Abstract:

In this paper, new implied volatility indexes are used to investigate directional
connectedness between precious metals such as gold, silver and currencies like US
dollar/Euro. We found that the gold is least volatile variable and used as a safe
heaven asset. The investors decision on how to invest during periods of low vs.
highly volatile regimes require thorough understanding of dynamics in commodity
pricing. Dynamic and directional characterization of relationships among various
financial variables are proposed by Diebold & Yilmaz (2012, 2014, 2015). Therefore,
inferences on the directional implied volatility between precious metals like gold,
silver and currencies like US dollar, Euro is determined by the same model. It is
observed that results across various sample countries indicating connectedness
between precious metals and currencies is established by the bi-directional spillover
information. We observed that precious metals provide a useful and effective
means of diversifying a portfolio. The trick to achieving success with them is to
know goals and risk profile before jumping in. The volatility in metals can be
harnessed to accumulate wealth but may also ruin if left unchecked. The
transmission pattern is varying over a period, most linkages between metals and
currencies are established from mid-2009 to mid-2012 which is a period that
witnessed the start of global recovery.
Introduction:
The relationship between the precious metals and currencies is always found to be
interesting. Previous studies focused on the relationship between metals and
currencies volatility during the period of global crisis. Majority of these studies are
based on the statistical model volatilities not on the price model volatilities. In this
paper, connectedness between the metals implied volatility and currencies are
examined in two major currencies. This has not been done earlier in metalscurrencies to the best of our knowledge. Post financial crisis of 2008 precious metals
received a special attention as an alternative investment in addition to oil. Until the
collapse of the Bretton Woods system, Gold has been treated as a store of value and
medium of exchange. Post Bretton Woods world also gold was held by government
and investors as a part of their reserves. It acts effective inflation hedge due to
belief in the inherent monetary value. Almost same is the case of silver, it is also
considered to be the store of value and medium of exchange, recently extensive
usage of silver in various pharmacy products has raised its demand. Investors
started to buy and hold platinum as an alternative which led to price co-movement
in these metals.
India is the worlds largest importer of gold. In 2010, India imported 92% of its gold
consumption and rest is met through recycling. Gold imports are third overall and
lag only behind oil and capital goods. Exchange rate is effected by huge import of
gold. In addition to extensive usage of gold and silver as jewelry, they find
application in industries like automotive and chemical industries. These industries
also use oil to derive various petrochemical products resulting in having relationship
among commodities.
Oil is used as a source of energy, most of countries in the world are net importers of
oil which is traded mostly in US dollars. Imports of oil denominated in US dollars
forms major part of imports for many countries and has implications on the foreign
exchange rate. Economic theory successfully explained the links between these

commodity and exchange rate markets. For economies importing majority of oil
consumptions (such as India), increase in international oil prices can lead to inflation
and exchange rate shocks. In such situations, Investors look at precious metals to
hedge their portfolios against inflation and currency risk. These precious metals are
considered to be an alternative of international reserve currency. Fulfilling demand
of these metals through imports has an effect on exchange rate and vice-versa.
Regular usage of oil and precious metals in industries like automobiles and
petrochemicals force co-movement in the prices of these commodities. Causal
linkages were not explained by any of the theories. For example, whether exchange
rate variations cause change in prices of locally traded precious metals or increase
in imports due to demand of these metals lead to change in exchange rate is still
open. Pindyck and Rotemberg (1990) in their studies analyzed seven unrelated
commodities and found the presence of unexplained excess co-movement. Shafiee
and Topal (2010) presented evidence for the linkages between gold prices, oil prices
and inflation with the results indicating stable range for the ratio of gold and oil
prices over a long period. Commodities have informational content in predicting the
direction of inflation, interest rate and industrial production by Awokuse and Yang
(2003).
Silver and Gold were considered to be international currencies of trade and the ratio
between the two metals was 16 to 1. Governments might have changes, but either
of these two metals buried in the back yard, preserved your wealth. The odd thing
of government currencies is that they start out strong and then end up debased
because different metal is substituted for silver and gold with the implied value.
In 1964 the US mint took silver out of coins, it costs more to buy silver than the coin
worth to produce. The present US government can print all of the dollars they
wanted, and the price of gold and silver will tend to reflect in rise in value. The
apparent rise in the value of precious metals can be attributed to two things i.e.
demand and supply (no. of people wanting it) but this is not so. The world population
doubled in last 50 years.

Accuracy of implied
volatilities of latent
process is more than ARCH
models or realized
volatilities. Volatilities are
forward looking and
represent the markets
consensus on the expected
future uncertainty as they
are derived from market
option prices. Information
about the implied volatility
linkages about the relation
between market
participants expectations
of future uncertainty
provide insights of building
accurate equity and option
valuation models and
improves forecasts of cross
market volatility. Options
were priced with higher
volatilities with high fear
and vice- versa. Implied volatility analysis tracks the investors sentiment, inferred
volatility connectedness reflects fear connectedness. Since beginning of the twentyfirst century the reasons behind the significant increase in cross-border financial
activity in the euro area are regulatory convergence and the elimination of currency
risk. Though cross border banking benefits risk diversification in business portfolios,
it has drawbacks like foreign capital is likely to be much more mobile than domestic
capital, foreign banks may cut and run during crisis, moreover financial or sovereign
crises in a country can quickly spill over into other countries in an integrated
banking system.
Main reason for financial support to Greece in May 2010 was the fear of contagion
because of sudden loss of confidence among investors whose attention was
directed towards macroeconomic and fiscal imbalances within EMU countries and
high exposure of several European Union banks to Greece. The cost of new loans
and a credit contraction increased due to tensions in EMU sovereign bond markets.
Safe haven status resulted in increase of demand for German bund from late 2009.
All these actions emerged few questions among economists, policy makers and
practitioners to address What extent was the sovereign risk premium increase in the
euro area during debt crisis due only to deteriorated debt sustainability in member
countries? What is the role of degree of connectedness?
Since fundamentals of different countries interconnected by their cross border flows
of goods, services and capital or common shocks affecting economies and
transmission between countries. These effects are known in the literature as
Spillovers, interdependence or fundamentals-based contagion. The shift in

market sentiment, change in interpretation given to existing information or trigger

herding behavior known as pure contagion in literature.
When an exchange rate agreement is shared across group of countries, it is
reasonable that the economic fundamentals of euro area countries are inter
connected by their cross border flow of goods, services and capital, other variables
beyond deteriorated debt sustainability might also be at the origin of financial stress
transmission. Transmission and contagion between sovereigns in the euro area
context were studied using correlational based methods, conditional value at risk
and granger causality approach.
In this paper we will make use of Diebold and Yilmaz measures of connectedness
framework which is closely linked with both modern network theory and modern
measures of systematic risk for defining, measuring, and monitoring connectedness
in financial and related macroeconomic environments.
Favern proposed an extension to Global Vector Autoregressive(GVAR) models to
capture time varying interdependence between EMU sovereign yield spreads.
This paper gives a methodological contribution, and empirical insights into
assessment of financial stress transmission. This information helps in understanding
yield development over time and provide a barometer for vulnerability. The
connectedness measure will allow to sidestep the issues associated with the
definition and existence of episodes of fundamental based or pure contagion, it
is a bridge between these two visions.