to examine the behaviour of gold and crude and to
conduct a thorough analysis of the factors that are influential on such behaviour in order to
understand the changes and movements in these asset prices. Gold investors differ from investors
in capital markets, derivative markets and other commodity market instruments. Gold has a
distinctive investor profile because it stands both as a store of value and as a reserve. Thus, its
pricing involves many different factors. Therefore, the present study investigated the long-term
and short-term correlations between gold prices and the prices of crude oil and exchange rate,
whose investors were thought to have similar behaviour to those of gold.

Future studies in this area could be conducted according to two approaches. One approach is
replicating the present study with the use of different time periods and time series in order to obtain
a better understanding of whether volatility is permanent or whether there is a breakdown of
volatility over time. Also, time periods covering the financial crisis can provide support for the
validity of previous findings. The second approach would involve analyzing macro-variables in
terms of the local currencies for Economic Co-operation and Development or other country
groups.

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 Reference

https://www.sciencedirect.com/science/article/abs/pii/S0301421513009531

https://ideas.repec.org/a/eee/ecmode/v30y2013icp792-798.html

https://www.emerald.com/insight/content/doi/10.1108/EJMBE-10-2017-016/full/html

http://granthaalayah.com/Articles/Vol5Iss10/30_IJRG17_A10_740.pdf

https://econpapers.repec.org/article/eeereveco/v_3a27_3ay_3a2013_3ai_3ac_3ap_3a621-
636.htm

https://www.researchgate.net/publication/274427957_Crude_oil_equity_and_gold_futures_open
_interest_co-movements

https://www.researchgate.net/publication/288480060_Stock_market_returns_and_the_price_of_
gold

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Record of Meetings with the Project Guide for the Final Research Project

SR.NO DATE PURPOSE REMARKS SIGNATURE

(PROJECT GUIDE)

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