gold:report

JANUARY 2006

Commodity Prices and the Influence of the US Dollar

By Nikos Kavalis, GFMS Limited1
Introduction
Recent years have seen the commodities complex enjoy an impressive bull run. With few exceptions, commodity prices have experienced major increases and have generally outperformed traditional investments. This trend has brought the asset class under the focus of the nancial community. Indeed, the involvement of speculators in the commodities markets has been on the increase, while a limited number of longer-term strategic players are also believed to have entered the game. As a general rule, commodities are priced in US dollars. Recent years have seen the US currency weaken. Other things remaining equal, this weakness in the currency in which an asset is denominated would, by denition, result in an increase in the assets price. The commodities bull run thus discussed above is, at least in some part, expected to be related to the decline in the US dollar exchange rate.
1

The question arises: what is the extent to which recent years rise in commodities prices was a product of the depreciation in the US dollar that has taken place over the same period? Can uctuations in the said currency fully explain changes in commodity prices, or is there only a partial effect (if any at all)? If the latter were true, a measure of the partial impact of changes in the dollar on commodity prices would by denition indicate how effective commodities

more suitable than others as diversifying investment instruments to protect against changes in the US currency. Finally, is any relationship between commodity prices and the US dollar unchanged over time, or does it vary with changing circumstances in the world economy and the relevant markets? For instance, is the link equally strong both during times when the dollar is rising and falling, and if not, when is it stronger, and why?

would be as a hedge against uctuations in the US currency. The question

Methodology & Data

A simple look at the underlying fundamental markets is sufcient to show that this recent rally in commodities prices cannot be purely explained by the weakness of the greenback. There is little doubt, for instance, of the fundamental tightness in energy and metals markets (one driven by either demand or supply shocks), which would have boosted related commodities prices regardless of any changes in the strength of the greenback.

becomes ever more relevant in the light of arguments for adding commodities and related derivatives to portfolios, in an effort to diversify away from traditional investments and assets linked in one way or another to the dollar. Furthermore, it would be interesting to examine whether this ability to provide a hedge against the dollar varies across different commodities. This would indicate which commodities, if any, are

This report was prepared by GFMS Limited on behalf of the World Gold Council. Please read the disclaimer on the nal page.

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To further illustrate this point, one can look at the relative performance of different commodities over time. Were the dollar the only driver of changes in commodity prices, one would expect these to have moved in the same way over time. Looking at the charts in Appendix 3 at the end of the report, which feature indexed mid-weekly prices for a number of commodities over the 1994-2004 period, this has clearly not been the case. To evaluate the strength of the relationship between the dollar and commodity prices, there are a number of statistical approaches that can be used. The most simple and widely used approach is to look at the correlation between the two, measured by the correlation coefcient. A brief explanation of the meaning of correlation and some technical notes on the calculation of the correlation coefcient are provided in the technical appendix (Appendix 2) at the end of this report. More specically, for this particular case, we look at the correlations between the dollar and the individual price of a number of commodities, a list of which can be seen in Appendix 1 of this report. With the exception of lead, all commodities in the list are components of at least two of the leading tradable commodity indices (Goldman Sachs Commodity Index, It is important to note here that the analysis in this report provides no information whatsoever on the causality that drives any correlations between the dollar and commodity prices. The purpose of the report is to simply examine whether the two tend to move consistently in relation to one another, so as to evaluate the dollar-hedge property of different commodities, and not to develop a model of how changes in one feed into the other. In fact, the existence of strong correlation between two assets could coincide with a complete lack of causal relationship between them. To remove any non-stationarities inherent in the variables (for instance, trend), which could produce spurious results with a bias to exaggerate the correlation coefcient, it is customary to look at the correlation in changes or returns in the two variables examined. To demonstrate this point, an example of an extreme case where use of returns rather than levels
Figure 1: Trade Weighted Dollar

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generates a radically different correlation coefcient is provided in the technical appendix at the end of this report. When discussing returns throughout this report, we are referring to spot or net returns, meaning ones related to the change compared to the previous observation. Furthermore, rather than using simple or arithmetic returns we have decided to use log- or geometric returns. A brief explanation of the differences between the two is also provided in the reports technical appendix. With regards to the data series used, for the US currency exchange rate we look at the trade weighted dollar. For the commodities studied, we use the consensus benchmark price in each market. Where they are available, spot prices are used, while the nearest month contract price is used as a proxy where they are not. Spot prices are used to strip out the effects of changes in the contango or backwardation3 prevailing in each of the market,

US$ Effective Exchange Rate Index: 1990=100

130 First Period July 1995 June 1997

120

110

Reuters/Jefferies CRB Total Return Index, Dow-Jones AIG Commodity Index). Two approaches are followed: we rst look at static correlations over a set period, and then examine the evolution of rolling annual correlations over the same period. To reduce the noise inherent in daily data, we use mid-week observations.2

100

90 Second Period January 2002 - December 2004 80 1995 1997 1999 2001 2003

Source: Bank of England

2 We decided not to use weekly averages, due to statistical problems inherent with temporal aggregation of data, as explained in Mills, T C (1990), Time Series Techniques for Economists, Cambridge: Cambridge University Press, chapter 11.5, and the references contained therein. 3 Detailed information on the notions of contango & backwardation, and how these can affect returns on investments on commodities, see Metals & Backwardation and Investing in commodities: a risky business?, available in the research section of the World Gold Council Website (URL: http://www.gold.org/value/stats/research/index.html)

JANUARY 2006

which could bias the results in either direction. Detailed information of the prices used and the sources used is provided in Appendix 1 at the end of this report.

idea of how the strength of the implied relationship in question might vary under different circumstances. Table 1 below features the list of commodities examined for the purposes of

The differences observed between the two periods seem to indicate that the relationship between commodities and the dollar becomes stronger during times when the latter is weakening. One possible explanation why this could be the case is that during times of dollar weakness investors diversify part of their capital away from dollar-linked assets. This move can benet investments in commodities (and in fact has done so in the past), boosting the negative relationship between the two. Moreover, during the 2002-2004 period, the commodities complex received

Static Correlation Analysis

In this section we evaluate how strong the correlation between log returns in the trade-weighted dollar and the prices of different commodities were over two distinct three-year periods. The rst period examined was the one commencing in July 1995 and ending at end-June 1998, while the second period was the one commencing at the beginning of 2002 and nishing at end-2004. Note that while throughout the former period the dollar trended upwards, it was on a declining trend over the latter. Thus, comparing the results from the two would provide an

this report, along with their correlation coefcients with the trade weighted dollar calculated over the two periods discussed. Looking at the table, a number of interesting points are immediately obvious. First of all, the majority (although for the earlier period a relatively close one) of commodities examined demonstrate

negative correlation with the US dollar. Secondly, the number of commodities negatively correlated with the dollar is larger for the later period. Furthermore, for most commodities examined, this correlation is stronger over the later period that it is in the earlier one.

exceptional attention from the nancial media, which certainly boosted the sectors popularity with investors. The unimpressive performance that equity markets demonstrated over parts of the period was another factor that

Table 1: Static Correlations Analysis

Correlation Coefcient over 07/95 - 06/98 Period -0.07 -0.01 0.10 0.01 -0.03 0.00 -0.09 0.00 -0.06 -0.12 0.05 0.13 -0.21 -0.18 -0.11 -0.08 0.03 -0.18 -0.19 0.01 -0.13 -0.03 Correlation Coefcient Signicant at 5% level* No No No No No No No No No No No No Yes Yes No No No Yes Yes No No No Correlation Coefcient over 01/02 - 12/04 Period -0.17 -0.17 -0.20 -0.15 0.11 0.06 -0.08 -0.20 -0.18 0.01 -0.07 -0.16** -0.01 -0.16 -0.09 -0.12 -0.14 -0.08 -0.51 -0.37 -0.16** -0.01 Correlation Coefcient Signicant at 5% level* Yes Yes Yes No No No No Yes Yes No No No No No No No No No Yes Yes Yes No

certainly gave commodities further relative appeal. The increased investor involvement in the sector resulted in commodity prices being in greater part driven by speculative activity, boosting the strength of the negative correlation of prices with the US dollar, which was declining at the same time for different reasons. Another interesting fact is that the coefcients calculated for the different commodities vary greatly. The majority of them seem too low to indicate a signicant link exists. Performing a statistical test conrms this, and in fact shows that only four commodities coefcients are signicant for the rst period examined, while eight are signicant for the second. A description of the construction and properties of the statistical test used is provided in the technical appendix at the end of this report, while the results are presented in Table 1.

Natural Gas Oil, Light Crude Unleaded Gasoline Heating Oil Live Cattle Lean Hogs Wheat Corn Soybeans Sugar Cotton Coffee Cocoa Aluminium Copper Zinc Nickel Lead Gold Silver Platinum Palladium

*see technical appendix for explanation **Coffee and platinum showing the same correlation coefcient but only one being signicant is due to rounding to two decimal places. The coefcient for coffee is in fact 0.155, while that for platinum 0.160.

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The commodities that demonstrated signicant correlation with the dollar over the rst period were cocoa, gold, aluminium and lead. Over the second period, they were gold, silver, unleaded gasoline, corn, soybeans, crude oil natural gas and platinum. Interestingly, none of the coefcients that were found to be signicant were positive, in accordance to our expectations (basis the conjecture that, if anything, commodities are expected to be negatively correlated with the dollar). At -0.51, the correlation coefcient calculated between gold and the dollar for the latter period dwarfs all the other statistics we calculated for this section. The second strongest link in the list, the one with silver, is signicantly weaker, the correlation coefcient being -0.37. All other coefcients we calculated stood at -0.21 or lower (in absolute terms). It is worth a mention, furthermore, that gold was the only commodity with a signicant correlation coefcient over both periods examined. It would thus seem to be the case that, basis the sample examined, gold is a better hedge against the dollar than other commodities. This comes as no surprise, as the yellow metal has always been considered to have an inverse relationship with the greenback . This relationship is to a large extent self-fuelled, due to investors trading on the back of it. Moreover, the correlation coefcient
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w w w. g o l d . o rg

tion of silver, which is discussed later in this report). This fact is in accordance with a known practice in the investment world, that of the ight to quality. The term refers to the action of investors moving their capital away from riskier or more volatile assets and into ones considered to be safer and less volatile. The move tends to take place during times of uncertainty in the nancial markets and world economy, and reects some

that their ability to provide a hedge against changes in the US dollar is very limited compared to gold and, to an extent, silver. We nally repeated the exercise using the three leading commodity indices, Goldman Sachs Commodity Index, CRB Index (the spot index related to the Reuters/Jefferies CRB Total Return Index) and Dow-Jones AIG Commodity Index. The results are presented in Table 2 below, and come as no surprise given our previous ndings (namely that gold and silver were the most strongly correlated commodities from the group, and that over the second period the links between commodities and the dollar were much stronger). As expected, over the rst period, logreturns in all three indices demonstrated very weak and statistically insignicant negative correlation to log-returns in the greenback, while over the second period, the gures were higher (in absolute terms). Looking at the differences between the coefcients and focusing on the 2002-2004 period, the AIG is the index with the strongest negative correlation to the dollar, while the CRB the one with the lowest. Again, this is not surprising, as the AIG is the index with the highest weighting in gold and

investors risk aversion. The second highest (in absolute terms) correlation coefcient calculated was the one between silver and the dollar over the 2002-2004 period. It is our understanding that the link between the two is indirect and primarily stems from the relationship between gold and silver prices, which GFMS have documented in past publications . This point is discussed further in later sections of this report. Having examined changes in the prices of the two metals, we have concluded that these show signicant positive correlation. As mentioned previously, the remaining six commodities with signicant correlation coefcients showed much weaker links to the US currency. Furthermore, none of the six were signicant over both periods examined. We can thus deduce
5

Table 2: Static Correlations Analysis Commodity Indices

Correlation Coefcient over 07/95 - 06/98 Period -0.05 -0.06 -0.11 Correlation Coefcient Signicant at 5% level* No No No Correlation Coefcient over 01/02 - 12/04 Period -0.21 -0.26 -0.15 Correlation Coefcient Signicant at 5% level* Yes Yes No

between the yellow metal and the dollar over the rst period examined is a mere 0.19. The difference between the coefcients calculated over the two periods is thus more pronounced for gold than for the other commodities (with the excep4

GSCI AIG CRB Spot

*see technical appendix for explanation

For example, see Gold as a Hedge against the US Dollar by Forrest Capie, Terence C. Mills and Geoffrey Wood, available in the research section of the World Gold Council Website (URL: http://www.gold.org/value/stats/research/index.html) 5 For example, World Silver Survey 2005, Chapter 2

JANUARY 2006

silver and the CRB contains neither of the two metals .

6

log-returns on the prices of each of the commodities and the trade weighted dollar, we looked at the averages over

Nevertheless, the principal ndings of the static analysis were in line with the ones from this exercise. More specically, the rolling averages indicated that gold is the commodity that demonstrates the

Rolling Correlation Analysis

In this section, we look at how the 52week rolling correlation coefcients

the last two years of the two periods examined above and performed the test we used in the previous section to establish whether these were signicant. The results are presented in Table 3 below. Interestingly, many of the commodities that had demonstrated signicant correlation with the dollar under the static analysis failed to do so when using this approach. In fact, only gold and silver were signicant, and only for the second period discussed.
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strongest link to the dollar, with silver being the second best. Furthermore, the averages calculated over the 2003-2004 period for these two commodities were markedly higher (in absolute terms) than the ones over the earlier period. More specically, the average 52-week correlation coefcient between gold and the trade weighted dollar stood at -0.21 over the earlier period and at -0.56 over the more recent one. The

evolved for each the commodities under examination, over the same two periods discussed in the static correlation analysis section above (an explanation of what is meant by 52-week rolling correlation coefcients is provided in the technical appendix at the end of this report). Having compiled a series of 52-week rolling correlation coefcients between

Table 3: Rolling Correlations Analysis Period Averages of 52Week Coefficients

Correlation Coefcient over 07/96 - 06/98 Period -0.12 -0.01 0.13 0.03 0.00 -0.02 -0.07 0.06 -0.04 -0.03 -0.04 0.16 -0.22 -0.21 -0.14 -0.07 0.04 -0.21 -0.21 -0.02 -0.14 -0.07 Correlation Coefcient Signicant at 5% level* No No No No No No No No No No No No No No No No No No No No No No Correlation Coefcient over 01/03 - 12/04 Period -0.14 -0.17 -0.19 -0.14 0.19 0.04 -0.08 -0.19 -0.18 0.08 -0.02 -0.14 0.02 -0.16 -0.02 -0.12 -0.10 -0.06 -0.56 -0.38 -0.12 0.00 Correlation Coefcient Signicant at 5% level* No No No No No No No No No No No No No No No No No No Yes Yes No No

respective averages for silver were 0.02 and -0.38. Figures 2 and 3 provide an illustration of the daily evolution of the rolling correlation coefcient between the trade weighted dollar and gold as well as silver over the 1995-2004 period (thus including both subsets discussed above). Two interesting obvious: First of all, there is a clear upward trend in the strength of the implied relationship between the dollar and each of the two commodities, over the period from the turn of the millennium through to the end of 2004. Secondly, over much of the nine-year period examined, the rolling coefcients for the two commodities seem to have moved in a similar manner. This is mainly due to the fact that, as we mentioned in the previous section, there is a strong positive correlation between gold and facts are immediately

Natural Gas Oil, Light Crude Unleaded Gasoline Heating Oil Live Cattle Lean Hogs Wheat Corn Soybeans Sugar Cotton Coffee Cocoa Aluminium Copper Zinc Nickel Lead Gold Silver Platinum Palladium

*see technical appendix for explanation

For information on the weightings of individual commodities in each of the indices, see Indices Enticing Investors, available in the research section of the World Gold Council Website (URL: http://www.gold.org/value/stats/research/index.html) 7 We decided to average the 52-week rolling correlations over the July 1996 June 1998 and January 2003 December 2004 periods, so that overall, all and no more than the weekly observations used in our initial samples (July 1995 June 1998 and January 2002 December 2004) are used in the analysis. This way, when comparing the results of the two analyses we can be certain that the same amount of information is used, and that only the methodology changes.

gold:report
silver prices (the rolling correlation
Figure 2: Gold Rolling 52-Week Correlation Coefficients

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coefcient averaged 0.58 over the 19952004 period). This evidence provides some empirical support to our understanding that the link between silver and the US dollar is by and large driven by the one between the white metal and gold. The remaining commodities that were signicantly correlated to the dollar had average coefcients of -0.22 or less (always in absolute terms). Furthermore, similarly to the case under the static analysis, gold was the only one from the group with a signicant average for both periods we looked into. The conclusions we can draw from this exercise are thus similar to the ones we saw under static analysis. Firstly, gold is by far the most relevant commodity in hedging against the US dollar. Secondly, it becomes particularly relevant during times of dollar weakness. We nally looked at the rolling correlations between the three spot indices and the trade weighted dollar. Figure 4 provides an illustration of these correlations over the 1995-2004 period. Again the conclusions are essentially identical to those drawn from the previous section, the correlations between the AIG index and the dollar being stronger than the ones between either of the other two indices and the US currency. It is worth noting that, despite average correlations for the two periods in question being unimpressive for the other commodities, there were shorter periods over which some of them were more than adequately correlated to the greenback. Nevertheless, we believe this evidence to be circumstantial, and driven by specic conditions that prevailed in the relevant markets at certain times.
52-Week Correlation Coefficient

0.2 0.1

52-Week Correlation Coefficient

0.0 -0.1 -0.2 -0.3 -0.4 -0.5 -0.6 -0.7 -0.8 -0.9 1995 1997 1999 2001 2003

Figure 3: Silver Rolling 52-Week Correlation Coefficients

0.2

52-Week Correlation Coefficient

0.1 -0.0 -0.1 -0.2 -0.3 -0.4 -0.5 -0.6 1995 1997 1999 2001 2003

Figure 4: Commodity Indices Rolling 52-Week Correlation Coefficients

0.3 AIG 0.2 0.1 0.0 -0.1 -0.2 -0.3 -0.4 -0.5 -0.6 1995 1997 1999

GSCI CRB

2001

2003

JANUARY 2006

The Theoretical Case for Gold Providing a Hedge Against the US Dollar
Having established the statistical case for gold being superior to other commodities as a hedge against the dollar, it is interesting to examine the theoretical properties behind this attribute the metal seems to possess. What are the reasons gold is a suitable instrument for hedging against the US dollar, and more specically, what are the reasons it is a more suitable instrument in this regard, compared to other commodities? First of all, like all physical commodities, gold is an asset that bears no credit risk. Holding assets in the metal involves no counterparty and is no ones liability. This of course does not apply to investments in paper gold products, which by denition involve an issuing institution. In addition to that, the physical properties of the metal make it an excellent alterna-

tive to money. Gold is durable. Unlike many of the other commodities examined, other things remaining equal (i.e. assuming no changes in price), there is no depreciation in the value of gold, other than any storage costs that might apply. Gold is fungible. It is, at least in theory, innitely divisible with virtually no losses (other than any operational costs the process might incur). Furthermore, gold has a high value to volume ratio, which makes it easily transferable, with low transport and storage costs. Moreover, gold is one of the deepest commodity markets with the highest liquidity. At end-2004, above ground stocks of gold, dened as cumulative mine production, stood at roughly 153,000 tonnes (source: GFMS, Gold Survey 2005), translating to over $2.1 trillion (using the end-2004 gold price). As a point of reference, the equivalent gure for silver, the second most strongly correlated com-

modity to the dollar according to our analysis above, is less than $0.2 trillion. This liquidity of the gold market conveys nancial characteristics on the metal, thus making it a suitable alternative to at money. The most important such property

though, is golds legacy as a monetary commodity, and the fact that investors treat and trade it as one. For a great part of human history, large parts of the world accepted the metal as the ultimate store of value. In fact, it was not until the 1970s that gold stopped being the benchmark for the international currency market. After the move to a system of oating at currencies, and currency and ination risk developed, so did the need to hedge against this risk, using some sort of hard, value-retaining asset. The natural choice for this was and has been the commodity that had in the past acted as such, namely gold.

www.gfms.co.uk info@gfms.co.uk GFMS is the worlds foremost precious metals consultancy, specialising in Products & Services include: Publications, Consultancy Services, Price Forecasts, Seminars. as ofcial sector activity research. He is also responsible for developing econometric modeling, which is currently focused on future gold and silver prices.

research into the global gold, silver, platinum and palladium markets. GFMS is based in London, UK, but has representation in Australia, India, China, Spain, Germany and Russia, and a vast range of contacts and associates across the world.

Nikos Kavalis Metals Analyst, GFMS Limited

Nikos Kavalis joined GFMS on 1st September 2003. He is primarily assisting Philip Klapwik in investment as well

Nikos holds a rst degree in Econometrics and Economics from the University of York, and a MSc in Econometrics and Mathematical Economics from the

London School of Economics.

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Appendix 1: The Data
The list of commodities examined in the report, as well as the price used as a benchmark for each of these can be seen in the table below. Note that all prices used were denominated in US dollars. The source used to retrieve the
Commodity Natural Gas Oil, Light Crude Unleaded Gasoline Heating Oil Live Cattle Lean Hogs Wheat Corn Soybeans Sugar Cotton Coffee Cocoa Aluminium Copper Zinc Nickel Lead Gold Silver Platinum Palladium

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series was the EcoWin database, and where data was unavailable, the previous or most recent observation was used. As an indicator of US dollar performance, the Bank of England Effective Exchange Rate Index was used.

Price Used Henry Hub, Spot, Close Spot (WTI), Nymex New York, Spot, Close No.2, New York, Spot, Close Futures 1-Pos, CME, Close Futures 1-pos, CME, Close Futures 1-Pos, CBT, Close Futures 1-Pos, CBT, Close Futures 1-Pos, CBT, Close NYBOT World No. 11 Futures 1-Pos, Close No. 2 Futures 1-Pos, NYBOT, Close Arabica C Futures 1-Pos, NYBOT, Close Futures 1-Pos, NYBOT, Close Spot, LME, Close Spot, LME, Close Spot, LME, Close Spot, LME, Close Spot, LME, Close LBMA London PM, Fixing LBMA London, Fixing LPPM London PM, Fixing LPPM London PM, Fixing

JANUARY 2006

Appendix 2: Technical Appendix

N.B. The algebraic expressions below are provided as a reference and are not essential to understanding the rest of this report and appendices. show very strong correlation and are not directly related to one another. This could be due to the same (or similar) exogenous factors driving both variables, the two series being non-stationary or pure
1

The formula of the correlation coefcient is the following:

(1)

i. Notes on Correlation
The notion of correlation between two variables refers to the way in which either of the two moves in relation to the other. In the case of positive correlation, both variables tend to move in the same direction (when one variable increases, so does the other), while in the case of negative correlation they tend to move in opposite directions (when one variable increases, the other decreases). Further to the question of whether correlation exists between two variables is the question of how strong this correlation is. This idea of strength refers to the consistency in the way in which changes in one variable relate to changes in the other. The more consistent the link, the

chance. Having discussed the notion of correlation between two variables, the question of how to measure such a property immediately arises. The correlation coefcient, known also as the Pearson Product-Moment Correlation Coefcient, is a number that summarises the

where N is the sample size, x and y are deviation scores:

(2)

X and Y are sample means:

(3)

direction (positive or negative) and degree (i.e. strength or closeness) of linear relations between two variables. This can take values from 1 through 0 to 1. In accordance to intuition, a positive correlation coefcient indicates the two series are positively correlated and vice versa. Furthermore, the higher the (5) Combining (1), (2), (3) and (4) above: (4) SX and SY are sample standard deviations:

absolute value of the coefcient, the more strongly the two series are said to be correlated (the extreme case of perfect correlation being an absolute value of 1). It is important to distinguish here

stronger we say the correlation between the two variables is. A different way to dene this is by looking at the ratio between absolute changes in the two variables. The more consistent this ratio is across the population (or sample), the stronger the correlation between the two variables. It is important to note here that, when discussing the idea of correlations, it is customary to assume a linear relationship between the two series. Furthermore, it is essential to understand that the idea of correlation only refers to how two series move in relation to one another and is by no means indicative of any causal relationship between them. Indeed there are many examples of variable pairs that
1

Finally, the distinction between static and rolling correlation coefcients should be made. The former refers to the correlation coefcient calculated over a certain period, while the latter covers a series of correlation coefcients, each calculated over a sub-sample of a certain length (in the case of this report, this sample length was one year or 52 weeks), ending on each of the observations under examination. For example, in the Static Correlation Analysis section we look at the correlation coefcients of log-returns in weekly prices over two set periods, while in the Rolling Correlation Analysis section, using the same two sub-samples, we

between population correlation coefcients (normally denoted describe the theoretical ), which correlation

across the whole spectrum of values two variables can take, and sample correlation coefcients (normally denoted r), which provides an empirical measure of the correlation between two variables, basis a specic sample of values under examination. As it involves analysis of given periods of data, our analysis and discussion of results throughout this paper is, by denition, strictly limited to the latter measure.

For more on non-stationary variables see James D. Hamilton, 1994, Time Series Analysis, Princeton University Press, Chapters 15-20

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generate two series of correlation coefcients, each calculated over a 52week period. In order to demonstrate the reasons for using this approach, we can examine an extreme case, for which the difference in results using the two different approaches

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coefcient is a mere -0.08, while when using absolute returns, it is undened (as changes in Series 1 are xed at 1 across the sample, and the correlation coefcient is meaningless if there is no variation in the data). Further to deciding to examine the correlation in returns in our analysis of commodities and the US dollar, we decided to use log-returns. The log-return

ii. Notes on the use of Log-Returns

As mentioned in the Methodology & Data section earlier in the report, in order to avoid generating spurious results, we decided to look at the correlation between changes rather than levels of weekly prices. The theoretical case

(levels and differences) is particularly pronounced. Consider the following series: A simple look at the data is sufcient to decide that the two series show essentially no link to one another. Using expression (5) above though generates an impressive correlation

between two observations Xt and X(t-1) of variable x, at time t and (t+1) is dened as:

coefcient of 0.87, which indicates a very high correlation exists between the

Series 1 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Series 2 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100

two series. Taken at face value, such a result provides a very misleading picture, implying that the two variables move consistently in relation to each other (despite this clearly not being the case). Looking at the same two series, and repeating the exercise using changes in the two series rather than levels generates radically different results. When looking at percentage or log-returns (more on that below), the correlation One of the main differences between the two lies in the formula used to compound simple and log returns. More specically, This approach is an alternative to using simple returns (or percentage returns), dened as:

whereas,

iii. Notes on testing of the correlation coefficient

In order to test the null hypothesis that the sample correlation coefcients estimated are zero, against the two-sided alternative that they are not, we used the following test statistic: cient between the two variables x and y, and N the size of the sample used. The above statistic follows a t-distribution, with N-2 degrees of freedom. To examine whether each of the correlation coefcients are signicant or not, we

behind this argument is discussed in much of the literature on non-stationary time series .
2

simply generated the above statistic and compared it to the relevant value of the Where rxy is the sample correlation coeft-distribution.

for example, William H. Greene, Econometric Analysis, Fifth Edition, 2003, Prentice, Hall, p. 631-636

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Appendix 3: Reference Charts Indexed Price Charts

Indexed Prices 500 Natural Gas Index: 5th Jan 1994 = 100 400 Wheat Aluminium 300 Index: 5th Jan 1994 = 100 Live Cattle Indexed Prices 400 350 300 250 200 150 100 50 0 1994 1996 1998 2000 2002 2004 0 1994 1996 1998 2000 2002 2004 Oil Lean Hogs Corn Copper

200

100

Indexed Prices 350 Unleaded Gasoline 300 Index: 5th Jan 1994 = 100 250 200 150 100 50 0 1994 1996 1998 2000 2002 2004 Sugar Gold Index: 5th Jan 1994 = 100 Soybeans

Indexed Prices 350 Heating Oil 300 250 200 150 100 50 0 1994 1996 1998 2000 2002 2004 Cotton Zinc Silver

Indexed Prices 500 Coffee Platinum Index: 5th Jan 1994 = 100 400 Index: 5th Jan 1994 = 100 Nickel

Indexed Prices 1000 Cocoa Palladium 800 Lead

300

600

200

400

100

200

0 1994 1996 1998 2000 2002 2004

0 1994 1996 1998 2000 2002 2004

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Disclaimer
This report is published by the World Gold Council (WGC), 55 Old Broad Street, London EC2M 1RX, United

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Kingdom. Copyright 2006. All rights reserved. This report is the property of WGC and is protected by U.S. and international laws of copyright, trademark and other intellectual property laws. This report is provided solely for general information and educational purposes. The information in this report is based upon information generally available to the public from sources believed to be reliable. WGC does not undertake to update or advise of changes to the information in this report. Expression of opinion are those of the author and are subject to change without notice. The information in this report is provided as an as is basis. WGC makes no express or implied representation or warranty of any kind concerning the information in this report, including, without limitation, (i) any representation or warranty of merchantability or tness for a particular purpose or use, or (ii) any representation or warranty as to accuracy,

prospective investors should seek advice from their nancial advisers, take into account their individual nancial needs and circumstances and carefully consider the risks associated with such investment decision.

info@gold.org. This report is not, and should not be construed as, an offer to buy or sell, or as a solicitation of an offer to buy or sell, gold,

JANUARY 2006

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