Beyond the glitter: An empirical assessment of the true risk and hedging role of precious metals

Abstract

Precious metals are an essential component of asset class within the global financial market offering diverse benefits. Being significant store of value, they are immune to default risk, provide hedge against inflation and are deemed to be safe haven. This highlights the importance of precious metals in the broader context of financial and economic stability. This paper focuses on the S&P Precious Metal Index (PMI) to explore its resilience towards financial market risks and examines if it could offer effective hedge during crises. Using Markov Regime Switching model, we find significant volatility persistence in PMI returns undermining its suitability for dynamic hedging. However, absence of speculative trends makes the PMI a safe asset. Further, financial market stress, as revealed by estimated Component GARCH and Discrete Threshold Models, does not affect the unique and market risk of investing in PMI. Although we could not establish PMI as a strong safe haven or a zero-beta asset, its potential to be included in a risk-avert investor's portfolio cannot be negated. Its consistently low and stress-invariant time-varying beta safeguards wealth against losses. The role of PMI becomes particularly salient while considering portfolio optimization during crises. In recent years, particularly during and after the pandemic the hedging effectiveness of PMI has increased. There is, however, a point of concern. The market risk of PMI is explained mostly by its lagged values rather than exogenous factors like market stress. Given the endogenous nature of market risks, chaotic dynamics might be in operation making forecasting and regulating PMI prices difficult.