The gold market v1.0

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The gold market v1.0

  1. 1. Business Opportunities in Gold Opportunities in Gold Market in Market inIndia India Compiled by Mr. Prafulla M. Kharote
  2. 2. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTECONTENTS1.CURRENT ECONOMIC SITUATION AND GOLD MARKET......................................................................52.INTRODUCTION TO THE GOLD MARKET...............................................................................................9 The Post World War II Politics of Gold......................................................................................................11 The London Gold Fixing.............................................................................................................................13 Gold and European Union..........................................................................................................................14 The Two-Tier System..................................................................................................................................15 The Special Drawing Right (SDR) as "Paper Gold"...................................................................................16 How Foreign Exchange Intervention Affects the Money Supply?............................................................18 The Breakdown of Bretton Woods.............................................................................................................193.International Gold Market...........................................................................................................................22 The London Bullion Market Association (LBMA)....................................................................................22 The London Good Delivery Bar.................................................................................................................22 London Clearing Houses............................................................................................................................23 Transactions at the Fix...............................................................................................................................25 Pricing Nonstandard Contracts.................................................................................................................27 The Gold Lease or Gold Libor Rates..........................................................................................................284.GOLD PRODUCTS AVAILABLE IN INTERNATIONAL MARKET...........................................................30 The Gold Forward Price.............................................................................................................................30 Gold Swaps...................................................................................................................................................31 Gold Futures...............................................................................................................................................34 How Futures Markets Deal with Credit Risk........................................................................................35 The Equilibrium Futures Price..............................................................................................................36 Exchange for Physicals...............................................................................................................................39 Gold Forward Rate Agreement (FRA).......................................................................................................40 | CURRENT ECONOMIC SITUATION AND GOLD MARKET 2
  3. 3. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTE Gold Interest Rate Swaps...........................................................................................................................43 Gold Interest Rate Guarantees...................................................................................................................45 Option Terminology..................................................................................................................................46 Options on Spot Gold............................................................................................................................47 Options on Gold Futures.......................................................................................................................47 Definition Summary..............................................................................................................................48 Gold Options as Insurance....................................................................................................................49 Floors and Ceilings.................................................................................................................................52 Over-the-Counter Options....................................................................................................................53 Writing Gold Options............................................................................................................................565.THE INDIAN GOLD MARKET....................................................................................................................576.GOLD DEMAND IN INDIA........................................................................................................................587.From Rural to Urban...................................................................................................................................598.Gold Price Performance...............................................................................................................................619.Reserve Banks 200 tonnes purchase (2009)..............................................................................................6210.Products in Gold Market of India..............................................................................................................62 Gold Exchange Traded Fund - the smart way to invest in gold...............................................................62 E – GOLD: THE NEW AVTAR OF GOLD – by NSEL...............................................................................6611.Banking on Gold..........................................................................................................................................70 GOLD COINS.............................................................................................................................................70 LOAN AGAINST GOLD.............................................................................................................................73 GOLD DEPOSIT SCHEME (GDS) by SBI..................................................................................................76 Physical Business........................................................................................................................................78 Consignment Business...............................................................................................................................79 Sale of Gold on Fixed and Unfixed basis ..............................................................................................79 Gold as Loan................................................................................................................................................81 Gold Forwards.............................................................................................................................................81 Proprietary Trading in Gold .....................................................................................................................82 | CURRENT ECONOMIC SITUATION AND GOLD MARKET 3
  4. 4. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTE12.Other businesses related to Gold Market..................................................................................................83 Gold Mining................................................................................................................................................83 Gold Refinery.............................................................................................................................................84 Numismatic Gold Coins.............................................................................................................................8413.The Future of Gold.....................................................................................................................................86Bibliography....................................................................................................................................................88 | CURRENT ECONOMIC SITUATION AND GOLD MARKET 4
  5. 5. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTE 1. CURRENT ECONOMIC SITUATION AND GOLD MARKETThe global economic crisis instigated by the sub-prime mortgage lending in the U.S.has led to many investors taking refuge under the precious yellow metal. Prices of theprecious yellow metal have shown a resilient up-move ever since 2008, and even todaywhile the global economy is recovering, many smart investors are preferring to takerefuge under the precious yellow metal, thus safeguarding themselves against thebackdrop of downbeat global economic events such as: • Downgrade of U.S. sovereign rating from ‘AAA to ‘AA+ with a negative outlook • Debt overhang situation in the Euro zone • Inflationary pressures in the Emerging Market EconomiesBut whether it is prudent to invest in the precious yellow metal at present?CAN GOLD GET BOLDER?Gold has been historically considered as an important asset class mainly for threereasons: • It is a hedge against inflation • It adds stability to the investment portfolio • Asset Allocation avenueAnd as an asset class, gold over the year has shown a secular uptrend. In 1971, the priceof gold was about U.S. dollar 32 an ounce and today (mid-August 2011), gold hascrossed U.S. dollar 1,800 an ounce mark. This indicates that price of gold has gone upby 56 times over the last 40 years. Even in the last 13 years (i.e. since Jan 2, 1998) asdepicted in the chart hereunder, until August 22, 2011 gold prices have appreciated by | CURRENT ECONOMIC SITUATION AND GOLD MARKET 5
  6. 6. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEwhooping 559% (on an absolute basis).At present the House of Representatives have voted on August 2, 2011 for an increasein the U.S. debt ceiling limit by U.S. $2.1 trillion (making it U.S $16.4 trillion), and alsoagreed to cut federal spending by U.S. $2.4 trillion dollars or more. This in our opinionwould purely bloat the U.S. economy (which already has been made a 92% increase indebt ceiling in the last 3 decades) and make its debt to GDP ratio daunting to manage. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 6
  7. 7. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTE Big fat U.S. debt ceiling (Source: whitehouse.gov)Moreover while the debt ceiling limit is increased, the long-term risk of sovereigndefault crisis by the U.S. still remains because this decision of increasing debt ceilinglimit is purely a case of postponing a sovereign default to happen. Moreover thedawdling pace of economic growth rate is not justifying the increase in debt ceilinglimit, and high unemployment rate (9.10% in July 2011) remains a cause of concern.The picture in Europe too narrates a gloomy story. With Greeces failure to put itspublic finances in place has caused a situation of a debt overhang in the Euro zone,and is also spreading a contagion to the other countries in the Euro zone.In India, while the Reserve Bank of India (RBI) has maintained its anti-inflationarystance and increased policy rates 12 times successively since March 2010; the resultshavent been too positive as the inflation bug continues to haunt and be over thecomfort level (of 8.00%) of RBI (WPI inflation for July 2011 was 9.22%).Thus taking a view of the aforementioned downbeat economic factors we are of theopinion that the northward trajectory for gold would be maintained as globaleconomic recovery appears to be facing stumbling blocks. In fact being aware of thesame most economies led by the U.S. and the Euro zone ones are maintaining elevated | CURRENT ECONOMIC SITUATION AND GOLD MARKET 7
  8. 8. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTElevels of gold reserves too (as revealed by the chart below), in order to hedge the riskof an economic breakdown. Moreover if the U.S. dollar weakens due to bloated debt toGDP ratio, the northward trajectory would be clearly paved for the precious yellowmetal. Heaping up goldHence taking into account the fundamentals for gold presented above, Gold as anasset class makes a strong case for inclusion in ones portfolio (as it would insure /hedge your portfolio against the various risks it is exposed to). | CURRENT ECONOMIC SITUATION AND GOLD MARKET 8
  9. 9. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTE 2. INTRODUCTION TO THE GOLD MARKETThe gold market is a unique 24-hour-a-day market for the purchase or sale of one ofhistorys longest-valued commodities. What gives the market its special character isthe use of gold simultaneously as industrial commodity, as decoration (jewelry), andas a monetary asset. To understand the gold market, it is important to understand thelatter function. Because gold has often formed a component of the local money supply,its history is intertwined with national and central bank politics.GOLD AS MONEYGold is only one of many commodities that over the years have served as money--as amedium of exchange--in international trade and financial transactions. Suchcommodities have frequently varied. In many local communities (including nation-states), the most widely used commodity, or the product most traded with outsiders,has often functioned as money. In the Oregon territory from 1830 to 1840, for example,beaver skins were a customary medium of exchange. Then, as the population shiftedfrom fur trapping to farming, wheat became the chief form of money, and from 1840 to1848 promissory notes were made payable in so many bushels of wheat. Later, with theCalifornia gold discoveries in 1848, the Oregon legislature repealed the law makingwheat legal tender, and proclaimed that thereafter only gold and silver were to be usedto settle taxes and debts. For similar reasons, tobacco long served as the principalcurrency in Virginia. When the Virginia Company imported 150 "young and uncorruptgirls" as wives for the settlers in 1620 and 1621, the price per wife was initially 100pounds of tobacco--later climbing to 150 pounds.Only a few currencies, however, have had long-run durability as well as multi-territorial acceptability. Silver and gold are two of these. Roughly speaking, from thetime of Columbus discovery of America in 1492 to the California gold discovery in1848, silver dominated in common circulation in America and Europe, while goldcame into dominance following the Californian and Australian gold discoveries. Underthe rule of the British Empire, the British pound sterling and the gold standard wereadopted in much of the world. Toward the end of World War Two, the U.S. dollar andgold became the principal international reserve assets under the Bretton Woods | CURRENT ECONOMIC SITUATION AND GOLD MARKET 9
  10. 10. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEagreement--a market position the U.S. dollar and gold have maintained despite the defacto dissolution of that system in the early 1970s. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 10
  11. 11. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTETHE POST WORLD WAR II POLITICS OF GOLDUnder the Bretton Woods Agreement forged at the Mt. Washington Hotel in BrettonWoods, New Hampshire in 1944, each member of the newly created InternationalMonetary Fund (IMF) agreed to establish a par value for its currency, and to maintainthe exchange rate for its currency within 1 percent of par value. In practice, since theprincipal reserve currency would be the U.S. dollar, this meant that other countrieswould peg their currencies to the U.S. dollar, and--once convertibility was restored--would buy and sell U.S. dollars to keep market exchange rates within the 1 percentband around par value. The United States, meanwhile, separately agreed to buy goldfrom or sell gold to foreign official monetary authorities at $35 per ounce in settlementof international financial transactions. The U.S. dollar was thus pegged to gold, andany other currency pegged to the dollar was indirectly pegged to gold at a pricedetermined by its par value.What does it mean to fix the price (the exchange value) of a currency or a commoditylike gold? If no trading other than with official authorities is allowed (as whensomething is "inconvertible"), then fixing the price is easy. The central bank orexchange authority simply says the price is "X" and no one can say differently. If youwant to trade gold for dollars, you have to deal with the central bank, and you have totrade at central bank prices. The central bank may in fact even refuse to trade withyou, but it can still maintain the lawyerly notion that the exchange rate is "fixed."(Such a refusal, of course, will only lead to black market trading outside officialchannels.) If, however, free trade is allowed, fixing the price requires a great dealmore. The price can be fixed only by altering either the supply of or the demand forthe asset. For example, if you wanted to fix the price of gold at $35 per ounce, youcould only do so by being willing and able to supply unlimited amounts of gold to themarket to drive the price back down to $35 per ounce whenever there would otherwisebe excess demand at that price, or to purchase unlimited amounts of gold from themarket to drive the price back up to $35 per ounce whenever there would otherwise beexcess supply at that price.In order to peg the price of gold you would thus need two things: a large stock of goldto supply to the market whenever there is a tendency for the market price of gold togo up, and a large stock of dollars with which to purchase gold whenever there is atendency for the market price of gold to go down. No problem. The U.S. had plenty of | CURRENT ECONOMIC SITUATION AND GOLD MARKET 11
  12. 12. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEgold--about 60 percent of the worlds stock. And, naturally, it also had plenty ofdollars, which could be created with the stroke of a pen.After the Bretton Woods Agreement, the price of gold remained uncontroversial forthe next decade. But around 1960 the private market price of gold began to show apersistent tendency to rise above its official price of $35/ounce. So, in the fall of 1960,the United States joined with the central banks of the Common Market countries aswell as with Great Britain and Switzerland to intervene in the private market for gold.If the private market price did not rise above $35 per ounce, it was felt, the BrettonWoods price was de facto the correct price, and in addition no one could complain ifdollars were not exchangeable for gold. This coordinated intervention, which involvedmaintaining the gold price within a narrow range around $35 per ounce, becameformalized a year later as the gold pool. Since London was the center of world goldtrading, the pool was managed by the Bank of England, which intervened in theprivate market via the daily gold price fixing at N. M. Rothschild. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 12
  13. 13. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTETHE LONDON GOLD FIXINGIn its current form, the London gold price fixing takes place twice each business day,at 10:30 A.M. and 3:00 P.M. in the "fixing room" of the merchant banking firm of N. M.Rothschild. Five individuals, one each from five major gold-trading firms, are involvedin the fixing. The firms represented are Mocatta & Goldsmid, a trading arm ofStandard Chartered Bank; Sharps Pixley, a dealer owned by Deutsche Bank; N. M.Rothschild & Sons, whose representative acts as the auctioneer; Republic-Mase, abullion subsidiary of Republic Bank; and Samuel Montagu, a merchant bankingsubsidiary of Midland Bank (owned by HSBC). Each representative at the fixing keepsan open phone line to his firms trading room. Each trading room in turn has buy andsell orders, at various prices, from customers located all over the world. In addition,there are customers with no existing buy or sell orders who keep an open line to atrading room in touch with the fixing and who may decide to buy or sell depending onwhat price is announced. The N. M. Rothschild representative announces a price atwhich trading will begin. Each of the five individuals then confers with his tradingroom, and the trading room tallies up supply and demand--in terms of 400-ouncebars-- from orders originating around the world. In a few minutes, each firm hasdetermined if it is a net buyer or seller of gold. If there is excess supply or demand anew price is announced, but no orders are filled until an equilibrium price isdetermined. The equilibrium price, at which supply equals demand, is referred to asthe "fixing price." The A.M. and P.M. fixing prices are published daily in majornewspapers.Even though immediately before and after a fixing gold trading will continue at pricesthat may vary from the fixing price, the fixing price is an important benchmark in thegold market because much of the daily trading volume goes through at the fixingprice. Hence some central banks value their gold at an average of daily fixing prices,and industrial customers often have contracts with their suppliers written in terms ofthe fixing price. Since a fixing price represents temporary equilibrium for a largevolume of trading, it may be subject to less "noise" than are trading prices at othertimes of the day. Usually the equilibrium fixing price is found rapidly, but sometimesit takes twenty to thirty tries. Once in October 1979, with supply and demandfluctuating rapidly from moment to moment, the afternoon fixing in London lasted anhour and thirty-nine minutes. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 13
  14. 14. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEThe practice of fixing the gold price began in 1919. It continued until 1939, when theLondon gold market was closed as a result of war. The market was reopened in 1954.When the central bank gold pool began officially in 1961, the Bank of England--asagent for the pool--maintained an open phone line with N. M. Rothschild during themorning fixing (there was as yet no afternoon fixing). If it appeared that a fixing pricewould be established that was above $35.20 or below $34.80, the Bank of England (asagent) became a seller or buyer of gold in an amount sufficient to ensure that thefixing price remained within the prescribed bands.GOLD AND EUROPEAN UNIONWhile the gold pool held down the private market price of gold, gold politics took anew turn in the international arena. This was related to the fact that Europeancountries, which had complained of a "dollar shortage" in the 1950s, where nowcomplaining of a "dollar glut." They were accumulating too many dollar reserves.Although it was actually Germany that was running the greatest surplus andaccumulating the most dollar reserves in the early 1960s, it was France under theleadership of Charles de Gaulle that made the most noise about it. During World WarII, in conversations with Jean Monnet, de Gaulle had supported the notion of a unitedEurope--but a Europe, he insisted, under the leadership of France. After the war,France had opposed the American plan for German rearmament even in the context ofEuropean defense. France had been induced to agree, however, through Marshall Planaid, which France was not inclined to refuse after it became embroiled in the Indo-China War. But now, in the 1960s, de Gaulles vision of France as a leading worldpower led him to withdraw from NATO because NATO was a U.S.-dominated militaryalliance. It also led him to oppose Bretton Woods, because the international monetarysystem was organized with the U.S. dollar as a reserve currency.In the early 1960s there was, however, no realistic alternative to the dollar as a reserveasset, if one wanted to keep reserves in a form that both would bear interest and couldbe traded internationally. Official dollar-reserve holders not only were made exemptfrom the interest ceilings of the Federal Reserves Regulation Q for their deposits inNew York but also began as a regular practice to hold dollars in the Euro-Dollarmarket--a free market where interest rates found their own level. Prior to 1965, centralbanks were the largest suppliers of dollars to the Euromarkets. Thus dollar reserveholders received a competitive return on their dollar assets, and the United Statesgained no special benefit from the use of the dollar as a reserve asset. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 14
  15. 15. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTENevertheless, de Gaulles stance on gold made domestic political sense, and inFebruary 1965, in a well-publicized speech, he said: "We hold as necessary thatinternational exchange be established . . . on an indisputable monetary base that doesnot carry the mark of any particular country. What base? In truth, one does not seehow in this respect it can have any criterion, any standard, other than gold. Eh! Yes,gold, which does not change in nature, which is made indifferently into bars, ingotsand coins, which does not have any nationality, which is held eternally and universally. . . .?" By the "mark of any particular country" he had in mind the United States, whichannounced the Foreign Credit Restraint Program about a week later, in part as a directresponse to de Gaulles speech. France stepped up its purchases of gold from the U.S.Treasury and in June 1967, when the Arab-Israeli Six-Day War led to a large increase inthe demand for gold, withdrew from the gold pool.THE TWO-TIER SYSTEMThen in November 1967, the British pound sterling was devalued from its par value of$2.80 to $2.40. Those holding sterling reserves took a 14.3 percent capital loss in dollarterms. This raised the question of the exchange rate of the other reserve assets: if thedollar was to be devalued with respect to gold, a capital gain in dollar terms could bemade by holding gold. Therefore demand for gold rose and, as it did, gold pool sales inthe private market to hold down the price were so large that month that the U.S. AirForce made an emergency airlift of gold from Fort Knox to London, and the floor ofthe weighing room at the Bank of England collapsed from the accumulated tonnage ofgold bars.In March 1968, the effort to control the private market price of gold was abandoned. Atwo-tier system began: official transactions in gold were insulated from the freemarket price. Central banks would trade gold among them at $35 per ounce but wouldnot trade with the private market. The private market could trade at the equilibriummarket price and there would be no official intervention. The price immediatelyjumped to $43 per ounce, but by the end of 1969 it was back at $35. The two-tiersystem would be abandoned in November 1973, after the emergence of floatingexchange rates and the de facto dissolution of the Bretton Woods agreement. By thenthe price had reached $100 per ounce.When the gold pool was disbanded and the two-tier system began in March 1968,there was a two-week period during which the London gold market was forceably | CURRENT ECONOMIC SITUATION AND GOLD MARKET 15
  16. 16. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEclosed by British authorities. A number of important changes took place during thosetwo weeks. South Africa as a country was the single largest supplier of gold and hadfor years marketed the sale of its gold through London, with the Bank of Englandacting as agent for the South African Reserve Bank. With the breakdown of the goldpool, South Africa was no longer assured of steady central bank demand, and--withthe London market temporarily closed--the three major Swiss banks (Swiss BankCorporation, Swiss Credit Bank, and Union Bank of Switzerland) formed their owngold pool and persuaded South Africa to market through Zurich.In 1972, the second major country supplier of gold, the Soviet Union, also began tomarket through Zurich. In 1921, V. I. Lenin had written, "sell [gold] at the highestprice, and buy goods with it at the lowest price." Since the Soviet ruble was notconvertible, the Soviet Union used gold sales as one major source of its earnings ofWestern currencies, and in the 1950s and 1960s sold gold through the MoscowNarodny in London (a bank that had also provided dollar cover for the Soviets duringthe early days of the Cold War). In Zurich, the Soviet Union dealt gold via theWozchod Handelsbank, a subsidiary of the Soviet Foreign Trade Bank, theVneshtorgbank. (In March 1985, the Soviet Union announced that the Wozchod wouldbe closed because of gold-trading losses and would be replaced with a branch office ofthe Vneshtorgbank. The branch office, unlike the Wozchod, would not be required topublish information concerning operations.)London, in order to stay competitive, subsequently turned itself more into a gold-trading center than a distribution center. When the London market reopened inMarch 1968 after the two-week "holiday," a second daily fixing (the 3:00 P.M. fixing)was added in order to overlap with U.S. trading hours, and the fixing price wasswitched to U.S. dollar terms from pound sterling terms. But by the 1980s, Londonsnew role as a trading center had begun to be challenged by the Comex gold futuresmarket in New York.THE SPECIAL DRAWING RIGHT (SDR) AS "PAPER GOLD"During the early years of the gold pool, it came to be believed that there was adeficiency of international reserves and that more reserves had to be created by legalfiat to enable reserve-holders to diversify out of the U.S. dollar and gold. In retrospect,this was a curious view of the world. The form in which reserves are held willultimately always be determined on the basis of international competition. People will | CURRENT ECONOMIC SITUATION AND GOLD MARKET 16
  17. 17. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEhold their wealth in the form of a particular asset only if they want to. If they do nothave an economic incentive to desire a particular asset, no legal document will alterthat fact. A particular currency will be attractive as a reserve asset if these four criteriaexist: (1) an absence of exchange controls so people can spend, transfer, or exchangetheir reserves denominated in that currency when and where they want them; (2) anabsence of applicable credit controls and taxes that would prevent assets denominatedin the currency from bearing a competitive rate of return relative to other availableassets; (3) political stability, in the sense that there is a lack of substantial risk thatpoints (1) and (2) will change within or between government regimes; (4) a currencythat is in sufficient use internationally to limit the costs of making transactions. Thesefour points explain why, for example, the Swiss but not the French franc has beentraditionally used as an international reserve asset.Many felt that formal agreement on a new international reserve asset was neverthelessneeded, if only to reduce political tension. And while France wanted to replace thedollar as a reserve asset, other nations were looking instead for a replacement for gold.The decision was made by the Group of Ten (ten OECD nations with most of thevoting rights in the IMF) to create an artificial reserve asset that would be tradedamong central banks in settlement of reserves. The asset would be kept on the booksof the IMF and would be called a Special Drawing Right (SDR). In fact it was a newreserve asset, a type of artificial or "paper gold," but it was called a drawing right byconcession to the French, who did not want it called a reserve asset.The SDR was approved in July 1969, and the first "allocation" (creation) of SDRs wasmade in January l970. Overnight, countries gained more reserves at the IMF, becausethe IMF added new numbers to its accounts and called these numbers SDRs. Thetiming of the allocation was especially maladroit. In the previous four years the UnitedStates had been in the process of financing the Great Society domestic social programsof the Johnson administration as well as a war in Vietnam, and the world was beingflooded with more reserves than it wanted at the going price of dollars fordeutschemarks, yen, or gold. In the 1965 Economic Report of the President, Johnsonwrote, in reference to his Great Society Program and the Vietnam War: "The FederalReserve must be free to accommodate the expansion in 1965 and the years beyond1965." U.S. money supply (M1) growth, which had averaged 2.2 percent per year duringthe 1950s, inched upward slightly during the Kennedy years (2.9 percent per year for1961- 1963) but changed materially under the Johnson administration. The growth rateof M1 averaged 4.6 percent per year over 1964-1967, then rose to 7.7 percent in 1968.Under the Nixon administration that followed, money growth initially slowed to 3.2percent in 1969 and 5.2 percent in 1970, then accelerated to 7.1 percent for 1971-1973. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 17
  18. 18. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEThe latter three years would encompass the breakdown of Bretton Woods, and wouldalso have a material effect on the price of gold.HOW FOREIGN EXCHANGE INTERVENTION AFFECTS THE MONEY SUPPLY?In order to succeed, a regime of fixed exchange rates (and under Bretton Woods, ratesfor the major currencies were fixed in terms of their par values, which could not becasually altered) requires coordinated economic policies, particularly monetarypolicies. If two different currencies trade at a fixed exchange rate and one currency isundervalued with respect to the other, the undervalued currency will be in excessdemand. By the end of the 1960s both the deutschemark and the yen had becomeundervalued with respect to the U.S. dollar. Therefore the countries concerned(Germany and Japan) had two choices: either increase the supplies of their currenciesto meet the excess demand or adjust the par values of their currencies upward enoughto eliminate the excess demand.As long as either country intervened in the market to maintain the par value of itscurrency with respect to the U.S. dollar, an increased supply of the domestic currencywould take place automatically. To see why this is so, take the case of Germany. Inorder to keep the DM from increasing in value with respect to the U.S. dollar, theBundesbank would have to intervene in the foreign exchange market to buy dollars. Itwould buy dollars by selling DM. The operation would increase the supply of DM inthe market, driving down DMs relative value, and increase the demand for the dollar,driving up the dollars relative value.Any time the central bank intervenes in any market to buy or sell something, itpotentially changes the domestic money supply. If the central bank buys foreignexchange, it does so by writing a check on itself--by giving credit to the seller. Centralbank assets go up: the central bank now owns the foreign exchange. But central bankliabilities go up also, since the check represents a central bank liability. The seller ofthe foreign exchange or other asset will deposit the central banks check, in paymentfor the value of the assets, in an account at a commercial bank. The commercial bankwill in turn deposit the check in its account at the central bank. The commercial bankwill now have more reserves, in the form of a deposit at the central bank. The bankcan use the reserves to make more loans, and the money supply will expand by amultiple of the initial reserve increase. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 18
  19. 19. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEIs there anything the German authorities can do to prevent the money- supplyincrease? Essentially not, as long as they attempt to maintain the fixed exchange rate.There is, however, an operation referred to as sterilization. Sterilization refers to thepractice of offsetting any impact on the monetary base caused by foreign exchangeintervention, by making reverse transactions in terms of domestic assets (such asgovernment bonds). For example, if the money base went up by DM4 billion becausethe central bank bought dollars in the foreign exchange market, a sterilizationoperation would involve selling DM4 billion worth of domestic assets to reducecentral bank liabilities by an equal and offsetting amount. If the Bundesbank solddomestic assets, these would be paid for by checks drawn on the commercial bankingsystem and reserves would disappear as the commercial banks checking accountswere debited at the central bank.However, the Bundesbank could not simultaneously engage in complete sterilization(a complete offset) and also maintain the fixed exchange rate. If there was no changein the supply of DM, the DM would continue to be undervalued with respect to thedollar, and foreign exchange traders would continue to exchange dollars for DM.During the course of 1971, the Bundesbank intervened so much that the German high-powered money base would have increased by 42 percent from foreign exchangeintervention alone. About half this increase was offset by sterilization, but, even so,the increase in the money base--and eventually the money supply--by more than 20percent in one year was enormous by German standards. The breakdown of theBretton Woods system began that year.THE BREAKDOWN OF BRETTON WOODSIt came about this way. From the end of World War II to about 1965, U.S. domesticmonetary and fiscal policies were conducted in such a way as to be noninflationary. Asworld trade expanded during this period, the relative importance of Germany andJapan grew, so that by the end of the 1960s it was unreasonable to expect any system ofinternational finance to endure without a consensus at least among the United States,Germany, and Japan. But after 1965, U.S. economic policy began to conflict withpolicies desired by Germany and Japan. In particular, the United States began a strongexpansion, and moderate inflation, as a result of the Vietnam War and the GreatSociety program. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 19
  20. 20. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEWhen it became obvious that the DM and yen were undervalued with respect to thedollar, the United States urged these two nations to revalue their currencies upward.Germany and Japan argued that the United States should revise its economic policy tobe consistent with those in Germany and Japan as well as with previous U.S. policy.They wanted the United States to curb money- supply growth, tighten credit, and cutgovernment spending. In the ensuing stalemate, the U.S. policy essentially followedthe recommendations of a task force chaired by Gottfried Haberler. This was a policyof officially doing nothing and was commonly referred to as a policy of "benignneglect." If Germany and Japan chose to intervene to maintain their chosen par values,so be it. They would be allowed to accumulate dollar reserves until such time as theydecided to change the par values of their currencies. That was the only alternative ifthe United States would not willingly change its policy. It was clearly understood atthe time that a unilateral action on the part of the United States to devalue the dollarby increasing the dollar price of gold would be matched by similar Europeandevaluations.In April 1971, the Bundesbank took in $3 billion through foreign exchangeintervention. On May 4 it took in $1 billion in the course of the day. On May 5 theBundesbank took in $1 billion during the first hour of trading, then suspendedintervention in the foreign exchange market. The DM was allowed to float upward. OnAugust 15 the U.S. president, Nixon, suspended the convertibility of the dollar intogold and announced a 10 percent tax on imports. The tax was temporary and wasintended to signal the magnitude by which the United States thought the par values ofthe major European and Japanese currencies should be changed.An attempt was made to keep the Bretton Woods system going by a revisedagreement, the Smithsonian agreement, reached at the Smithsonian Institution inWashington on December 17-18, 1971. Called by President Nixon "the most importantmonetary agreement in the history of the world," it lasted only slightly more than ayear, but beyond the 1972 U.S. presidential election. At the Smithsonian Institution theGroup of Ten agreed on a realignment of currencies, an increase in the official price ofgold to $38 per ounce, and expanded exchange rate bands of 2.25 percent around theirnew par values.Over the period February 5-9, 1973, history repeated itself, with the Bundesbank takingin $5 billion in foreign exchange intervention. On February 12, exchange markets wereclosed in Europe and Japan, and the United States announced a 10 percent devaluationof the dollar. European countries and Japan allowed their currencies to float and, overthe next month, a de facto regime of floating exchange rates began. The floating ratesystem has persisted to the present; with none of the five most widely traded | CURRENT ECONOMIC SITUATION AND GOLD MARKET 20
  21. 21. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEcurrencies (the dollar, the DM, the British pound, the Japanese yen, and the Swissfranc) in any way officially fixed in exchange value with respect to the others. (Briefly,from October 1990 to September 1992, the DM and the British pound were nominallylinked in the Exchange Rate Mechanism of the European Monetary System.) With thebreakdown of Bretton Woods, there began a slow dismantling of the array of controlsthat had been erected in its name. This included gold.As part of the Jamaica agreement in 1976 (which ludicrously proclaimed a "NewInternational Economic Order"), IMF members agreed to demote the role of gold. Butfew central banks subsequently followed up this agreement in practice. One associatedchange that did come about, however, affected the private gold market in the UnitedStates. On January 2, 1975, after forty years of prohibition, U.S. citizens were allowed topurchase gold bullion legally. The Comex in New York subsequently became animportant center for the trading of gold futures. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 21
  22. 22. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTE 3. INTERNATIONAL GOLD MARKETTHE LONDON BULLION MARKET ASSOCIATION (LBMA)The center of world gold trading is London, and the center of London gold and silvertrading is the London Bullion Market, operated by the London Bullion MarketAssociation (LBMA). Members are classified into market making members, whichinclude all of the participants in the twice-daily London gold fix described in Part 1, aswell as other bullion houses (for a total of 14), and ordinary members, of which thereare about 50. Most bullion houses act both as brokers for customers, and as primarydealers who hold positions of their own in order to profit from the bid/asked spread orfrom equilibrium price movements.Market makers are obligated to make two-way prices (that is, for both buying andselling) throughout the day. Ordinary dealers will usually quote prices to their ownclients, but have no obligation to make two-way markets or to quote to other dealers.The fixing of the gold price starts at 10:30 a.m. in the morning (and lasts until a singleprice representing temporary equilibrium between supply and demand is found,usually a few minutes later), and again at 3:00 p.m. in the afternoon. (A silver pricefixing takes place beginning at 12 noon.) During these time periods the fix is theprincipal focus of trading, but trading by the same firms occurs before and after the fixand indeed gold trades around the world for almost 24 hours a day. The time overlapsbetween various trading centers can be seen in the daily gold price chart above fromKitco.comMost gold trading around the world takes place "loco London", meaning the gold issold for delivery in London.THE LONDON GOOD DELIVERY BARThe LMBA sets down standards for gold bars that can be accepted for "good delivery."The London good delivery bar is a benchmark standard for spot (or physical) goldtransaction. The requirements are: | CURRENT ECONOMIC SITUATION AND GOLD MARKET 22
  23. 23. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTE Weight: 350-430 fine troy ounces Fineness: minimum 995 parts per 1000 fine gold Assayers/Melters Stamp: any approved by the LMBA a serial number and fineness, along Obligatory Marks: with an assayer and melter stamp of weight to within .025 troy ounces must be of good appearance, free from Appearance: cavities, and easy to handle and stack usually takes place at one of the London Delivery: bullion clearing housesPrice quotations in the spot market are usually expressed in U.S. dollars, and arequoted as the price per fine troy ounce, such as:$1292.50-$1292.80/ozHere the bid or buying price is $1292.50 per fine troy ounce, and the asked or sellingprice is $1292.80 per fine troy ounce. Spot delivery will take place in terms of Londongood delivery bars on the spot date, which is the second working day after the tradedate.Although the price is quoted in dollars per ounce, all trades must take place in termsof so many gold bars, because physical delivery must take place in whole multiples ofgold bars. The standard amount for a dealer spot price quotation is ten 400 oz. bars, or4000 ozs. of gold. Thus if one purchased the standard amount at the dealers askedrate listed above, one would pay:10 x 400 x $1292.80 = $5,171,200in two working days to the seller, and receive in return 4000 ozs. of gold at one of thebullion clearing houses.LONDON CLEARING HOUSES | CURRENT ECONOMIC SITUATION AND GOLD MARKET 23
  24. 24. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEA bullion clearing house nets out gold transactions, much as banks do in tradingforeign exchange. Only the net difference between total purchases and total sales vis-a-vis a counterparty is actually transferred. But a bullion clearing bank may takephysical delivery of bullion, whereas a foreign exchange clearing bank only takesdelivery of foreign exchange in the form of accounting entries (a checking balance atsome foreign bank).LMBA clearing houses include the Bank of England, the five dealers at the gold fixing,and a few other houses whose identities have varied from time to time. The number ofclearing members is smaller than the number of market making members (8 versus14), because the financial and other requirements are much stricter for clearingmembers.The volume of precious metals cleared by the members of the LBMA has traditionallybeen kept confidential, but in January 1997 the LBMA released figures for the final(December) quarter of 1996. The average daily volume cleared between the (then) 14market making members of the LBMA was approximately 933 tons (about $10 billionat prices then current), compared with annual global mine production ofapproximately 2,300 tons. That is, an amount equal to total annual gold productionwas cleared every 2.5 days. (The total amount of silver cleared daily was approximately7,775 tons.)Of course, because most gold is traded loco London, these clearing figures representthe result of worldwide gold trading, not just trading in London. Of the 933 tonscleared daily, it was estimated that about 218 tons represented London trades, while ofthe 7,775 tons of silver cleared daily, about 3,732 tons represented London trades.Gold accounts at a bullion house may be allocated or unallocated. The unallocatedaccount is most typical. One holds on deposit a specific number of ounces of gold, butthese ounces of gold are not identified with any individual physical gold bars. Theseunallocated accounts may or may not bear interest, and may or may not haveinsurance and storage charges. All clearing accounts are unallocated accounts, andcontain identical (hypothetical) 400 oz. bars.Most gold trading takes place by paper transfers between unallocated accounts.Bookkeeping entries avoid the transactions costs and security risks of moving theactual metal. Traders clear their trades with one another through book entry transfersin or out of accounts at one or more clearing members, while clearing members cleartheir net trades with one another through their gold accounts at the Bank of England,as well as by physical gold transfers. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 24
  25. 25. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEAllocated accounts, by contrast, contain individual gold bars with given serialnumbers. In effect, allocated accounts are safe-keeping or custody accounts. Suchaccounts do not bear interest, are normally subject to charges, and may not be used asclearing accounts.TRANSACTIONS AT THE FIXThe London daily price fixings allow everyone to deal on equal terms, and largevolumes to be transacted at a single price. In addition, the price is widely publicized,so it is undisputed. Once a price has been found such that net gold for sale (in 5 bardenominations--i.e., units of 2000 oz.) is equal to net gold for purchase, transactionsthen take place according to the following formula.A seller on the fix receives the fixing price plus $.05 per ounce of gold (fix+.05). Abuyer on the fix pays the fixing price plus $.25 per ounce of gold (fix+.25). This isequivalent to a market bid price of fix+.05, and a market asked price of fix+.25, for atotal spread of $.20. This spread is narrower than the normal dealing spread, which istypically $.30 or higher.Fixing orders may be placed in various ways.Example 1: A market order. A client leaves an order to sell 20,000 ozs. at the PM fix.Example 2: A price limit order. The client places an order to buy 25,000 ozs. at theAM fix, if the fixing price is at or lower than $1290/oz.Example 3: An average rate order. A client places at order to buy 10,000 ozs. at theaverage of the AM fixing price for July 2011. (Simple question in risk management:How will the firm manage this order?)Example 4: Dynamic order. The client stays on the horn, listening to the fixingcommentary, and changes his order according to the new fixing price being triedNow that we have seen how spot gold is priced "loco London," we can examine howother local markets, and other types of gold contracts, are priced in reference to theLondon spot market. This includes other spot delivery locations, gold forward andfutures contracts--such as the gold futures contract at the NYMEX in New York-- and | CURRENT ECONOMIC SITUATION AND GOLD MARKET 25
  26. 26. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEgold swaps, forward rate agreements, and options. (In 1994 the COMEX merged withthe NYMEX, and the principal gold futures contract now trades there.)London is only one of many important centers for gold trading. The second principalcenter for spot or physical gold trading, for example, is Zurich. For eight hours a day,trading occurs simultaneously in London and Zurich--with Zurich normally opening,and closing, an hour earlier than London. During these hours Zurich closely rivalsLondon in its influence over the spot price, because of the importance of the threemajor Swiss banks--Credit Suisse, Swiss Bank Corporation, and Union Bank ofSwitzerland--in the physical gold market. Each of these banks has long maintained itsown refinery, often taking physical delivery of gold and processing it for other regionalmarkets.In addition to other gold delivery locations, there are other weight and qualitystandards which create differential prices. Examples include the London and Tokyokilo bars (which are 32.148 ozs., instead of the circa 400 oz. "large bars"), the 10 tolabars (3.75 ozs.) popular in India and the Middle East, the 1, 5 and 10 tael bars(respectively 1.203, 6.017, and 12.034 ozs.) found in Hong Kong and Taiwan, and thebaht bar (0.47 ozs) of Thailand. Gold content is another difference. The London gooddelivery bar is only required to have a minimum of 995 parts gold to 1000 parts total.But a gold content of 9,999 parts gold to 10,000 parts total ("four nines") is commonlytraded, as is a content of 990 parts to 1,000 total (the baht bar being an example of thelatter ratio). Gold purity is important to industry. Jewellers might want gold in theform of grain for alloying, while electronics firms may require "five nines"--meaning .99999 purity. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 26
  27. 27. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEPRICING NONSTANDARD CONTRACTSNonstandard contracts can be priced by reference to the standard loco London gooddelivery bar, by taking into account the simple arbitrage relationships that would turnone into another. The primary variables to keep track of are the costs of shipping goldfrom one location to another, the cost of refining gold to different purity levels, andthe interest or financing cost for the time required to accomplish these activities.Suppose a dealer is offered non-good delivery bars of .995 purity loco Panama City.Here is one chain of calculations the dealer might go through to come up with a pricequotation. First the dealer notes that London good delivery bars of .9999 purity can besold in Tokyo for $.50/oz premium to the standard loco London price. He knows thatif he buys the bars in Panama, he could sell them in Tokyo, but first he would have toship them to an appropriate location to upgrade their purity.The dealer also knows that he can upgrade to London large bars for good delivery, andhave the gold content refined to .9999 purity, for $.50/oz at the Johnson Mattheyrefinery in Salt Lake City, Utah. There is a two-week turnaround time for the upgrade.Shipping time is one day from Panama City to Salt Lake, and two days from Salt Laketo Tokyo.The dealer calculates the cost of shipping and insurance from Panama to Salt Lake as$.40/oz, while shipping from Salt Lake to Tokyo is $.70/oz. The total time consumedwould be 15 days, which at 6 percent interest and spot gold at, say, $300/oz amounts to300 x .06 (15/360) = $.75/oz.So the dealer adds up: shipping costs $1.10, plus interest cost $.75, plus refining cost$.50, minus selling premium in Tokyo of $.50. The net cost to the dealer to sell thePanama bars in Tokyo is $1.85/oz.Therefore the dealers best, or break-even, quotation to the person offering him non-standard gold bars in Panama City would be the spot price for good delivery locoLondon minus $1.85. If spot gold were at $300/oz. bid, the most the dealer could affordto bid for the Panama bars would be $298.15/oz. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 27
  28. 28. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTETHE GOLD LEASE OR GOLD LIBOR RATESGold bears interest. Positive interest. Many people do not know this. They are used tothe notion of storing their gold with some bank or warehouse, and paying for storagecost. They then view the storage and insurance cost as a negative interest rate. But thishas little to do with the way gold is priced or traded in the wholesale market.The forward price of gold--the price agreed now for gold to be purchased or sold atsome time in the future--is a function of the gold spot price, and the interest ratesrepresenting alternative uses of resources over the forward time period. So before wediscuss gold forward prices, we should discuss gold and dollar interest rates.This brings us to the gold lease rate, or the gold interest rate paid on gold deposits.Another term that is used is gold libor, by analogy with the London InterbankOffered Rate for Eurocurrencies traded in London. Despite the apparent literalconnotation of each of these labels, "gold libor rates" and "gold lease rates" arealternative descriptions that refer to the bid-asked gold interest rates paid on gold.The bid rate (deposit rate, borrowing rate) is the gold interest rate paid for borrowinggold (that is, on gold deposits), while the asked or offered rate is the gold interest ratequoted for lending gold. The expressions "bid-asked gold lease rates" or "bid-askedgold libor rates" are thus interchangeable.If the gold borrowing rate is 2 percent per annum, for example, then 100 ozs of goldborrowed for 360 days must be repaid as 102 ozs of gold. (Gold interest rates, like mostmoney market rates, are nearly always quoted on the basis of a 360-day year.) In theearly 1980s gold deposits rarely yielded over 1 percent, but in recent years have rarelyyielded less than 1 percent.Because of large central bank gold holdings, gold loans are one of the cheapestfinancing sources for the gold mining industry. A mining company borrows gold andsells it on the spot market to obtain funds for gold production. The interestinstallments on the gold loan are payable in gold. And when the loan matures, theprincipal (and any final interest due) is repaid directly from mine production.Central banks are the major lenders of gold. They accounted for around 75 percent ofthe gold on loan, estimated at around 2,750 tonnes, at the end of 1996. Central banksin recent years have been under pressure to earn a return on their gold holdings, and | CURRENT ECONOMIC SITUATION AND GOLD MARKET 28
  29. 29. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEtherefore lend to, for example, gold dealers who have mismatched books between golddeposits and gold loans. (The practice of central bank gold lending first becamenewsworthy in 1990, when the investment banking firm Drexel, Burnham, Lambertwent bankrupt while owing borrowed gold to the Central Bank of Portugal.)The gold lending (or borrowing) rate, then, is one of the components that determinethe gold forward price. Lets see how this works. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 29
  30. 30. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTE 4. GOLD PRODUCTS AVAILABLE IN INTERNATIONAL MARKETTHE GOLD FORWARD PRICESuppose the spot price of gold is $300/oz. The gold lease rate for 180 days is 2 percentper annum. And the Euro-Dollar rate for 180 days is 6 percent per annum. (Forsimplicity here, we ignore all bid-asked spreads. But they are easily included in thefollowing calculations.)I borrow $300 at the Euro-Dollar rate. In 180 days I will have to repay the dollarborrowing with interest in the amount $300 (1+.06(180/360)) = $300 (1.03) = $309.With the borrowed money I can buy 1 oz. of gold, and place it on deposit for 180 days.The amount of gold I will get back is 1 (1+.02(180/360) = 1 (1.01) = 1.01 oz.Thus, 1 oz. of gold with a spot price of $300 has grown into 1.01 ounces in 180 days,with a value of $309. This translates into a 180-day forward value of $309/1.01 = $305.94. Spot price: $300.00 180-day Forward Price: $305.94Notice that both the gold lease and the Euro-Dollar rate have gone into thiscalculation. Specifically:$305.94 = $300 [1+.06 (180/360)] / [1+.02 (180/360)].In general, if the spot price is S, the forward price is F(T) for a time-horizon of T days(up to a year), the Euro-Dollar rate is r, and the gold lease rate is r*, we have therelationF(T) = S [1 + r (T/360)] / [1 + r* (T/360)].Notice that in the numerical example we just used, the forward price $305.94 isapproximately 2 percent higher than the spot price of $300. That is, the 180- dayforward premium of $5.94 is approximate 2 percent of the spot price of $300. (An exact2 percent would be $6.) Why is this? | CURRENT ECONOMIC SITUATION AND GOLD MARKET 30
  31. 31. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTETo see what is involved, lets subtract the spot rate S from both sides of the aboveequation. The left- hand side will be the forward premium F(T) - S. Simplifying theright-hand side, we obtain:F(T) - S = S [( r - r*)( T/360)] / [1 + r* (T/360)].That is, the forward premium (F(T)-S) is approximately equal to the spot rate Smultiplied by the difference between the Eurodollar rate r and the gold lease rate r*(once we have adjusted this rate for the fraction of a year: T/360).Since in the numerical example the Euro-Dollar rate was 6 percent, while the least ratewas 2 percent, the forward premium at an annual rate is approximately 6-2 = 4percent. For 180 days, or half a year, it is approximately 2 percent.So, as long as we are talking about an annual rate- -that is, before we do the daysadjustment--the gold forward premium in percentage terms is approximately thedifference between the Euro-Dollar rate and the gold lease rate.We can view this same relationship in other ways: given a Euro-Dollar rate and a goldforward premium (in percentage terms), we can back out the implied lease rate.Looking back at the chart from Kitco, above, it is easy to see that subtracting the goldlease rate from the "prime rate" gives us approximately the gold forward rate. (Notethat "prime rate" is a misleading term to use: the relevant interest rate in the goldmarket is the Euro-Dollar rate by which banks borrow and lend among themselves,not the commercial "prime" lending rate--which is often an administered, rather thana market, interest rate.)Gold forward rates are sometimes referred to as "GOFO" rates, because GOFO was theReuters page that showed gold forward rates.GOLD SWAPSThere are many different hedging and trading operations in the gold market, all ofwhich bring us back to the same relationship between forward and spot rates we sawin the previous section. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 31
  32. 32. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEFor example, gold dealers will buy gold forward from mining companies. The miningcompanies, thus assured of a fixed forward price at which to sell their production, goto work producing. Meanwhile, the gold dealers, to hedge themselves againstmovements in the gold price, borrow gold and sell it in the spot market. (To repeat,dealers "borrow" gold by taking in gold deposits, and paying out the gold lease rate.)Restated, gold dealers buy gold forward from mining companies at a price F(T). Tohedge themselves, the dealers borrow gold at an interest rate r*, and sell it in themarket at a price S. They earn interest on the dollar proceeds of the spot gold sale atan interest rate r.Thus, for each ounce of gold purchased, the dealer must payF(T) [1+ r* (T/360) ] .While for each ounce of gold sold, the dealer earns:S [1 + r (T/360)].All excess profit (beyond bid-asked spread) gets eliminated when these amounts areequal. Which givesF(T) [1+ r* (T/360) ] = S [1 + r (T/360)] .This is, of course, exactly the same formula as before.Generally speaking, gold dealers will quote forward prices to their customers (theseare called "outright" forwards), but forward trades between dealers mostly take placein connection with a simultaneous spot transaction. That is, in the form of "swaps." Aswap transaction is a spot sale of gold combined with a forward repurchase, or a spotpurchase of gold combined with a forward sale. This type of trading requires lesscapital and is subject to less price risk. The swap rate is F(T)-S, and as we saw before,this difference is (when quoted as a percentage of the spot price) essentially thedifference between the Euro-Dollar rate and the gold lease rate.A spot sale of gold combined with a forward purchase is also called a cash-and-carrytransaction. The transaction provides immediate cash, the cost of which is the carry,or the difference between forward and spot rates. The dollar lender (who buys thegold), meanwhile has possession of the gold as security. So a cash-and-carry (one formof a swap) boils down to a dollar loan collateralized with gold. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 32
  33. 33. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEThe typical dealing spread between Euro-Dollar deposits is 1/8 of 1 percent, or .125percent, while the typical spread between gold deposit and loan rates is .20 percent.This translates into bid-asked swap rate, or cash-and-carry, spreads of about .30percent. For example: Euro-Dollar rates Gold lease rates Gold swap rates1 month 3.0625-3.1875 0.50-0.70 2.35-2.653 months 3.1250-3.2500 0.55-0.75 2.40-2.706 months 3.3125-3.4375 0.70-0.90 2.45-2.7512 months 3.5625-3.6875 1.00-1.20 2.35-2.65Note that the gold swap rate can be independently viewed as the collateralizedborrowing rate. A small central bank, for example, with plenty of gold to spare, couldborrow dollars for 3 months and pay--not the 3-month asked Euro-Dollar rate of 3.25percent--but rather the gold swap rate of 2.70 percent. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 33
  34. 34. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEGOLD FUTURESGold futures are traded at the COMEX in New York (which merged with the NYMEXon August 3, 1994, and is now known as the "COMEX Division" of the New YorkMercantile Exchange), at the TOCOM in Tokyo, and--until recently-- at the SIMEX inSingapore. Gold futures are also traded at the Chicago Board of Trade (CBOT) and atthe Istanbul Gold Exchange. (The latter is mostly a market for spot gold. For example,over 8 million ounces of gold were traded spot at the Istanbul Gold Exchange in 1997,but only about 43,000 ounces were traded through the futures market.)Forward gold is traded for contract settlement at standardized intervals from spotsettlement, in intervals that correspond to foreign exchange forward contracts: 1, 2, 3,6, and 12-month forwards are typical. Spot gold traded on Wednesday June 24 willsettle on Friday, June 26. A one-month forward trade on June 24 will take us to July 26,which is a Sunday, so settlement of a one-month forward will be on Monday, July 27. Atwo-month forward trade on June 24 will take us to August 26, which is a Wednesday,so settlement of a two-month forward contract will be on August 26. And so on.Futures, by contrast, are traded for fixed dates in the future. At the COMEX andCBOT, gold is traded for settlement in February, April, June, August, October, andDecember, as well as the current and next two calendar months. Istanbul trades thenext six months for Turkish lira-denominated contracts, or the next 12 months for U.S.dollar-denominated contracts. The last trading day for a futures contract is the fourthto last business day in the delivery month (at the CBOT or Istanbul), or the third tolast business day (at the COMEX). That is, the August 2008 COMEX gold future tradesuntil the third to last business day in August 2008. At the TOCOM, there are futuresfor the current or next odd month, and all even months within a year. The last tradingday is the third to last business day, except for December, when the last trading day isDecember 24.Despite the different trade date conventions, however, if futures and forwardsettlement dates happen to correspond, forward and futures prices are the same,subject to slight differences related to delivery grade or location (Manhattan, say,versus London). | CURRENT ECONOMIC SITUATION AND GOLD MARKET 34
  35. 35. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEHOW FUTURES MARKETS DEAL WITH CREDIT RISKThe main different between futures and forwards is the way futures markets handlecredit risk. In the forward market, a credit evaluation must be made of thecounterparty--evaluating the counterpartys ability to pay cash if gold was purchasedforward, or the ability to deliver the gold, if gold was sold forward.The futures market doesn’t worry about such customer credit evaluations. Instead, afutures contract is configured as a pure bet, based on price change. So one is asked topost a security bond, called "margin", which covers the typical variation in the valueof a contract for several days. Going long a futures contract is a bet that the price isgoing up, while going short is a bet the price is going down. Cash flows from pricechanges take place daily. So those who post the required margin against possiblelosses (and who replenish this margin if necessary) are considered credit-worthy,while those who cant post margin arent credit-worthy. Customers post margin withmember firms of the futures exchange, who in turn post margin with clearingmember firms. The clearing member firms post margin (on the customers behalf) ata clearinghouse. This way of dealing with credit risk is a much cleaner structure thanin the forward market world of customer credit evaluations, accounting reports, andother types of intrusive financial reporting. (Of course, exchange member firms and,especially, clearing member firms still have to undergo the usual sorts of creditchecks.)To close out a long position, one sells (goes short) an off-setting contract. To close outa short position, one buys (goes long) an off-setting contract. The opening andsubsequent closing of a futures position is referred to as a "round turn". Brokeragefees are usually charged per round turn, at the time the future contract is closed out.At discount brokerage firms in the U.S., in June 2008, the typical customer margin ona 100 oz. gold futures contract was about $1350, while there was a typical brokeragecharge of $25 per round turn.The size of the futures bet depends on the stated size of the futures contract. The cashflow will be the change in price multiplied by the contract size.At the COMEX, CBOT, and the SIMEX, the contract size is 100 ozs of gold with afineness of .995. So if gold (of that fineness) went from $1299/oz at contract opening to | CURRENT ECONOMIC SITUATION AND GOLD MARKET 35
  36. 36. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTE$1297.50/oz as the days futures settlement price, a long contract would lose $150, whilea short contract would gain $150. (The calculation on the short position is $1299 minus$1297.50, multiplied by 100.)The TOCOM trades 1 kilo bars (32.148 ozs) of .9999 fineness. The price is stated asyen/gram. So the daily change in value of a single contract is the change in the yenprice per gram, multiplied by 1000 grams.The Istanbul gold futures contract is for 3 kilograms of gold of .995 fineness, quotedeither in terms of U.S. dollars per ounce, or Turkish lira per gram. The daily change invalue of a U.S. dollar- denominated contract is the change in dollars per oz, multipliedby 96.444 ozs. The daily change in value of a Turkish lira-denominated contract is thechange in the Turkish lira price per gram, multiplied by 3000 grams.The "initial" margin that must be posted as a security bond is large enough to coverseveral days expected/loss or gain, and is thus related to the standard deviation ofdaily contract value changes. The margin is held by a clearinghouse which thus"guarantees" that the losing side of the daily futures bet pays the winning side. Forevery customer that goes long a contract, the clearinghouse takes the other side, goingshort. For every customer that goes short a contract, the clearinghouse takes the otherside, going long. The clearinghouse thus is in a position to move cash from the losingside of any futures bet to the winning side.If the initial margin is depleted by losses, it eventually reaches a "maintenance"margin level, below which the customer is required to replenish the margin to itsinitial level. For example, at discount brokerage firms in the U.S. in June 2008, atypical maintenance margin level for gold futures contracts at the COMEX was $1000per contract. So if the posted margin dropped below $1000 per futures contract,additional margin had to be posted to bring the total back to at least $1350 percontract (the typical initial margin level).Customers typically may post margin in the form of cash, or U.S. governmentsecurities with less than 10 years to maturity. Clearing members may post cash,government securities, or letters of credit with the clearinghouse. The details differ atdifferent exchanges.THE EQUILIBRIUM FUTURES PRICE | CURRENT ECONOMIC SITUATION AND GOLD MARKET 36
  37. 37. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEThe equilibrium futures price is that point where the market clears between longs andshorts. Arbitrage, however, forces the futures price to track the forward price (andvice-versa). Similarly, arbitrage between the futures market and the spot market onthe final day of trading forces the futures price to converge to the spot price. On thefinal trading day at the SIMEX, where no gold can actually be delivered on a futurescontract, the settlement price is set as the loco London price of the A.M. London pricefix. These forces convergent of the futures price to the price in the London spotmarket. At the COMEX and CBOT, the open longs take delivery of spot gold, whichaccomplishes the same thing.Delivery at the COMEX and the CBOT is one 100-oz bar (plus or minus 5 percent) orthree 1-kilogram gold bars, assaying not less than .995 fineness. (Note that 3 kilo barsis about 96 ounces of gold. The dollar amount actually paid at delivery depends, ofcourse, on the specific amount of gold delivered, which must be within 5 percent ofthe hypothetical 100 ozs per contract.) Delivery at the CBOT takes place by a vaultreceipt drawn on gold deposits made in CBOT-approved vaults in Chicago or NewYork. Gold delivered against futures contracts at the COMEX must bear a serialnumber and identifying stamp of a refiner approved by the COMEX, and made from adepository located in the Borough of Manhattan, City of New York, and licensed bythe COMEX. As noted previously, there is no delivery at the SIMEX. The futurescontract is purely cash- settled, with the final settlement price determined by theLondon A.M. gold fix.The U.S. dollar forward price of gold would be related to the U.S. dollar spot price ofgold by the relationshipF(T) = S [1 + r (T/360)] / [1 + r* (T/360)].where the spot price is S, the forward (or futures) price is F(T) for a time-horizon of Tdays, the Euro-Dollar rate is r, and the gold lease rate is r*. If the Euro-Dollar rate r ishigher than the gold lease rate r*, then the forward (futures) gold price will be higherthan the spot gold price. Historically gold lease rates have always been lower thanEuro-Dollar rates, so forward gold (or a gold futures contract) always trades at ahigher price than spot gold. The same is not true, for example, in the silver market.During the year 1998, silver lease rates have frequently exceeded Euro-Dollar rates, soforward silver has traded at a cheaper price than spot silver.Different terms are used to refer to the relationship between forward or futures pricesand spot prices. If forward gold (or a gold future) has a higher price than spot gold, theforward gold or gold future is said to be at a premium, or (in the London market) in | CURRENT ECONOMIC SITUATION AND GOLD MARKET 37
  38. 38. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEcontango. If forward gold has a lower price than spot gold, the forward gold or goldfuture is at a discount, or (in the London market) in backwardation.As we noted before, forward gold has in recent history always been in contango, or at apremium, because dollar interest rates have always been above gold lease rates. Wesaw in part 3 that the difference between the forward price and the spot price, F(T)-S,is the swap rate. Since the forward price of gold has always been at a premium inrecent years (since 1980, in particular), the swap rate has always been positive. Arelated term that is used in the U.S. futures markets is basis. Basis is the spot priceminus the futures price, or S-F(T), which is just the swap rate with the sign reversed.The gold basis has always been negative in recent years. The Federal Reserve Bank ofCleveland, for example, publishes monthly charts of the gold basis. Reverse the sign ontheir chart, and you are looking at the swap rate. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 38
  39. 39. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEEXCHANGE FOR PHYSICALSWhile forward gold is traded in the form of swaps, which combines a spot trade (buyor sell) with the reverse forward trade (sell or buy), gold futures can be traded in theform of EFPs (exchange for physicals), which combine a futures trade with thereverse spot trade. EFPs are traded for the same months as gold futures. The EFP pricerepresents the difference between the futures price and the spot price for thecombined trade.For example, a market maker may quote the August EFP at the COMEX as $1.10-$1.30in 100 lots. This means the market maker’s prices are good for a standard tradeinvolving 100 futures contracts (10,000 ozs of gold). The market maker will "buy" theEFP at $1.10/oz, or "sell" the EFP for $1.30/oz.This quotation implies that for $1.10/oz. the market maker offers to buy from you 100gold futures contracts, while simultaneously selling to you 10,000 ozs of spot gold. For$1.30/oz. the market maker will sell to you 100 gold futures contracts, whilesimultaneously purchasing 10,000 ozs of spot gold. To summarize: the market maker’sbid price is the price he will buy futures versus selling spot, while the market maker’sasked price is the price he will sell futures versus buying spot. The EFP price is thussimply a different way of looking at the basis or the swap rate.On June 24, 1998, the mid-market price (average of bid and asked prices) of the EFPassociated with the August 1998 COMEX gold contract was a positive $1.25, while themid-market price associated with the Dec 1998 COMEX gold contract was a positive$5.60. By contrast, the EFP associate with the July 1998 COMEX silver contract was anegative $2.00. This reflected the fact that gold lease rates were below Euro-Dollarrates, while silver lease rates were above.Interest rates in the gold market are a principal concern of gold dealers and goldmining companies.In the forward market, these two interest rates give rise to the swap rate, while in thefutures market they determine the EFP price. Both swaps and EFPs involve a spot saleor purchase of gold, along with the reverse trade in the forward market (if a swap) orfutures market (if an EFP). | CURRENT ECONOMIC SITUATION AND GOLD MARKET 39
  40. 40. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEBecause Euro-Dollar rates have historically always exceeded gold lease rates, goldforward and futures have always traded at a premium (have always been in contango).There is nothing inevitable about this relationship, however.But there are many contracts in the gold market that do not involve the spot, forwardor future price of gold, but rather are simply written in terms of gold interest rates.These include gold forward rate agreements (FRAs), gold interest rate swaps,and gold interest rate guarantees (IRGs). Lets examine each of these contracts inturn.GOLD FORWARD RATE AGREEMENT (FRA)A gold forward rate agreement (FRA) is a contract whose payout depends onwhether the market interest rate diverges from an agreed "contract rate". It is called a"forward rate" agreement, because the interest rate applies to a gold deposit or loanstarting at some time period in the future. That is, the interest rate in question is thegold lease rate (also called gold libor). Recall that we used the gold "lease" rate as ageneric term to refer to both the bid rate for taking in gold deposits and the offer ratefor making gold loans. Recall also that the interest in this case is typically paid orreceived as so many ounces of gold. Similarly, a gold FRA will be typically settled withone party paying the other in gold.A typical FRA contract in this regard might be a gold deposit that begins three monthsfrom today, and lasts for three months (ending six months from today). This would becalled a 3 vs. 6 FRA. The terminology "3 vs. 6" implies the contract starts in 3 monthsand ends in 6 months.What is agreed to is a contractual interest rate: the FRA rate. If the actual realizedmarket rate turns out to differ from the FRA rate (as it almost inevitably will), thenone makes or receives payment depending on the terms of the contract.There are five principal parts to an FRA contract: the contract rate, the notionalamount of gold in a contract, the fixing date when the market interest rate iscompared to the contract rate, the start date of the deposit (or loan), and thematurity date of the deposit (loan). | CURRENT ECONOMIC SITUATION AND GOLD MARKET 40
  41. 41. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEOne can buy or sell this contract. The settlement amount S paid to the buyer of theFRA from the seller is calculated as follows:S = notional amount x (market rate - contract rate) x (days in period)/360.If the market rate is below the contract rate, so that the sign on the amount S isnegative, then the FRA buyer pays the FRA seller the absolute value of S.The calculation above assumes that payment is made at the end of the FRA period (onthe maturity date). But if (as is normally the case) payment is made on the start dateinstead, the settlement amount S given above is discounted by the market rate atwhich the contract was settled:S/[1 + market rate x (days in period)/360].Example: Consider a depositor who will have one ton (32,000 ounces) of goldavailable in 3 months, but will not be utilizing the gold for another 3 months afterthat. He wants to lock in the interest rate he will receive on his gold deposit now. Heasks for a quote of the 3 vs. 6 months FRA, and receives the quotation:3 vs. 6 FRA 1.50-1.80 %This quotation means he can "sell" the FRA at a contract rate of 1.50 percent (.015), or"buy" the FRA at a contract rate of 1.80 percent.So, in this case, he sells the FRA with a contract rate of 1.50, and a notional amount of32,000 ounces of gold.Three months from today, on the fixing date, he will determine the best market rateavailable, and this will be compared to the contract rate to determine the FRAsettlement amount. (The fixing date will typically be two business days prior to theconceptual start date of the deposit or loan.) Suppose the best deposit rate at that timeis 1.00 percent (.01). Suppose also that the three- month deposit period from start dateto maturity date is 92 days. The settlement amount S is then calculated as:S = 32,000 x (.01-.015) x (92/360) = - 40.889 oz.The sign here is negative, which means the FRA buyer pays the FRA seller (ourhypothetical depositor) 40.889 oz. of gold on the maturity date (if payment is madethen). If payment is made on the start date, it is discounted by the time period of thedeposit: | CURRENT ECONOMIC SITUATION AND GOLD MARKET 41
  42. 42. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTE40.889/[1+.01 x (92/360)] = 40.785 oz.So in this event the FRA buyer pays the FRA seller 40.785 oz. of gold on the start date.Now if the depositor deposits his ton of gold at the market rate of 1.00 percent forthree months, he will end up with an equivalent interest rate of 1.50 percent, the FRArate, because the difference has been paid out on the FRA contract.The same would have been true if the depositor had lost, rather than gained, from theFRA contract. For in that case the market rate paid on deposits would be higher than1.50 percent, but the depositor would lose the difference on the FRA contract.Similar examples could be done for gold borrowers. Gold borrowers typically borrowat the gold lease (gold libor) rate plus a margin: saymarket rate + .75%and make periodic gold interest payments at intervals of 6 months. By using FRAs for6 month intervals (such as 6 vs. 12, 12 vs. 18, 18 vs. 24, etc.), the next few interestpayments on this loan can be locked in asFRA rate + .75%if that seems desirable. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 42
  43. 43. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTEGOLD INTEREST RATE SWAPSIt is important not to get the word "swap" as used here confused with "swap" in thegold forward market. There the term referred to the relationship between spot andforward prices. Here, in "interest rate swap," we are referring to a trade of a fixedinterest rate for a floating interest rate.The swap "buyer" in an interest rate swap agrees to pay a fixed interest rate to anotherparty, and in return receives at periodic intervals an interest rate that fluctuates(floats) with the market. That is, the buyer pays a fixed gold rate and receives themarket- determined gold lease rate (or some equivalent).The other side of the interest rate swap contract is the seller who receives fixed andpays floating.If, for example, the floating rate is the 3-month gold lease rate, then every 3 monthsthere will be a net interest payment whenever the market lease rate diverges from thefixed rate. If the market rate is above the fixed rate, then the swap buyer (who paysfixed) will receive an interest payment representing the positive net difference offloating minus fixed. If the market rate is below the fixed rate, then the swap seller(who receives fixed) will receive an interest payment representing the positive netdifference of fixed minus floating.In essence, then, a gold interest rate swap is just a series of gold FRAs. If thefloating rate in the market is above the fixed rate, the swap buyer (who pays fixed) isin the same position as the buyer of an FRA. If we equate the "fixed rate" with the"contract rate" in an FRA, then the FRA buyer receives a positive cash flow if themarket rate is above the fixed rate.So buying a gold interest rate swap represents the purchase of a series of gold FRAs ata single contract rate (fixed rate), while selling a gold interest rate swap represents thesale of a series of gold FRAs at a single contract rate (fixed rate).Why would someone want to do this? Lets consider an example.Example: Consolidated Gold Nuggets has an existing loan of 1 million ozs. of goldwith two years remaining to maturity. It pays floating interest at the 3-month gold | CURRENT ECONOMIC SITUATION AND GOLD MARKET 43
  44. 44. Opportunities in Gold Market in India Mr. PRAFULLA M. KHAROTElease rate plus a margin of 1.75 percent. However, gold lease rates have fallen, and thetreasurer wishes to lock in a low fixed rate. Renegotiating the loan will involvecontractual penalties. The treasurer shops the market and determines she can buy atwo- year gold interest rate swap, paying 2 percent fixed against the floating 3-monthgold lease rate flat. She does the swap.Her swap payments are2% - 3-month gold lease.Her loan payments are3-month gold lease + 1.75%.The net interest payment is the sum of these:2% + 1.75% = 3.75% .So by doing the gold interest rate swap, she has turned the floating rate loan into afixed rate loan of 3.75 percent. | CURRENT ECONOMIC SITUATION AND GOLD MARKET 44

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