Delta Global Partners Research: The Cutting Edge

Title: The Tail Risks and Gold

Region: Global Date: 20th September 2010 No of Pages: 3 www.dgp.co.in

Gold prices in international markets have been on the ascend in recent times. The news of
AngloGold Ashanti, world’s 3nd largest gold miner was to cover its $1.4 bn production hedges (
forward sales) and a likely fresh round of quantitative easing in USA pushed the Gold prices to a
new all time high of USD 1,276/oz, ignoring the “bubble” call made by George Soros. Gold has
returned almost 27% in last one year thus gaining positively in every of the last 10 years. The
financial (ETFs) & investment demand (bars/coins) as a safe haven in an uncertain economic
environment rather than jewelry demand is now driving the gold prices. Global gold based ETFs
hold around 2,000 tonnes of Gold. In Q2 of 2010, ETFs accounted for 28% of the global demand
for Gold. The anticipated festive/wedding demand in India as well as restocking by jewelers for
the Christmas/New Year sales in US and Europe is also helping the gold to rally. China’s
upcoming National Holiday week is also likely to add to the demand.

Gold is in a “Sweet Spot” now. The world now has started worrying about the “Tail Risks” in the
global economies - Deflation v/s Inflation, Double Dip v/s Strong V shape above trend
Recovery-in USA and developed economies, Gold due to its unique characteristics makes it a
good hedge to these Tail Risks. But first, some basics-What are Tail Risks?

“Tail Risks” are events with exceptionally low probability of occurrences, which lead to either
extreme downside (losses) or large upside in the returns from an investment. These are extreme
events which are unexpected or fall to far right or left of the normal distribution (frequency)
curve of the normal events (mean). In theory, 99.7% of all the expected events are likely to fall
within the + or – 3 standard deviations times the mean or normal event (Chart I).
Chart I: The Tail Risks and Sweet Spot of GOLD

Increasing “LEFT “Tail Risks Normal Risks Increasing “RIGHT” Tail Risks

Developed Markets Some of the EM Cutting Edge

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are here Markets are here

Left Right
Tail Tail

Severe Deflation Neutral/Trend Level of Inflation Higher Inflation

Gold will perform as paper Gold will be driven

currencies get debased & deficits
rise and real interest rates fall.
Gold enjoys the safe haven
demand.
Gold will perform being a
more by physical
“real asset” and thus an
or real demand
inflation hedge
Source: Delta Global Partners Research

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Delta Global Partners Research: The Cutting Edge
Title: The Tail Risks and Gold

Region: Global Date: 20th September 2010 No of Pages: 3 www.dgp.co.in

If we apply the same theory to frequency or distribution of investment returns, the Tail Risks are
the returns that may fall beyond the + or – 3 standard deviation times of the mean return.
That’s-Very High Profits (Right Tail Risk) or Very High Losses (Left Tail Risk), with very low
probability (100%-99.7%=0.03%) of the same occurring. Though the right tail risk may for
sometime be welcomed, the left tail risk of extreme downside is most avoidable and needs to be
hedged. That’s what precisely makes the cost of insuring against the left tail risk is much higher
than cost of a normal or expected event.

Getting back to Gold-Different factors or a combination of them at different times drive the Gold
prices higher or lower. The function or role of Gold keeps on shifting at times. And this precisely
is the reason for breakdown of the historical short term co relation of Gold with other asset
classes or macro variables. So Gold wears a different “Hat” depending on the prevailing
“Economic Weather” in the world. Broadly Gold functions either as a “Commodity” or as
“Monetary Unit (currency)” or as a “Financial Asset” (Table I).

Table I: GOLD – A all weather HAT
The “Hats” The “Roles” The “Weathers”
Currency/Monetary Unit Hedge Currency Depreciation/Debasement
Currency/Monetary Unit Safe Haven Uncertainty & Financial Crisis
Commodity Store of Value Rising Inflation
Commodity Physical/Industrial Use For Jewelery/Dentistry/Electronics
Financial Asset Insurance/Diversification Investment Portfolio Returns
Source: Delta Global Partners Research

Let’s come back to the prevailing economic scenario or rather the uncertainty of it. The world is
worried on a severe deflation in US, similar to Japan. That’s our “Left Tail Risk”, which is
characterized by sustained fall in general level of prices in the economy due to lack of demand or
credit. Low or Zero interest rates, rising unemployment and steep fall in prices of risky assets
such as stocks or commodities are some of the outcomes of deflation.

As against this, Inflation is a rise in general price levels in an economy due to excessive demand
vis a vis supply or higher money supply. When higher inflation is demand driven, especially

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accompanied by higher credit growth, interest rates rise, unemployment is lower, risky assets
such as stocks and commodities do well. As excessive deflation is a Left Tail Risk, an abnormally
higher inflation is a “Right Tail Risk” since its own adverse economic consequences.

So a severe deflation and abnormally higher inflation vis a vis the trend-both are the “Tail Risks”
for which an investor doesn’t generally plan or budget for in a normal scenario. If we use the
normal distribution curve of inflation, with mean as the long term trend or neutral level of Delta Global Partners Research: The
inflation, it will look like the one in Chart I above. The two tails risks are the ones which are the
most dreaded now, specially the severe deflation one-Left Tail Risk is of immediate concern.

Since the positive relationship of price performance of Gold with higher inflation is well
established, we can easily conclude that Gold being a real asset will do well to hedge this Right
Tail Risk. In near term, higher economic slack would prevent inflation from rising. We can now
try and evaluate the role of Gold as a hedge in a Severe Deflationary scenario-The Left Tail Risk,
since the left side of the curve will determine the probability of extreme downside to the returns.

Severe Deflation is usually associated with economic or policy uncertainty, risk aversion, very
low real interest rates, currency debasing and higher budget deficits (to stimulate the economy)
probably financed by printing more and more money. All these factors are positive for Gold
prices thus threatening the traditional role of it as only an inflation hedge.

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Delta Global Partners Research: The Cutting Edge
Title: The Tail Risks and Gold

Region: Global Date: 20th September 2010 No of Pages: 3 www.dgp.co.in

To conclude, Gold is right now in a “Sweet Spot” since its ability to wear different hats, will make
it as an efficient hedge for the Tail Risks on either side of the curve in any of the unexpected
extreme “Economic Weathers”- A Severe Deflation or a Runaway Inflation. So hold on to
GOLD.

Devendra Nevgi Delta Global Partners

deven@dgp.co.in Founder & Principal Partner
Tel: + 91 9867 277 977
IMPORTANT DISCLAIMER:

The note and the suggestions are for information purposes only and not to solicit any business or give any recommendation. Delta
Global Partners do not take any responsibility of the losses that may arise out of actions taken based on the note. The figures and
charts are not authenticated by any authority. Please make an independent review before taking any decision. Delta Global Partners
does not intend to act as a portfolio manager or investment advisor registered with SEBI or under any other law. The author of the
note may or may not have exposure to the strategies suggested, if any.

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