Gold Derivatives: Gold Derivatives: - World Gold Council

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there is a deep and liquid forward market, going out at least as far as the gold lending market. Much of the lending of gold by central banks is short-term – typically out to three months, though the average tenor has been increasing. The existence of a long-term gold forward market in the absence of a long-term gold lending market depends on the expectation that gold interest rates will remain low and stable. To see this, suppose the producer wants to sell gold five years forward, and the gold lending market only extends one year. He decides to create a synthetic forward contract by borrowing the gold for one year at a time, using the new gold loan to pay back the old. The final price he gets for the gold will equal the initial spot price plus the five year dollar interest rate less the cost of borrowing the gold for the five years. If the cost of borrowing is unpredictable, the price is very uncertain. But the uncertainty about the average level of the one year gold interest rate over the next five years is probably of the order of ½%, so the uncertainty in the realised forward price is around 2-3%. The gold producer can create a synthetic long-term forward contract using the short term lending market, and thereby get rid of the great bulk of the price risk he otherwise faces. The idea of a producer using a synthetic forward contract may seem unrealistic. In practice, the producer is more likely to seek to sell the gold forward to a bank. But the hedging issue does not disappear. In the absence of a counterparty who wants to buy the gold forward five years, the bank will hedge its risk by short term gold borrowing. The bank then takes on the risk that gold interest rates will rise. A producer who wants to sell production forward therefore faces a choice: he can pass the gold lease rate risk on to the bank and get a fixed price forward contract, or he can accept a forward contract where the price is adjusted in line with lease rates, and he bears the lease rate risk. The fixed price deal will probably prove more expensive since long-term lease rates are on average higher than shortterm lease rates. Whether the bank writes a contract with a fixed lease rate, taking on the lease rate risk, or whether the producer agrees to keep the risk by accepting a floating lease rate, the point is the same. It is only because the risk is small, because gold interest rates are so stable, that it makes sense to do the transaction at all in the absence of a long-term forward buyer of gold. Were gold interest rates as volatile as oil interest rates, the final price on a long-term floating lease rate forward sale contract would be so uncertain that it would be quite ineffective in hedging future revenues. The premium a bank would charge to offer a fixed rate deal would tend to be so large as to make hedging unattractive. It follows that if the gold lending market were expected to become much more volatile, the long maturity derivatives market would shrink. Gold Derivatives: The market impact 33
The value of a forward contract A forward contract written at market prices has zero financial value initially. Someone who has sold production forward can negate the contract either by cancellation or by buying gold forward on the same terms. But as time passes, and the gold spot price and gold and dollar interest rates move, the forward price of gold changes and the contract becomes an asset to one side and a liability to the other. From the perspective of a producer who has sold known production forward this change in value may not seem significant. Any change in value of the forward contract is exactly offset by a change in the value of his future output. But there are at least three reasons why the change in the value of the forward contract is important. First, it represents the effect of hedging as opposed to not hedging. Second, it may create financing problems. Suppose the forward price has risen since the inception of the contract, so the hedge is loss-making from the producer’s perspective. From the bank’s perspective, the contract with the producer is now an asset, while the hedging transaction it has entered into to offset the risk is an equal and opposite liability. If the producer were to get into financial difficulties and be unable to honour the forward sale, the value of the contract is the amount which the bank stands to lose. To protect itself, the bank may demand margin (a financial payment on account), or collateral (the posting of some asset as security) or even the right to terminate the contract prematurely. The third reason that the value is important is that it can actually be realised. It is far easier and cheaper to buy gold forward and then sell it than it is to buy a gold mine and then sell it. It is the low level of transactions costs which allows producers to modify their hedges rapidly. The value of a forward sale contract can be realised by terminating it or by entering into an offsetting purchase contract. To get some idea of the sensitivity of a forward contract to changes in market conditions, consider the case of a producer who has sold gold forward five years at a fixed price when the spot price is $300/oz, and gold and dollar interest rates are 2% and 7% respectively. The fair forward price is $381/oz. If the spot gold price rises by $30/oz (a typical annual move) then the fair forward price in five years rises to 330x(1.07/1.02) 5 = $419/oz. The producer is committed to selling his gold in five years at $381/oz when the fair forward price today is $419/oz. To cancel the hedge, the producer would have to agree today to buy the gold back at $419/oz, locking in a loss of $38/oz in five years’ time. Discounting the $38/ oz, the hedge has a negative value of $27/oz today. Of course, if the gold price had fallen $30/oz, the hedge contract would have a positive value of $27/oz to the producer. But it is not only the gold price that can affect the value of the contract. If dollar interest rates go up 1% (again, a typical annual move) while spot gold stays at $300/oz, the fair forward price rises to $399/oz, and the hedge contract’s value 34 Gold Derivatives: The market impact
Page 1 and 2: WORLD GOLD COUNCIL Gold Derivatives
Page 3 and 4: Gold Derivatives: The market impact
Page 5 and 6: 4 Gold Derivatives: The market impa
Page 7 and 8: 6 Gold Derivatives: The market impa
Page 9 and 10: About the author Anthony Neuberger
Page 11 and 12: When the derivative contract mature
Page 13 and 14: Owners of gold can use the derivati
Page 15 and 16: The level and volatility of lease r
Page 17 and 18: 0 Tonnes 2500 Gold Production Annua
Page 19 and 20: Breakdown of Production in 1968 Lat
Page 21 and 22: Thus while output responds to price
Page 23 and 24: Of the approximately 140,000 tonnes
Page 25 and 26: price of gold following substantial
Page 27 and 28: y the way in which reserves are vie
Page 29 and 30: 1.4 Data issues Published statistic
Page 31 and 32: mismatch of maturity, of lending ra
Page 33: 2.2 Gold derivative contracts The v
Page 37 and 38: position. In an ideal world, if the
Page 39 and 40: (in different maturities) to exploi
Page 41 and 42: Looking at gold as a commodity, it
Page 43 and 44: Gold futures and forward contracts
Page 45 and 46: In practice, the transaction is mos
Page 47 and 48: 2.7: Producer hedging We have seen
Page 49 and 50: Accounting for hedges has long been
Page 51 and 52: But the bank which has sold the hed
Page 53 and 54: The gross numbers are impressive -
Page 55 and 56: 3.1 The debate outlined The argumen
Page 57 and 58: some 4,000 tonnes. This is a small
Page 59 and 60: stock - so many billion dollars - r
Page 61 and 62: tion is now forecast to have peaked
Page 63 and 64: 62 Gold Derivatives: The market imp
Page 65 and 66: We use ordinary least squares regre
Page 67 and 68: To apply the model to our regressio
Page 69 and 70: y changes in hedging caused by chan
Page 71 and 72: 16/04/99: Gold Fields announces tha
Page 73 and 74: (5%) significance levels. Closer in
Page 75 and 76: followed the Washington Agreement (
Page 77 and 78: and total withdrawal by just one of
Page 79 and 80: distribution). Since the interest r
Page 81 and 82: contracts they have with producers.
Page 83 and 84: In the case of a producer whose mar
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Gold Forward Lease Rates 1993-99 5.
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emains valid, that term premia have
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The second and third sections of th
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over-production will cause forward
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There is a welfare gain from openin
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a strategy to a specialised interme
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2.1 Derivatives market and leverage
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prices of their bonds and reducing
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equire physical delivery, the matur
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the contract is actually in their p
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the GNMA market, reduced random flu
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Cash settlement is also significant
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3.5 Evidence from options: price le
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additional benefits in terms of inc
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Gray R.W., 1964, ‘The Attack on P
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114 Gold Derivatives: The market im
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The simple summation treats all opt
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APPENDIX 3 The Washington Agreement
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