Mansor H.

IBRAHIM, PhD
International Centre for Education in Islamic Finance
(INCEIF)
Kuala Lumpur Malaysia
A. H. BAHAROM, PhD Candidate
Taylors University
Subang Jaya Selangor Malaysia
E-mail: [email protected]
[email protected]

THE ROLE OF GOLD IN FINANCIAL INVESTMENT:

A MALAYSIAN PERSPECTIVE

Abstract. The paper assesses whether gold investment provides diversification,

hedge, or safe haven benefit for the case of Malaysia using daily data from August
2001 to March 2010. The results indicate that at best gold serves as a diversification
asset for Malaysian investors. In the analysis, we also find changing investment role
of gold in recent years marked by global financial market uncertainties. The hedge
and safe haven properties of gold investment documented in the initial sub-sample
have been degraded to only diversification property. Moreover, the extreme market
conditions tend to weaken the role of gold as a diversification asset in financial
portfolio formation.
Keywords: Financial Investment, Gold, Diversification, Hedge, Safe Haven

JEL Classification: G10, G11

1. INTRODUCTION

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

The recurring heightened volatility in the stock markets is normally viewed to

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

The crisis episodes seem to conjure up the image of gold as an alternative

investment asset or an important part of assets in financial portfolios. The emerging
interest in gold in times of crises perhaps stems from its historical use as a medium of
exchange and standard of value and its stable purchasing power over times. In light of
these, few studies have raised an empirical inquiry as to whether gold can at least
diversify portfolio risk or at best provide a safe haven. Notable among these studies
are recent works by Capie et al. (2005), Hillier et al. (2006) and Baur and Lucey
(2010). Capie et al. (2006) examine whether gold serves as a hedge against
fluctuations in sterling-dollar and yen-dollar rates and arrive at a conclusion that gold
possesses the exchange rate hedge property. However, they also note that the extent of
hedging tends to vary over time. Hillier et al. (2006) evaluate the investment role of
precious metals – gold, platinum and silver. They note low correlations between these
three metals and stock market returns, which suggest the diversification role of the
precious metals. Evidence for their hedging ability is also uncovered during the
periods of abnormal stock market volatility. Finally, Baur and Lucey (2010) estimate
the relations between U.S., U. K. and German stock and bond returns and gold returns.
The Role of Gold in Financial Investment: A Malaysian Perspective
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They document evidence for the hedging role of gold. Moreover, gold also provides a
safe haven in extreme market conditions.

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

In the analysis, we look at the relation between domestic gold and stock market
returns within a regression framework. Based on daily data from August 2001 to
March 2010, our analysis covers both full sample and two equally-divided sub-
samples. The latter is implemented such that we can roughly address possible
changing relations between gold and stock returns in the recent period marked by
heightened volatility during years surrounding the US subprime crisis. The next
section details the empirical approach. Section 3 describes the data followed by
estimation results in section 4. Finally, section 5 concludes with the main findings.

2. EMPIRICAL APPROACH

In line with Baur and Lucey (2010), we rely on a regression model to assess the
investment role of gold. More specifically, since we observe evidence of time-varying
conditional variances of the regression residuals, we base our analysis on the
EGARCH(1, 1) specification. To begin, our basic EGARCH(1, 1) model is written as:

∆Gt = β 0 + β1 ∆S t + β 2 ∆S t −1 + ε t (1)

ε t | I t −1 ~ N (0, ht ) (2)

ε t −1 ε t −1
log ht = θ 0 + θ1 +θ2 + θ 3 log ht −1 (3)
ht −1 ht −1
Mansor H. Ibrahim, A. H. Baharom
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where G is gold prices, S is stock prices and ∆ is the first-difference operator. Both
gold and stock prices are expressed in natural logarithm. Thus, ∆G and ∆S represent
the continuously compounded rates of return of respectively gold and stock
investments. Note that we incorporate once-lagged stock return in the regression since
the changes in stock prices may be impounded into the prices of gold with lag. We
find lag 1 to be sufficient according to the AIC information criterion.

Equation (1) is the mean equation, which we use to infer the investment role of
gold. In equation 2, we specify the error density function, conditional on information
up to time t – 1, to be normally distributed with mean 0 and variance ht. Equation (3)
specifies the error variance to follow an EGARCH(1, 1) process. The EGARCH
model has an advantage in that it requires no non-negativity restrictions of the
parameters in the variance equation as in the case of the traditional GARCH(1, 1)
specification. Moreover, it allows positive and negative shocks to have asymmetric
influences on volatility (Lobo, 2000 and Koutmos et al., 2006). Based on (3), negative
news (i.e. εt < 0) leads to higher volatility if θ2 < 0.

As noted, the investment role of gold is inferred from (1). More specifically, gold
serves as a diversification asset if the sum of stock market coefficients is significantly
more than 0 but less than 1. On the contrary, if it is insignificantly different from 0 or
significantly negative, then gold has the hedging property. Then, in order to assess
whether gold is a safe haven, we extend the basic mean equation to include an
interactive dummy as:

∆Gt = β 0 + β1 ∆S t + β 2 ∆S t −1 + β 3 ( DP × ∆S ) t + β 4 ( DP × ∆S ) t −1 + ε t (4)

where DP is a dummy variable taking the value of 1 if the stock returns are in the pth
percentile and 0 otherwise. We consider p = 1, 2.5, 5, and 10. Equation (4) nests
equation (1) as a special case when the extreme market conditions do not change the
relations between gold and stock returns, i.e. β 3 = β 4 = 0 .

Based on the estimation of (4), we test the following hypotheses (H1 and H2)
using the standard Wald F-statistics:

H1: β1 + β 2 = 0 (5)

H2: β 1 + β 2 + β 3 + β 4 = 0 (6)
The Role of Gold in Financial Investment: A Malaysian Perspective
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Hypothesis 1 evaluates the diversifying and hedging roles of gold investment in normal
market conditions, as stated above. Meanwhile, hypothesis 2 adds the safe haven role
in the analysis. Namely, if the hypothesis is not rejected or if the coefficient sum is
negative, then gold investment serves as a safe-haven for investors. If we find the
coefficient sum to be significantly positive, we further test whether it is equal to 1.

We estimate the EGARCH(1, 1) with mean equation (1) and (4) for the whole
sample. In addition, we also have interest in examining the possible changing
investment role of gold. We observe changing market conditions over time, marked by
heightened volatility in years surrounding the US sub-prime crisis. Arguably, this
might intensify the flight to quality and, accordingly, change the correlation structure
between stock and gold returns. To this end, we divide the sample into two sub-
samples. The second sub-sample corresponds to the period of higher volatility in the
Malaysian stock market arising from its responses to market uncertainties in the
western world.

3. DATA

We employ daily data from August 2001 to March 2010, the span of which is
dictated by data availability of gold prices. The prices of one troy ounce domestic gold
bullion, known as Kijang Emas, are used to represent gold prices. Normally, existing
studies on the issue employ global gold prices (in US dollar) converted into the
currency unit of a country under study using the USD rate of the domestic currency to
represent gold prices. We have no reason to believe that the emerging stock markets,
which are small relative to the global markets, have influences on or relations to the
global gold prices. Accordingly, the evidence for significant relation between global
gold and stock market returns may reflect exchange rate change – stock return relation.
For example, the concurrent ringgit depreciation and stock market downturn observed
during the Asian crisis may suggest a safe-haven role of gold even if the global gold
prices drop but less proportionately than the depreciation rate, i.e. gold lacks the
property of a safe haven. For stock prices, we use the Kuala Lumpur composite index.
Table 1 provides descriptive statistics of the two series in first-difference, i.e. their
rates of return. Meanwhile, Figure 1 plots the two series in both level and first
difference forms. We also depict the conditional volatility of the stock market return to
reflect changing market conditions over time.

Both gold and stock prices exhibit an upward trend over the sample period,
respectively recording positive average daily returns of 0.06% and 0.03%. The time
pattern of stock prices also demonstrates marked reduction in 2002 and late 2007 to
2008, respectively the years of the Argentine financial crisis and the US subprime
crisis. Interestingly, gold return seems to be relatively more volatile than stock market
return as reflected by their respective standard deviations. Both series are
Mansor H. Ibrahim, A. H. Baharom
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characterized by excess kurtosis or volatility clustering. The Jargue-Bera test statistics
for normality soundly reject the null of normal distribution for both yields. These
characteristics seem to justify the adoption of GARCH-type models in empirical
specification. We further estimate an AR(1)-EGARCH(1, 1) for the market return and
extract its time-varying conditional variances. From the plot in Figure 1, while there is
a short-lived heightened volatility at the beginning of the sample, the volatility pattern
of the stock market is more pronounced and prolonged in recent years. Indeed, based
on the stock market volatility plot, we can roughly divide the sample into two sub-
periods, the low volatility and high volatility regimes.

Table 1: Descriptive Statistics

∆G ∆S
Mean 0.000561 0.000305
Median 0.000000 8.72E-05
Maximum 0.124645 0.042587
Minimum -0.078182 -0.099785
Std. Dev. 0.011909 0.008518
Skewness 0.092587 -0.999659
Kurtosis 12.58588 15.06466

Jarque-Bera 8656.123 14082.94

Probability 0.000000 0.000000

Observations 2260 2260

4. ESTIMATION RESULTS

This section presents the estimation results of the models. We first look at the full
sample and then discuss the results from sub-sample estimation. We equally divide the
sample into two sub-samples. Thus, the first sub-sample covers the period August
2001 – November 2005 and the second sub-sample the period December 2005 – March
2010. We have interest to see whether the recent heightened volatility of the
Malaysian stock market influences its relations with the domestic gold bullion market.
Five models are estimated – the basic model and four extended models to allow for the
return relations in extreme market conditions. We define the extreme market
conditions in term of percentiles. More specifically, a dummy variable is created,
which is then interacted with the market return, to represent the extreme market
conditions. The dummy takes the value of 1 if the market returns are lower or equal to
the pth percentile. We consider p = 10, 5, 2.5 and 1 based on the full-sample market
returns.
The Role of Gold in Financial Investment: A Malaysian Perspective
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Figure 1: Graphical Plots of the Series
8.4 .15

.10
8.0

.05
7.6
.00

7.2
-.05

6.8 -.10
02 04 06 08 02 04 06 08

Natural Log of Gold Prices Gold Return

7.4 .08

7.2
.04

7.0
.00
6.8
-.04
6.6

-.08
6.4

6.2 -.12
02 04 06 08 02 04 06 08

Natural Log of Stock Prices Stock Market Return

.0012

.0010

.0008

.0006

.0004

.0002

.0000
02 04 06 08

Stock Market Volatility

Table 2 provides estimation results for the full sample. Panel (a) and panel (b)
respectively present the results of mean and variance equations. Meanwhile, panel (c)
gives the Wald-F statistics for the investment role – diversification, hedge and safe
haven - of gold. If the hypothesis of zero coefficient sum is not rejected, we do not
conduct further test of unitary coefficient sum, the reason of which is obvious.
Likewise, if we find the interactive dummies to be insignificantly different from zero,
we do not carry out the test to see whether their relations during extreme market
conditions are significant. Take note from the results that the coefficients of the
variance equation are all significant. The volatility tends to depend most on its past
volatility. Moreover, there seems to be no leverage effect in the gold market as is
normally observed for stock assets. The past negative shocks (negative error terms)
Mansor H. Ibrahim, A. H. Baharom
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tend to dampen future volatility instead of intensifying it as reflected by the positive
coefficient of the standardized error terms, i.e. θ 2 . These characteristics of error
variances prevail in all models estimated and, as a result, will not be reiterated in
further discussion

Table 2: Estimation Results – Full Sample

Estimated Basic Extended Model with Percentiles (P)

Coefficients Model P = 10 P=5 P = 2.5 P=1

(a) Mean Equation

β0 0.0008*** 0.0010* 0.0010* 0.0009* 0.0009*
β1 0.0190 0.0205 0.0144 0.0116 0.0114
* *** **
β2 0.0876 0.0444 0.0589 0.0724 0.0770*
β3 -- -0.0123 0.0005 0.0052 -0.0019
β4 -- 0.1383** 0.1230** 0.0893 0.1045

(b) Variance Equation

θ0 -0.1547* -0.1643* -0.1645* -0.1612* -0.1651*
θ1 0.1092* 0.1119* 0.1114* 0.1114* 0.1129*
θ2 0.0502* 0.0495* 0.0501* 0.0498* 0.0488*
θ3 0.9915* 0.9907* 0.9906* 0.9909* 0.9906*

(c) Hypothesis Testing

2 0.1067 0.0649 0.0733 0.0840 0.0883
∑ βi = 0 [13.636]* [2.230] [3.311]*** [4.949]**
i =1
[5.741]**
2 0.1067 0.0733 0.0840 0.0883
∑ βi = 1 [958.32]* -- [528.69]*
i =1
[588.12]* [611.65]*
4 0.1909 0.1968
∑β
i =1
i =0 -- [20.266]* [18.440]* -- --
4 0.1909 0.1968
∑β
i =1
i =1 -- [363.87]* [271.65]* -- --
Note: *, **, and *** denote significance at 1%, 5% and 10% respectively. The
numbers in squared brackets are Wald-F statistics.
The Role of Gold in Financial Investment: A Malaysian Perspective
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Looking at the basic model, we note the significance of once-lagged stock return.
Its coefficient is positive. The Wald-F tests for the coefficient sum of the stock market
returns in panel (c) indicate that it is significantly distinguishable from 0 but less than
1. Thus, based on (1), the gold investment does not seem to provide a hedging role.
At best, since the relation between gold and stock returns is positive but less than
perfectly correlated, it serves as a diversifying role in financial portfolio formation.
When we incorporate extreme market conditions, we note the increased relations
between gold and market returns. Using the 10th percentile, their relation in normal
market conditions is insignificantly different from zero. However, it turns positive and
significant during the extreme market conditions. At the 5th percentile, gold return
tends to be positively and significantly related to market return and their relation is
stronger during extreme stock market downturns. For the 2.5th and 1st percentiles, we
document no changes in the relations as the coefficients of the interactive dummies are
indistinguishable from zero. These results, thus, indicate the absence of a safe haven
characteristic in gold investment. To the contrary, during extreme stock market
conditions, the diversification role of gold seems to weaken.

The results for sub-sample estimation are given in Table 3. To conserve space,
we present only the estimated slope coefficients of the extended mean equation and test
statistics for the sum of the coefficients being equal to 0. Still, it should be noted that,
in all cases of positive coefficient sum, we uncover evidence that gold and stock
returns are less than perfectly correlated. The results from sub-sample analysis are
revealing as to potential changes in the investment role of gold. During the first sub-
period and based on the 10th percentile (panel a), we find negative and significant
relation between the two markets in normal stock market conditions. In extreme
market conditions, the two markets seem independent. Using other percentiles (5th,
2.5th, and 1st), we also document evidence suggesting insignificant relation between the
two markets regardless of market conditions. Take note that, if we focus on
contemporaneous correlations between gold and stock returns, we find the coefficient
to be negative but turns positive in the extreme market conditions. However, the stock
market is noted to have contradictory once-lagged effect on the gold market.
Incorporating this lagged effect such that we may assess the total effect, we arrive at
the conclusion that the two markets are at best independent during the first sub-period.
These results indicate that gold investment plays a hedging role during normal times
and serves as a safe haven during abnormal times of the stock market.

However, this property of gold investment tends to disappear during the recent
period. In all cases, we note significant and positive sum of stock market coefficients
during normal stock market conditions. The null hypothesis β 1 + β 2 = 0 is rejected
at 1% significance level. Moreover, there seems to be a strengthened relation between
the two in extreme market conditions since the interactive dummies are distinguishable
Mansor H. Ibrahim, A. H. Baharom
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from 0. In all cases, the estimated coefficient sum of stock market returns during
extreme market downturns is larger. Based on these sub-sample results, we incline to
point to the varying investment role of gold over times. In the Malaysian context, the
role of gold as a hedge and safe haven asset has been degraded to being a
diversification asset in recent years marked by global market uncertainties.

Table 3: Estimation Results - Subsamples

Estimated Slope Coefficients Hypothesis Testing

Percentile/ 2 4

Sample β1 β2 β3 β3 ∑ βi = 0
i =1
∑β
i =1
i =0

(a) P = 10
Aug03– -0.1421* 0.0310 0.1206*** 0.0754 -0.1111 0.0850
Nov05 [3.190]*** [0.947]
Dec05– 0.1472* 0.0494 -0.119*** 0.2113* 0.1965 0.2892
Mar10 [8.685]* [29.743]*

(b) P = 5
Aug03– -0.1255* 0.0714 0.0891 -0.1001 -0.0542 --
Nov05 [0.868]
Dec05– 0.1207** 0.0499 -0.0792 0.2408* 0.1707 0.3324
Mar10 [7.502]* [32.81]*

(c) P = 2.5
Aug03– -0.1102* 0.0633 0.0414 -0.0564 0.0469 --
Nov05 [0.774]
Dec05– 0.1127** 0.1022** -0.0690 0.1290** 0.2149 0.2749
Mar10 [13.16]* [22.27]*

(d) P = 1
Aug03– -0.1151* 0.0674 0.2444* -0.258*** -0.0478 -0.0622
Nov05 [0.839] [0.264]
Dec05– 0.1249* 0.1117* -0.1462** 0.1589** 0.2366 0.2493
Mar10 [17.66]* [16.68] *
Note: *, **, and *** denote significance at 1%, 5% and 10% respectively. The
numbers in squared brackets are Wald-F statistics.
The Role of Gold in Financial Investment: A Malaysian Perspective
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5. CONCLUSION

The heightened volatility of financial markets sparked by a series of financial

crises in different parts of the world has raised serious concern over stock investment
risk and, consequently, necessitates the need to identify alternative financial assets that
can ameliorate investment portfolio risk. In light of this, we empirically investigate
whether gold can serve as a diversification, a hedge, or a safe haven asset for the case
of Malaysia. We look at the issue from Malaysia’s investment perspective by
estimating the relations between gold and stock returns using daily domestic gold and
stock market data from August 2001 to March 2010. In general, we find gold to serve
as a diversification asset. The analysis also reveals two important findings. First,
during periods of extreme market conditions, the relations between gold and stock
market returns tend to be stronger. This signals the weakened diversification benefit of
gold investment during period of large market downturns. And second, based on two
equally-divided sub-samples, gold is found to provide a hedge against stock market
risk and a safe haven during extreme stock market downturns during the first sub-
sample. However, these properties of gold tend to disappear during recent years.
Thus, the investment role of gold has been degraded to be a diversification asset.
Again, the diversification benefit seems weakened during extreme market conditions.
In short, the investment role of gold is time-varying. Probably, in the case of
Malaysia, the degradation of gold from a hedge or safe haven asset to a diversification
asset over recent years is due to the prolonged volatility of the market during years
surrounding the sub-prime crisis.

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Mansor H. Ibrahim, A. H. Baharom
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