Gold Derivatives: Gold Derivatives: - World Gold Council

over-production will cause forward prices to fall and plans to be revised before
they are put into effect.
In addition to providing information which is socially valuable, forward markets
also lead to more efficient sharing of risk in the economy. In a world without
forward markets, each producer bears price risk on his own output. With forward
markets producers who are risk averse sell their production forward, and thereby
reduce or eliminate the risks they have to bear. The long side of the forward
market is taken by producers who are readier to bear risk or, more plausibly, by
consumers of the commodity who want to hedge their costs.
But access to the forward market is not restricted to producers and consumers. If
the hedging needs of producers who are selling forward are greater than the hedging
needs of consumers who are buying forward, the forward price will tend to be
forced below the consensus forecast of the future spot price. Long forward positions
will tend to deliver positive, if risky, returns 1 . Speculators 2 will be attracted
into the market, predominantly on the long side.
If risks are borne by those more prepared to bear them, then the cost of risk borne
by the economy as a whole is reduced. The existence of a forward market, by
improving the efficiency with which risk is borne, reduces the effective cost of
production of the commodity in much the same way as more efficient production
technologies. As with any other cost reduction, the ultimate impact depends on
the degree of competition upstream and downstream. If input and output markets
are competitive, the reduction in costs will lead to higher profits for producers,
which will in turn attract new investment which will then lead to increased
output and lower prices. The technological improvement whether it comes from
improved production technology or improved risk sharing technology, leads to
the creation of value. The division of this value between producers and consumers
depends on the relative elasticity of supply and demand.
On this traditional view, forward markets reduce the volatility of the underlying
spot price by providing a mechanism for concerting investment decisions, and
aggregating information about the future supply/demand balance. Forward markets
will tend to lower commodity prices by reducing the risk which producers
are forced to bear. By improving information flows and risk sharing, forward markets
will tend to improve welfare in the economy, though how that welfare gain is
shared between parties is not clear from the model.
2
The predicted positive expected returning on long forward positions is known as ‘normal backwardation’
and was first discussed by Keynes (1930) in his Treatise on Money. It is quite distinct from the other
use of the term backwardation to signify the situation when the current forward price is trading below
the spot price.
3
The term ‘speculator’ is used in a technical (and morally neutral) sense to signify an agent who has a
purely financial interest in the commodity, intending neither to produce it nor consume it.
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Gold Derivatives: The market impact