[Paper Review] The Price of Gold: A Global Required Yield Theory

 

 I found very interesting paper(http://papers.ssrn.com/sol3/papers.cfm?abstract_id=520382) introducing gold valuation theory. The authors introduce simple but powerful assumption - accepting gold as a global real store of wealth. Based on simple assumption and math, authors successfully derive valuation equation for gold which works fine.

 

 

Their test results were up to 2002, so I will update this post as soon as running a backtest in near future. 

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 They tested their theory from 1972 ~ 2002, and test results were quite astonishing. From their local gold prices and foreign exchange effects, mean percentage tracking error were 12%. As shown in [Figure 1]

 

 [Figure 1. Gold Price($) vs RYT model using quarterly inflation expectations]

Since there were one variable in their RYT model, they showed return based model which could minimize impact from estimating variable.

[Figure 2. Gold return estimation using quarterly data]

 

 

 
In conclusion, their formula explains key factor valuing gold price - growth/exchange rate, and inflation. I think authors' view of gold as a global real store of wealth makes gold a very attractive investing subject - an essential ingredient in asset allocation with multi assets. Even gold itself did not and will not have future value(cash) stream or earnings(equities have stream of dividends, bonds have stream have coupon), Real Yield Theory says that gold should provide a stream of services by maintaining real purchasing power over time.

 

 Gold price is proportional to change in domestic GDP/capita growth, domestic inflation, exchange rates and relative GDP weights.