Gold Derivatives: Gold Derivatives: - World Gold Council

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The existence of a rich array of derivative contracts beyond a simple forward contract allows participants to delegate the execution of trading strategies to financial intermediaries, and to enable them to manage more subtle risks than changes in the level of the spot price, such as changes in the future commodity lending rate, and changes in the volatility of prices. 2 Derivatives and market quality: theoretical considerations Much of the debate about the impact of derivatives markets on the underlying has turned on the issue of whether making markets more liquid, reducing barriers to participation and widening the range of risks which can traded is always beneficial, or whether it can damage the quality of the underlying market. In general it seems plausible that the opening of a new market, such as a forward market or a market in options, can only be beneficial. No one is forced to use the market. People who do use the market do so because they believe they get some benefit from using it. Even if the new market attracts irrational speculators who trade on whim or fashion, and they destabilise prices, they cannot exist forever. In the long run their irrational behaviour will cause them to lose money and they will be eliminated from the market. There are also informational benefits from opening new markets. Unless the new market is totally redundant, prices on the market will reveal information to the public. One might reasonably assume that increasing generally available information is beneficial. Yet these general considerations are not compelling. As Hart (1975) demonstrates, it is possible to design theoretical models in which the opening of a new financial market is damaging. He shows how in a world of rational utility maximising traders opening a new market can diminish welfare. The argument that irrational investors will be eliminated from the market in the long run is also not very powerful. The long run may turn out to be very long indeed. If there is a continuing supply of irrational investors into the market, there can well be a significant and persistent population of irrational investors as some die and others are born. In the rest of this section we explore the main theoretical reasons for believing that derivatives may affect the cash market: the ease of building a highly leveraged position, the ease of short-selling, the fragmentation of trading between cash and derivatives markets, the impact of hedging on physical production, and the ability of a large trader or cartel to manipulate prices. Gold Derivatives: The market impact 95
2.1 Derivatives market and leverage It has often been argued that low transaction costs and, particularly, the availability of high leverage, encourage speculation and that this speculation damages the underlying market. While the detailed argument varies somewhat, the general idea is that there are irrational investors who exhibit their irrationality through some kind of herding or trend following behaviour. These irrational investors are credit constrained so the existence of a futures market 6 allows them to enter the market and build up larger positions than they would otherwise take. Opening a futures market allows more investors to enter the market, which is a good thing since it improves the risk-sharing activity of the market. But it also reduces the average level of rationality, which is damaging. The real damage done, however, by the irrational investors occurs because their leveraged position tends to induce stampedes. Suppose that irrational investors have built up a large long position, forcing prices above their natural equilibrium level. If the market then starts to move down, their high leverage and limited access to credit forces them to liquidate part of their position. If these irrational investors are large in aggregate, the rest of the market will only be able to absorb the trades by moving prices still further down. The sales snowball, and prices crash through the equilibrium level. This argument seeks to relate the existence of derivatives markets to crashes, but the argument is symmetrical. It can be used equally well to explain steep price rises if the irrational investors start net short, and are forced to cover their short positions in a hurry. The conclusion is that easy leverage in general, and futures markets in particular, cause an increase in the volatility of the underlying. A number of authors have developed formal models to assess the net welfare impact of opening a derivative market, but the results depend on the parameters used. Stein (1987) for example has a model where speculators are not allowed to trade on the spot market but are active traders on the futures market. This can be seen as an extreme case of credit constrained speculators, and a spot market with very high margin requirements. The speculators have noisy information, but are irrational in the sense that they think their information is better than it really is. This makes the futures market price a noisy signal of supply disturbances. The noise is transmitted by arbitrage to the cash market, which reduces the quality of the cash market. The opening of the futures market therefore both increases the risk bearing capacity of the market and also adds noise. Stein shows that the benefit of the first can be more than offset by the damage done by the second, though this is not the case for what he takes to be realistic parameters. 6 The argument focuses on the way futures markets allow traders to get high leverage. Traders can also get leverage if they are allowed to buy spot on margin, so the arguments apply equally to margin requirements in the spot market. 96 Gold Derivatives: The market impact
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WORLD GOLD COUNCIL Gold Derivatives
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Gold Derivatives: The market impact
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4 Gold Derivatives: The market impa
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6 Gold Derivatives: The market impa
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About the author Anthony Neuberger
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When the derivative contract mature
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Owners of gold can use the derivati
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The level and volatility of lease r
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0 Tonnes 2500 Gold Production Annua
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Breakdown of Production in 1968 Lat
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Thus while output responds to price
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Of the approximately 140,000 tonnes
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price of gold following substantial
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y the way in which reserves are vie
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1.4 Data issues Published statistic
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mismatch of maturity, of lending ra
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2.2 Gold derivative contracts The v
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The value of a forward contract A f
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position. In an ideal world, if the
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(in different maturities) to exploi
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Looking at gold as a commodity, it
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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
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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
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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
Page 85 and 86: Gold Forward Lease Rates 1993-99 5.
Page 87 and 88: emains valid, that term premia have
Page 89 and 90: The second and third sections of th
Page 91 and 92: over-production will cause forward
Page 93 and 94: There is a welfare gain from openin
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Page 99 and 100: prices of their bonds and reducing
Page 101 and 102: equire physical delivery, the matur
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Page 107 and 108: Cash settlement is also significant
Page 109 and 110: 3.5 Evidence from options: price le
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Page 113 and 114: Gray R.W., 1964, ‘The Attack on P
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Page 117 and 118: The simple summation treats all opt
Page 119 and 120: APPENDIX 3 The Washington Agreement
Page 121: Headquarters: UK 45 Pall Mall Londo
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