In Part I of this series I derived a valuation framework for gold as a proven form of ‘insurance’ against potential losses in a portfolio of financial assets, and the currencies in which they are denominated. In Part II, I described a fair-value framework for modelling the price of gold. While the former approach implies that gold is significantly undervalued at present, the latter implies it is close to fair value. In this final part, I reconcile these two approaches by exploring the demand function for gold, and how it compares with that for money itself.
The Demand Function for Gold
We explored in Part II of this series how both long-term real interest rates and energy prices are key drivers for the price of gold. This is because they each represent an important aspect of the opportunity cost of holding gold as an idle, zero-yield asset, rather than investing in productive assets requiring capital and energy inputs. However, while relative cost (or valuation) is always an important factor when considering how much of something to own vis-à-vis something else, this should not be confused with the underlying, fundamental demand for that something. That is, when it comes to insurance, of course the premiums to be paid will be a factor when determining how much insurance protection to buy. But fundamental factors are also at play, in particular, perceptions of risk and risk preferences.
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