Gold Derivatives: Gold Derivatives: - World Gold Council

1.2 The role of storage
So far we have ignored the role of storage; the model presented applies most
naturally to the production of an agricultural commodity where there are two
periods – a time for investment and a time for consumption. But for commodities
like gold which are extracted rather than grown, and which can be stored if not
consumed, more sophisticated analysis is required.
Note that the existence of a forward market is equivalent to the existence of a
commodity lending market. If the forward market exists, a synthetic commodity
loan can be constructed by a spot sale and forward repurchase. Conversely, if a
lending market exists, a forward sale can be synthesised by a spot sale coupled
with borrowing the commodity. There may be some institutional differences between
the contract and its synthetic equivalent, but these are small relative to the
similarities, and at this stage of the analysis we can ignore them. For the present
then in discussing the impact of a forward market, I include commodity lending
markets as well as standard forward markets.
The equivalence between forwards and commodity lending also means that the
prices in the two markets are tied to each other. Assuming a standardised commodity,
and ignoring taxation, credit and other similar issues, the cost of borrowing
a commodity, expressed as an annually compounded rate b for a time of length
T must be related to the spot price today S 0
, the forward price today for delivery
at T denoted by F 0,T
, and the riskless rate of interest r (also continuously compounded)
by the formula:
F
0, T
= S e
( r−b)T
0
Note that, in this definition, the person borrowing the commodity also bears the
cost of storage, insurance and so on.
If there is a forward or a commodity lending market, and if individual agents are
too small to influence the market, people holding inventory presumably believe
that they are getting some benefit from holding stocks which equals or exceeds
the borrowing cost. Otherwise they would be better off lending the commodity
to someone else. Now the benefits from holding stocks include the savings when
there is breakdown in logistics, a surge in demand or a sudden spike in the price.
It is reasonable to assume that there will be a strong link between the size of these
benefits at the margin and the level of stocks held. If the level of stocks is very low,
a small hiatus in supplies could cause disruption, so the marginal value of inventory
is high. Conversely when stock levels are high, even a large and improbable
shock may have little impact, so the marginal value of inventory will be low, and
commodity borrowing rates will also be low.
Gold Derivatives: The market impact 91