Investors of all kinds have always been lured by the king of metals, and even the most hardnosed of them know it holds extra value for those who adorn themselves with it. Wharton finance and economics professor Urban Jermann has devised a new approach to capture that extra value in gold jewelry, allowing investors a better way to price gold.

“Because gold is used as an investment asset, it is believed to be worth more than its fundamental value as jewelry or as productive input. But how much more?” Jermann wrote in his research paper titled “Gold’s Value as an Investment.”

The true value of gold as an investment asset is an especially weighty question now with the Federal Reserve poised to raise interest rates from historically low levels to 1% or more over the course of this year. Higher interest rates would mean that “gold prices are not going to do well,” said Jermann.

“Gold is attractive as a store of value in times of low and negative real interest rates,” Jermann noted. “When interest rates go up again, the price of gold declines again. However, this is not the whole story.”

“Think about gold jewelry as something that people enjoy,” Jermann continued. “They get a service flow or a utility flow out of it.” That attribute makes gold a productive asset, where “it’s producing that enjoyment from decoration,” he added.

“What my model captures is that if interest rates rise, gold prices fall, but they will stop [falling] at some point.”  –Urban Jermann

That extra value of gold as jewelry ensures that unlike with stocks or bonds, it has a “floor price” beyond which it will not fall, Jermann explained. For instance, bond prices fall when interest rates rise and vice versa. But gold has an “option value” that investors could predict using a model he sets out in the paper.

“What my model captures is that if interest rates rise, gold prices fall, but they will stop [falling] at some point,” Jermann said. “At some point, people that like jewelry will buy the gold. They basically provide you as an investor some insurance. As interest rates rise, gold prices respond less to them because gold becomes less of an investment asset and more of a consumption good,” he added.

“That means that gold will never be worth zero,” Jermann continued. “These people [who want gold jewelry] will buy it, and if it’s cheap enough, they will buy more. As an investor, it gives you a floor and that keeps the price higher than what it would otherwise be.” As he noted in his paper: “From investors’ perspective, gold has an embedded put option because they can sell to users at some floor price.”

An Inflation Hedge

Does gold provide protection in the current spell of high inflation? “Gold is an inflation hedge in the long run, but not so in the short run,” Jermann noted. “Two thousand years ago, what you could buy with gold is roughly the same as now. It has really kept its value in terms of a broader basket of goods.”

Gold is not a good inflation hedge in the short run because “its prices just move more [than inflation],” Jermann explained. “If you want to hedge inflation with gold, you take on a lot more new risk because the price of gold is very volatile and moves for reasons unrelated to inflation.”

Empirically, gold prices are more sensitive to interest rates than they are to inflation, Jermann said. “The relationship between gold and interest rates has been very strong in the last 15 years.”

“People [who want gold jewelry] will buy it, and if it’s cheap enough, they will buy more. As an investor, it gives you a floor….”  –Urban Jermann

But the relationship between gold and inflation “is just not very strong,” he noted. “On a year-on-year basis, you’re not going to see much connection [between the two]. You see a connection if you look at them over 30, 40 or 50 years or if you look at countries where you have really high inflation.”

Refined Pricing Model

According to Jermann, the main contribution of his paper is his model that will help investors more accurately estimate future gold prices. Essentially, he has refined an approach that has been used for pricing bonds and derivatives.

“What the model does is show us a way to think about gold as bonds where interest rates matter,” he said. “But it’s not just a simple bond. It’s a bond with an option [to sell at a floor price].”

Jermann explained how his model is an advancement over conventional models. “Investors that use a standard model that compares interest rates and gold prices might estimate gold prices to fall by, say 20%. But my model will tell you that something else is happening. With the option value, there’s a non-linear relationship between gold and interest rates; it is a lot stronger when interest rates are low than when they’re high. This model allows you to better predict how much prices of gold could move. For investors, this is very useful.”