Gold Derivatives: Gold Derivatives: - World Gold Council

However the presence of a liquid lending market with low costs of borrowing gold
means that holding large inventories is relatively cheap and low risk. The Cross
Report estimates the amount of gold borrowed by the downstream sector in June
and December 1999 to be 1,135 and 1,465 tonnes respectively, with the bulk of
the change reflecting the seasonally higher gold demand in the fourth and first
quarters of the year.
While there are few reliable figures in this area, one would expect the level of
inventories to be sensitive to the level of lease rates. If lease rates rise from say 1%
to 4%, the cost of holding inventory quadruples, and demand for inventory should
fall back sharply. This is certainly what seems to have happened in the immediate
aftermath of the Washington Agreement. To a lesser extent, one would expect
inventories to be sensitive to the volatility of lease rates. A processor who has
substantial gold inventories can insulate himself from the volatility of the gold
price by borrowing the gold, but is then subject to the volatility of lease rates.
2.5 Speculative traders
In this report we use the term ‘speculator’ to refer to anybody who takes a long or
short position in gold with a view to making money from the change in the gold
price. Thus we distinguish speculators from producers or users of gold who are
hedging to reduce risk, from banks who act as intermediaries, offering derivative
products to customers and hedging the gold price risk, and from end users who
buy or hold gold as a convenient store of value.
In most commodity markets, the speculator is at risk from corners and squeezes.
The risks are much reduced in the case of gold. Suppose for example that speculators
are convinced that the price of a particular commodity is too high, and
decide to sell it short. They borrow the commodity and sell it, waiting for the
price to go down. If the price remains high, they roll their commodity loans, and
maintain their positions until the price falls, or they close out their positions if
they recognise that the price is not likely to fall. However, they face commodity
borrowing risk. If the amount of the commodity available for borrowing is cut
back, borrowing rates will rise until many of the speculators are forced to close
out their positions. They will be forced to realise losses in the short term even if
their views about the spot price in the long term are correct.
In the gold market, the cost of borrowing is relatively stable, so speculators do not
have to worry too much about commodity borrowing risk. Indeed the existence of a
liquid short-term gold lending market means that banks and other intermediaries
can offer long-term as well as short-term forward contracts at prices which allow
speculators to lock in expectations about future wholesale gold lending rates.
Gold Derivatives: The market impact 41