The challenge

17 October, 2024

Gold’s dual nature, as both a real good and a financial asset, means that its value is not easily explained by traditional asset pricing models. This is further complicated by gold’s continued use as a monetary asset within central bank reserves, despite the ending of the Gold Standard and the mandatory requirement to hold gold as reserves more than five decades ago.

As gold does not generate any cash flows, traditional discounted cash flow models are not applicable.1 Generally, commodity pricing models also fall short given gold’s unique and ever-growing above-ground stock that, among other things, diminishes primary production as marginal supply. Unlike most other commodities such as oil and wheat, gold cannot be consumed in the sense that its consumption makes it disappear.

Several theories suggest that gold’s expected return should equal the inflation rate. These include the work of Hotelling.2 His work on exhaustible resources proposes that commodity prices are linked to interest rates, implying an opportunity cost of production. Since interest rates and inflation rates co-move over longer horizons, price changes in commodities and the cost of production both move with interest rates (as proposed by Hotelling) and inflation rates (see Levin et al.).3

Unlike most other commodities, e.g. oil and wheat, gold cannot be consumed in the sense that its consumption makes it disappear.

But focusing on inflation, interest rates or mining costs as the main driver of gold prices is too narrow for several reasons.

First, gold has significantly outperformed both inflation and the risk-free interest rate: its average annual compounded return (in US dollars) from 1971 to 2023 was 8% for gold vs 4% for US CPI and 4.4% for the US 3-month Treasury.4 The probability that such excess returns are due to chance, rather than a characteristic of gold, is very low.

These returns also reject claims that the zero or low correlation of gold with the market, measured as a zero beta with respect to the market in a capital asset pricing model framework, implies that the return of gold is equal to the risk-free rate.5 Gold returns are not a proxy for the risk-free rate theoretically and indeed are greater empirically.6

Second, some research suggests producers are marginal price setters by linking gold prices to mining costs.7 However, it has been shown that miners react to higher gold prices by mining more costly deposits – driving mining costs up, and vice versa.8 Thus, causality appears to work in the opposite direction to that suggested by such research.

Finally, the large above-ground stock of gold comprises an ever-growing source of supply ready to return to market, competing with primary production that contributes less than 2% to the stock each year. This makes the gold price not only less sensitive to production but also materially distinguishes gold from other commodities.


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Footnotes

  1. Gold is an asset, not a liability.

  2. Hotelling (1931).

  3. Levin, Abhyankar and Ghosh (1994).

  4. A one-sided T-test of gold’s excess return vs CPI and the risk-free rate gives a p-value of 0.04 and 0.05 respectively. An alternative way to express this is that the probability of observing such a return if the expected excess return is zero, is very low.

  5. Baur and Lucey (2010).

  6. He, O’Connor and Thijssen (2022).

  7. Levin, Abyankhar and Ghosh (1994).

  8. O’Connor, Lucey and Baur (2016).

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