The gold market v1.0

Business Opportunities in Gold
Opportunities in Gold Market in
Market inIndia
India

Compiled by

Mr. Prafulla M. Kharote

Opportunities in Gold Market in India

Mr. PRAFULLA M. KHAROTE

CONTENTS

1.CURRENT ECONOMIC SITUATION AND GOLD MARKET......................................................................5

2.INTRODUCTION TO THE GOLD MARKET...............................................................................................9

The Post World War II Politics of Gold......................................................................................................11

The London Gold Fixing.............................................................................................................................13

Gold and European Union..........................................................................................................................14

The Two-Tier System..................................................................................................................................15

The Special Drawing Right (SDR) as "Paper Gold"...................................................................................16

How Foreign Exchange Intervention Affects the Money Supply?............................................................18

The Breakdown of Bretton Woods.............................................................................................................19

3.International Gold Market...........................................................................................................................22

The London Bullion Market Association (LBMA)....................................................................................22

The London Good Delivery Bar.................................................................................................................22

London Clearing Houses............................................................................................................................23

Transactions at the Fix...............................................................................................................................25

Pricing Nonstandard Contracts.................................................................................................................27

The Gold Lease or Gold Libor Rates..........................................................................................................28

4.GOLD PRODUCTS AVAILABLE IN INTERNATIONAL MARKET...........................................................30

The Gold Forward Price.............................................................................................................................30

Gold Swaps...................................................................................................................................................31

Gold Futures...............................................................................................................................................34

How Futures Markets Deal with Credit Risk........................................................................................35

The Equilibrium Futures Price..............................................................................................................36

Exchange for Physicals...............................................................................................................................39

Gold Forward Rate Agreement (FRA).......................................................................................................40

| CURRENT ECONOMIC SITUATION AND GOLD MARKET 2



Gold Interest Rate Swaps...........................................................................................................................43

Gold Interest Rate Guarantees...................................................................................................................45

Option Terminology..................................................................................................................................46

Options on Spot Gold............................................................................................................................47

Options on Gold Futures.......................................................................................................................47

Definition Summary..............................................................................................................................48

Gold Options as Insurance....................................................................................................................49

Floors and Ceilings.................................................................................................................................52

Over-the-Counter Options....................................................................................................................53

Writing Gold Options............................................................................................................................56

5.THE INDIAN GOLD MARKET....................................................................................................................57

6.GOLD DEMAND IN INDIA........................................................................................................................58

7.From Rural to Urban...................................................................................................................................59

8.Gold Price Performance...............................................................................................................................61

9.Reserve Bank's 200 tonnes purchase (2009)..............................................................................................62

10.Products in Gold Market of India..............................................................................................................62

Gold Exchange Traded Fund - the smart way to invest in gold...............................................................62

E – GOLD: THE NEW AVTAR OF GOLD – by NSEL...............................................................................66

11.Banking on Gold..........................................................................................................................................70

GOLD COINS.............................................................................................................................................70

LOAN AGAINST GOLD.............................................................................................................................73

GOLD DEPOSIT SCHEME (GDS) by SBI..................................................................................................76

Physical Business........................................................................................................................................78

Consignment Business...............................................................................................................................79

Sale of Gold on Fixed and Unfixed basis ..............................................................................................79

Gold as Loan................................................................................................................................................81

Gold Forwards.............................................................................................................................................81

Proprietary Trading in Gold .....................................................................................................................82




12.Other businesses related to Gold Market..................................................................................................83

Gold Mining................................................................................................................................................83

Gold Refinery.............................................................................................................................................84

Numismatic Gold Coins.............................................................................................................................84

13.The Future of Gold.....................................................................................................................................86

Bibliography....................................................................................................................................................88




1. CURRENT ECONOMIC SITUATION AND GOLD MARKET

The global economic crisis instigated by the sub-prime mortgage lending in the U.S.
has led to many investors taking refuge under the precious yellow metal. Prices of the
precious yellow metal have shown a resilient up-move ever since 2008, and even today
while the global economy is recovering, many smart investors are preferring to take
refuge under the precious yellow metal, thus safeguarding themselves against the
backdrop of downbeat global economic events such as:

• Downgrade of U.S. sovereign rating from ‘AAA' to ‘AA+' with a negative
outlook

• Debt overhang situation in the Euro zone

• Inflationary pressures in the Emerging Market Economies

But whether it is prudent to invest in the precious yellow metal at present?

CAN GOLD GET BOLDER?

Gold has been historically considered as an important asset class mainly for three
reasons:

• It is a hedge against inflation

• It adds stability to the investment portfolio

• Asset Allocation avenue

And as an asset class, gold over the year has shown a secular uptrend. In 1971, the price
of gold was about U.S. dollar 32 an ounce and today (mid-August 2011), gold has
crossed U.S. dollar 1,800 an ounce mark. This indicates that price of gold has gone up
by 56 times over the last 40 years. Even in the last 13 years (i.e. since Jan 2, 1998) as
depicted in the chart hereunder, until August 22, 2011 gold prices have appreciated by




whooping 559% (on an absolute basis).

At present the House of Representatives have voted on August 2, 2011 for an increase
in the U.S. debt ceiling limit by U.S. $2.1 trillion (making it U.S $16.4 trillion), and also
agreed to cut federal spending by U.S. $2.4 trillion dollars or more. This in our opinion
would purely bloat the U.S. economy (which already has been made a 92% increase in
debt ceiling in the last 3 decades) and make its debt to GDP ratio daunting to manage.




Big fat U.S. debt ceiling

(Source: whitehouse.gov)

Moreover while the debt ceiling limit is increased, the long-term risk of sovereign
default crisis by the U.S. still remains because this decision of increasing debt ceiling
limit is purely a case of postponing a sovereign default to happen. Moreover the
dawdling pace of economic growth rate is not justifying the increase in debt ceiling
limit, and high unemployment rate (9.10% in July 2011) remains a cause of concern.

The picture in Europe too narrates a gloomy story. With Greece's failure to put its
public finances in place has caused a situation of a debt overhang in the Euro zone,
and is also spreading a contagion to the other countries in the Euro zone.

In India, while the Reserve Bank of India (RBI) has maintained its anti-inflationary
stance and increased policy rates 12 times successively since March 2010; the results
haven't been too positive as the inflation bug continues to haunt and be over the
comfort level (of 8.00%) of RBI (WPI inflation for July 2011 was 9.22%).

Thus taking a view of the aforementioned downbeat economic factors we are of the
opinion that the northward trajectory for gold would be maintained as global
economic recovery appears to be facing stumbling blocks. In fact being aware of the
same most economies led by the U.S. and the Euro zone ones are maintaining elevated




levels of gold reserves too (as revealed by the chart below), in order to hedge the risk
of an economic breakdown. Moreover if the U.S. dollar weakens due to bloated debt to
GDP ratio, the northward trajectory would be clearly paved for the precious yellow
metal.

Heaping up gold

Hence taking into account the fundamentals for gold presented above, Gold as an
asset class makes a strong case for inclusion in one's portfolio (as it would insure /
hedge your portfolio against the various risks it is exposed to).




2. INTRODUCTION TO THE GOLD MARKET

The gold market is a unique 24-hour-a-day market for the purchase or sale of one of
history's longest-valued commodities. What gives the market its special character is
the use of gold simultaneously as industrial commodity, as decoration (jewelry), and
as a monetary asset. To understand the gold market, it is important to understand the
latter function. Because gold has often formed a component of the local money supply,
its history is intertwined with national and central bank politics.

GOLD AS MONEY

Gold is only one of many commodities that over the years have served as money--as a
medium of exchange--in international trade and financial transactions. Such
commodities have frequently varied. In many local communities (including nation-
states), the most widely used commodity, or the product most traded with outsiders,
has often functioned as money. In the Oregon territory from 1830 to 1840, for example,
beaver skins were a customary medium of exchange. Then, as the population shifted
from fur trapping to farming, wheat became the chief form of money, and from 1840 to
1848 promissory notes were made payable in so many bushels of wheat. Later, with the
California gold discoveries in 1848, the Oregon legislature repealed the law making
wheat legal tender, and proclaimed that thereafter only gold and silver were to be used
to settle taxes and debts. For similar reasons, tobacco long served as the principal
currency in Virginia. When the Virginia Company imported 150 "young and uncorrupt
girls" as wives for the settlers in 1620 and 1621, the price per wife was initially 100
pounds of tobacco--later climbing to 150 pounds.

Only a few currencies, however, have had long-run durability as well as multi-
territorial acceptability. Silver and gold are two of these. Roughly speaking, from the
time of Columbus' discovery of America in 1492 to the California gold discovery in
1848, silver dominated in common circulation in America and Europe, while gold
came into dominance following the Californian and Australian gold discoveries. Under
the rule of the British Empire, the British pound sterling and the gold standard were
adopted in much of the world. Toward the end of World War Two, the U.S. dollar and
gold became the principal international reserve assets under the Bretton Woods




agreement--a market position the U.S. dollar and gold have maintained despite the de
facto dissolution of that system in the early 1970s.




THE POST WORLD WAR II POLITICS OF GOLD

Under the Bretton Woods Agreement forged at the Mt. Washington Hotel in Bretton
Woods, New Hampshire in 1944, each member of the newly created International
Monetary Fund (IMF) agreed to establish a par value for its currency, and to maintain
the exchange rate for its currency within 1 percent of par value. In practice, since the
principal reserve currency would be the U.S. dollar, this meant that other countries
would peg their currencies to the U.S. dollar, and--once convertibility was restored--
would buy and sell U.S. dollars to keep market exchange rates within the 1 percent
band around par value. The United States, meanwhile, separately agreed to buy gold
from or sell gold to foreign official monetary authorities at $35 per ounce in settlement
of international financial transactions. The U.S. dollar was thus pegged to gold, and
any other currency pegged to the dollar was indirectly pegged to gold at a price
determined by its par value.

What does it mean to fix the price (the exchange value) of a currency or a commodity
like gold? If no trading other than with official authorities is allowed (as when
something is "inconvertible"), then fixing the price is easy. The central bank or
exchange authority simply says the price is "X" and no one can say differently. If you
want to trade gold for dollars, you have to deal with the central bank, and you have to
trade at central bank prices. The central bank may in fact even refuse to trade with
you, but it can still maintain the lawyerly notion that the exchange rate is "fixed."
(Such a refusal, of course, will only lead to black market trading outside official
channels.) If, however, free trade is allowed, fixing the price requires a great deal
more. The price can be fixed only by altering either the supply of or the demand for
the asset. For example, if you wanted to fix the price of gold at $35 per ounce, you
could only do so by being willing and able to supply unlimited amounts of gold to the
market to drive the price back down to $35 per ounce whenever there would otherwise
be excess demand at that price, or to purchase unlimited amounts of gold from the
market to drive the price back up to $35 per ounce whenever there would otherwise be
excess supply at that price.

In order to peg the price of gold you would thus need two things: a large stock of gold
to supply to the market whenever there is a tendency for the market price of gold to
go up, and a large stock of dollars with which to purchase gold whenever there is a
tendency for the market price of gold to go down. No problem. The U.S. had plenty of




gold--about 60 percent of the world's stock. And, naturally, it also had plenty of
dollars, which could be created with the stroke of a pen.

After the Bretton Woods Agreement, the price of gold remained uncontroversial for
the next decade. But around 1960 the private market price of gold began to show a
persistent tendency to rise above its official price of $35/ounce. So, in the fall of 1960,
the United States joined with the central banks of the Common Market countries as
well as with Great Britain and Switzerland to intervene in the private market for gold.
If the private market price did not rise above $35 per ounce, it was felt, the Bretton
Woods price was de facto the correct price, and in addition no one could complain if
dollars were not exchangeable for gold. This coordinated intervention, which involved
maintaining the gold price within a narrow range around $35 per ounce, became
formalized a year later as the gold pool. Since London was the center of world gold
trading, the pool was managed by the Bank of England, which intervened in the
private market via the daily gold price fixing at N. M. Rothschild.




THE LONDON GOLD FIXING

In its current form, the London gold price fixing takes place twice each business day,
at 10:30 A.M. and 3:00 P.M. in the "fixing room" of the merchant banking firm of N. M.
Rothschild. Five individuals, one each from five major gold-trading firms, are involved
in the fixing. The firms represented are Mocatta & Goldsmid, a trading arm of
Standard Chartered Bank; Sharps Pixley, a dealer owned by Deutsche Bank; N. M.
Rothschild & Sons, whose representative acts as the auctioneer; Republic-Mase, a
bullion subsidiary of Republic Bank; and Samuel Montagu, a merchant banking
subsidiary of Midland Bank (owned by HSBC). Each representative at the fixing keeps
an open phone line to his firm's trading room. Each trading room in turn has buy and
sell orders, at various prices, from customers located all over the world. In addition,
there are customers with no existing buy or sell orders who keep an open line to a
trading room in touch with the fixing and who may decide to buy or sell depending on
what price is announced. The N. M. Rothschild representative announces a price at
which trading will begin. Each of the five individuals then confers with his trading
room, and the trading room tallies up supply and demand--in terms of 400-ounce
bars-- from orders originating around the world. In a few minutes, each firm has
determined if it is a net buyer or seller of gold. If there is excess supply or demand a
new price is announced, but no orders are filled until an equilibrium price is
determined. The equilibrium price, at which supply equals demand, is referred to as
the "fixing price." The A.M. and P.M. fixing prices are published daily in major
newspapers.

Even though immediately before and after a fixing gold trading will continue at prices
that may vary from the fixing price, the fixing price is an important benchmark in the
gold market because much of the daily trading volume goes through at the fixing
price. Hence some central banks value their gold at an average of daily fixing prices,
and industrial customers often have contracts with their suppliers written in terms of
the fixing price. Since a fixing price represents temporary equilibrium for a large
volume of trading, it may be subject to less "noise" than are trading prices at other
times of the day. Usually the equilibrium fixing price is found rapidly, but sometimes
it takes twenty to thirty tries. Once in October 1979, with supply and demand
fluctuating rapidly from moment to moment, the afternoon fixing in London lasted an
hour and thirty-nine minutes.




The practice of fixing the gold price began in 1919. It continued until 1939, when the
London gold market was closed as a result of war. The market was reopened in 1954.
When the central bank gold pool began officially in 1961, the Bank of England--as
agent for the pool--maintained an open phone line with N. M. Rothschild during the
morning fixing (there was as yet no afternoon fixing). If it appeared that a fixing price
would be established that was above $35.20 or below $34.80, the Bank of England (as
agent) became a seller or buyer of gold in an amount sufficient to ensure that the
fixing price remained within the prescribed bands.

GOLD AND EUROPEAN UNION

While the gold pool held down the private market price of gold, gold politics took a
new turn in the international arena. This was related to the fact that European
countries, which had complained of a "dollar shortage" in the 1950s, where now
complaining of a "dollar glut." They were accumulating too many dollar reserves.
Although it was actually Germany that was running the greatest surplus and
accumulating the most dollar reserves in the early 1960s, it was France under the
leadership of Charles de Gaulle that made the most noise about it. During World War
II, in conversations with Jean Monnet, de Gaulle had supported the notion of a united
Europe--but a Europe, he insisted, under the leadership of France. After the war,
France had opposed the American plan for German rearmament even in the context of
European defense. France had been induced to agree, however, through Marshall Plan
aid, which France was not inclined to refuse after it became embroiled in the Indo-
China War. But now, in the 1960s, de Gaulle's vision of France as a leading world
power led him to withdraw from NATO because NATO was a U.S.-dominated military
alliance. It also led him to oppose Bretton Woods, because the international monetary
system was organized with the U.S. dollar as a reserve currency.

In the early 1960s there was, however, no realistic alternative to the dollar as a reserve
asset, if one wanted to keep reserves in a form that both would bear interest and could
be traded internationally. Official dollar-reserve holders not only were made exempt
from the interest ceilings of the Federal Reserve's Regulation Q for their deposits in
New York but also began as a regular practice to hold dollars in the Euro-Dollar
market--a free market where interest rates found their own level. Prior to 1965, central
banks were the largest suppliers of dollars to the Euromarkets. Thus dollar reserve
holders received a competitive return on their dollar assets, and the United States
gained no special benefit from the use of the dollar as a reserve asset.




Nevertheless, de Gaulle's stance on gold made domestic political sense, and in
February 1965, in a well-publicized speech, he said: "We hold as necessary that
international exchange be established . . . on an indisputable monetary base that does
not carry the mark of any particular country. What base? In truth, one does not see
how in this respect it can have any criterion, any standard, other than gold. Eh! Yes,
gold, which does not change in nature, which is made indifferently into bars, ingots
and coins, which does not have any nationality, which is held eternally and universally
. . . .?" By the "mark of any particular country" he had in mind the United States, which
announced the Foreign Credit Restraint Program about a week later, in part as a direct
response to de Gaulle's speech. France stepped up its purchases of gold from the U.S.
Treasury and in June 1967, when the Arab-Israeli Six-Day War led to a large increase in
the demand for gold, withdrew from the gold pool.

THE TWO-TIER SYSTEM

Then in November 1967, the British pound sterling was devalued from its par value of
$2.80 to $2.40. Those holding sterling reserves took a 14.3 percent capital loss in dollar
terms. This raised the question of the exchange rate of the other reserve assets: if the
dollar was to be devalued with respect to gold, a capital gain in dollar terms could be
made by holding gold. Therefore demand for gold rose and, as it did, gold pool sales in
the private market to hold down the price were so large that month that the U.S. Air
Force made an emergency airlift of gold from Fort Knox to London, and the floor of
the weighing room at the Bank of England collapsed from the accumulated tonnage of
gold bars.

In March 1968, the effort to control the private market price of gold was abandoned. A
two-tier system began: official transactions in gold were insulated from the free
market price. Central banks would trade gold among them at $35 per ounce but would
not trade with the private market. The private market could trade at the equilibrium
market price and there would be no official intervention. The price immediately
jumped to $43 per ounce, but by the end of 1969 it was back at $35. The two-tier
system would be abandoned in November 1973, after the emergence of floating
exchange rates and the de facto dissolution of the Bretton Woods agreement. By then
the price had reached $100 per ounce.

When the gold pool was disbanded and the two-tier system began in March 1968,
there was a two-week period during which the London gold market was forceably




closed by British authorities. A number of important changes took place during those
two weeks. South Africa as a country was the single largest supplier of gold and had
for years marketed the sale of its gold through London, with the Bank of England
acting as agent for the South African Reserve Bank. With the breakdown of the gold
pool, South Africa was no longer assured of steady central bank demand, and--with
the London market temporarily closed--the three major Swiss banks (Swiss Bank
Corporation, Swiss Credit Bank, and Union Bank of Switzerland) formed their own
gold pool and persuaded South Africa to market through Zurich.

In 1972, the second major country supplier of gold, the Soviet Union, also began to
market through Zurich. In 1921, V. I. Lenin had written, "sell [gold] at the highest
price, and buy goods with it at the lowest price." Since the Soviet ruble was not
convertible, the Soviet Union used gold sales as one major source of its earnings of
Western currencies, and in the 1950s and 1960s sold gold through the Moscow
Narodny in London (a bank that had also provided dollar cover for the Soviets during
the early days of the Cold War). In Zurich, the Soviet Union dealt gold via the
Wozchod Handelsbank, a subsidiary of the Soviet Foreign Trade Bank, the
Vneshtorgbank. (In March 1985, the Soviet Union announced that the Wozchod would
be closed because of gold-trading losses and would be replaced with a branch office of
the Vneshtorgbank. The branch office, unlike the Wozchod, would not be required to
publish information concerning operations.)

London, in order to stay competitive, subsequently turned itself more into a gold-
trading center than a distribution center. When the London market reopened in
March 1968 after the two-week "holiday," a second daily fixing (the 3:00 P.M. fixing)
was added in order to overlap with U.S. trading hours, and the fixing price was
switched to U.S. dollar terms from pound sterling terms. But by the 1980s, London's
new role as a trading center had begun to be challenged by the Comex gold futures
market in New York.

THE SPECIAL DRAWING RIGHT (SDR) AS "PAPER GOLD"

During the early years of the gold pool, it came to be believed that there was a
deficiency of international reserves and that more reserves had to be created by legal
fiat to enable reserve-holders to diversify out of the U.S. dollar and gold. In retrospect,
this was a curious view of the world. The form in which reserves are held will
ultimately always be determined on the basis of international competition. People will




hold their wealth in the form of a particular asset only if they want to. If they do not
have an economic incentive to desire a particular asset, no legal document will alter
that fact. A particular currency will be attractive as a reserve asset if these four criteria
exist: (1) an absence of exchange controls so people can spend, transfer, or exchange
their reserves denominated in that currency when and where they want them; (2) an
absence of applicable credit controls and taxes that would prevent assets denominated
in the currency from bearing a competitive rate of return relative to other available
assets; (3) political stability, in the sense that there is a lack of substantial risk that
points (1) and (2) will change within or between government regimes; (4) a currency
that is in sufficient use internationally to limit the costs of making transactions. These
four points explain why, for example, the Swiss but not the French franc has been
traditionally used as an international reserve asset.

Many felt that formal agreement on a new international reserve asset was nevertheless
needed, if only to reduce political tension. And while France wanted to replace the
dollar as a reserve asset, other nations were looking instead for a replacement for gold.
The decision was made by the Group of Ten (ten OECD nations with most of the
voting rights in the IMF) to create an artificial reserve asset that would be traded
among central banks in settlement of reserves. The asset would be kept on the books
of the IMF and would be called a Special Drawing Right (SDR). In fact it was a new
reserve asset, a type of artificial or "paper gold," but it was called a drawing right by
concession to the French, who did not want it called a reserve asset.

The SDR was approved in July 1969, and the first "allocation" (creation) of SDRs was
made in January l970. Overnight, countries gained more reserves at the IMF, because
the IMF added new numbers to its accounts and called these numbers SDRs. The
timing of the allocation was especially maladroit. In the previous four years the United
States had been in the process of financing the Great Society domestic social programs
of the Johnson administration as well as a war in Vietnam, and the world was being
flooded with more reserves than it wanted at the going price of dollars for
deutschemarks, yen, or gold. In the 1965 Economic Report of the President, Johnson
wrote, in reference to his Great Society Program and the Vietnam War: "The Federal
Reserve must be free to accommodate the expansion in 1965 and the years beyond
1965." U.S. money supply (M1) growth, which had averaged 2.2 percent per year during
the 1950s, inched upward slightly during the Kennedy years (2.9 percent per year for
1961- 1963) but changed materially under the Johnson administration. The growth rate
of M1 averaged 4.6 percent per year over 1964-1967, then rose to 7.7 percent in 1968.
Under the Nixon administration that followed, money growth initially slowed to 3.2
percent in 1969 and 5.2 percent in 1970, then accelerated to 7.1 percent for 1971-1973.




The latter three years would encompass the breakdown of Bretton Woods, and would
also have a material effect on the price of gold.

HOW FOREIGN EXCHANGE INTERVENTION AFFECTS THE MONEY SUPPLY?

In order to succeed, a regime of fixed exchange rates (and under Bretton Woods, rates
for the major currencies were fixed in terms of their par values, which could not be
casually altered) requires coordinated economic policies, particularly monetary
policies. If two different currencies trade at a fixed exchange rate and one currency is
undervalued with respect to the other, the undervalued currency will be in excess
demand. By the end of the 1960s both the deutschemark and the yen had become
undervalued with respect to the U.S. dollar. Therefore the countries concerned
(Germany and Japan) had two choices: either increase the supplies of their currencies
to meet the excess demand or adjust the par values of their currencies upward enough
to eliminate the excess demand.

As long as either country intervened in the market to maintain the par value of its
currency with respect to the U.S. dollar, an increased supply of the domestic currency
would take place automatically. To see why this is so, take the case of Germany. In
order to keep the DM from increasing in value with respect to the U.S. dollar, the
Bundesbank would have to intervene in the foreign exchange market to buy dollars. It
would buy dollars by selling DM. The operation would increase the supply of DM in
the market, driving down DM's relative value, and increase the demand for the dollar,
driving up the dollar's relative value.

Any time the central bank intervenes in any market to buy or sell something, it
potentially changes the domestic money supply. If the central bank buys foreign
exchange, it does so by writing a check on itself--by giving credit to the seller. Central
bank assets go up: the central bank now owns the foreign exchange. But central bank
liabilities go up also, since the check represents a central bank liability. The seller of
the foreign exchange or other asset will deposit the central bank's check, in payment
for the value of the assets, in an account at a commercial bank. The commercial bank
will in turn deposit the check in its account at the central bank. The commercial bank
will now have more reserves, in the form of a deposit at the central bank. The bank
can use the reserves to make more loans, and the money supply will expand by a
multiple of the initial reserve increase.




Is there anything the German authorities can do to prevent the money- supply
increase? Essentially not, as long as they attempt to maintain the fixed exchange rate.
There is, however, an operation referred to as sterilization. Sterilization refers to the
practice of offsetting any impact on the monetary base caused by foreign exchange
intervention, by making reverse transactions in terms of domestic assets (such as
government bonds). For example, if the money base went up by DM4 billion because
the central bank bought dollars in the foreign exchange market, a sterilization
operation would involve selling DM4 billion worth of domestic assets to reduce
central bank liabilities by an equal and offsetting amount. If the Bundesbank sold
domestic assets, these would be paid for by checks drawn on the commercial banking
system and reserves would disappear as the commercial banks' checking accounts
were debited at the central bank.

However, the Bundesbank could not simultaneously engage in complete sterilization
(a complete offset) and also maintain the fixed exchange rate. If there was no change
in the supply of DM, the DM would continue to be undervalued with respect to the
dollar, and foreign exchange traders would continue to exchange dollars for DM.
During the course of 1971, the Bundesbank intervened so much that the German high-
powered money base would have increased by 42 percent from foreign exchange
intervention alone. About half this increase was offset by sterilization, but, even so,
the increase in the money base--and eventually the money supply--by more than 20
percent in one year was enormous by German standards. The breakdown of the
Bretton Woods system began that year.

THE BREAKDOWN OF BRETTON WOODS

It came about this way. From the end of World War II to about 1965, U.S. domestic
monetary and fiscal policies were conducted in such a way as to be noninflationary. As
world trade expanded during this period, the relative importance of Germany and
Japan grew, so that by the end of the 1960s it was unreasonable to expect any system of
international finance to endure without a consensus at least among the United States,
Germany, and Japan. But after 1965, U.S. economic policy began to conflict with
policies desired by Germany and Japan. In particular, the United States began a strong
expansion, and moderate inflation, as a result of the Vietnam War and the Great
Society program.




When it became obvious that the DM and yen were undervalued with respect to the
dollar, the United States urged these two nations to revalue their currencies upward.
Germany and Japan argued that the United States should revise its economic policy to
be consistent with those in Germany and Japan as well as with previous U.S. policy.
They wanted the United States to curb money- supply growth, tighten credit, and cut
government spending. In the ensuing stalemate, the U.S. policy essentially followed
the recommendations of a task force chaired by Gottfried Haberler. This was a policy
of officially doing nothing and was commonly referred to as a policy of "benign
neglect." If Germany and Japan chose to intervene to maintain their chosen par values,
so be it. They would be allowed to accumulate dollar reserves until such time as they
decided to change the par values of their currencies. That was the only alternative if
the United States would not willingly change its policy. It was clearly understood at
the time that a unilateral action on the part of the United States to devalue the dollar
by increasing the dollar price of gold would be matched by similar European
devaluations.

In April 1971, the Bundesbank took in $3 billion through foreign exchange
intervention. On May 4 it took in $1 billion in the course of the day. On May 5 the
Bundesbank took in $1 billion during the first hour of trading, then suspended
intervention in the foreign exchange market. The DM was allowed to float upward. On
August 15 the U.S. president, Nixon, suspended the convertibility of the dollar into
gold and announced a 10 percent tax on imports. The tax was temporary and was
intended to signal the magnitude by which the United States thought the par values of
the major European and Japanese currencies should be changed.

An attempt was made to keep the Bretton Woods system going by a revised
agreement, the Smithsonian agreement, reached at the Smithsonian Institution in
Washington on December 17-18, 1971. Called by President Nixon "the most important
monetary agreement in the history of the world," it lasted only slightly more than a
year, but beyond the 1972 U.S. presidential election. At the Smithsonian Institution the
Group of Ten agreed on a realignment of currencies, an increase in the official price of
gold to $38 per ounce, and expanded exchange rate bands of 2.25 percent around their
new par values.

Over the period February 5-9, 1973, history repeated itself, with the Bundesbank taking
in $5 billion in foreign exchange intervention. On February 12, exchange markets were
closed in Europe and Japan, and the United States announced a 10 percent devaluation
of the dollar. European countries and Japan allowed their currencies to float and, over
the next month, a de facto regime of floating exchange rates began. The floating rate
system has persisted to the present; with none of the five most widely traded




currencies (the dollar, the DM, the British pound, the Japanese yen, and the Swiss
franc) in any way officially fixed in exchange value with respect to the others. (Briefly,
from October 1990 to September 1992, the DM and the British pound were nominally
linked in the Exchange Rate Mechanism of the European Monetary System.) With the
breakdown of Bretton Woods, there began a slow dismantling of the array of controls
that had been erected in its name. This included gold.

As part of the Jamaica agreement in 1976 (which ludicrously proclaimed a "New
International Economic Order"), IMF members agreed to demote the role of gold. But
few central banks subsequently followed up this agreement in practice. One associated
change that did come about, however, affected the private gold market in the United
States. On January 2, 1975, after forty years of prohibition, U.S. citizens were allowed to
purchase gold bullion legally. The Comex in New York subsequently became an
important center for the trading of gold futures.




3. INTERNATIONAL GOLD MARKET

THE LONDON BULLION MARKET ASSOCIATION (LBMA)

The center of world gold trading is London, and the center of London gold and silver
trading is the London Bullion Market, operated by the London Bullion Market
Association (LBMA). Members are classified into market making members, which
include all of the participants in the twice-daily London gold fix described in Part 1, as
well as other bullion houses (for a total of 14), and ordinary members, of which there
are about 50. Most bullion houses act both as brokers for customers, and as primary
dealers who hold positions of their own in order to profit from the bid/asked spread or
from equilibrium price movements.

Market makers are obligated to make two-way prices (that is, for both buying and
selling) throughout the day. Ordinary dealers will usually quote prices to their own
clients, but have no obligation to make two-way markets or to quote to other dealers.

The fixing of the gold price starts at 10:30 a.m. in the morning (and lasts until a single
price representing temporary equilibrium between supply and demand is found,
usually a few minutes later), and again at 3:00 p.m. in the afternoon. (A silver price
fixing takes place beginning at 12 noon.) During these time periods the fix is the
principal focus of trading, but trading by the same firms occurs before and after the fix
and indeed gold trades around the world for almost 24 hours a day. The time overlaps
between various trading centers can be seen in the daily gold price chart above from
Kitco.com

Most gold trading around the world takes place "loco London", meaning the gold is
sold for delivery in London.

THE LONDON GOOD DELIVERY BAR

The LMBA sets down standards for gold bars that can be accepted for "good delivery."
The London good delivery bar is a benchmark standard for spot (or physical) gold
transaction. The requirements are:




Weight: 350-430 fine troy ounces

Fineness: minimum 995 parts per 1000 fine gold

Assayers/Melters Stamp: any approved by the LMBA

a serial number and fineness, along
Obligatory Marks: with an assayer and melter stamp of
weight to within .025 troy ounces

must be of good appearance, free from
Appearance:
cavities, and easy to handle and stack

usually takes place at one of the London
Delivery:
bullion clearing houses

Price quotations in the spot market are usually expressed in U.S. dollars, and are
quoted as the price per fine troy ounce, such as:

$1292.50-$1292.80/oz

Here the bid or buying price is $1292.50 per fine troy ounce, and the asked or selling
price is $1292.80 per fine troy ounce. Spot delivery will take place in terms of London
good delivery bars on the spot date, which is the second working day after the trade
date.

Although the price is quoted in dollars per ounce, all trades must take place in terms
of so many gold bars, because physical delivery must take place in whole multiples of
gold bars. The standard amount for a dealer spot price quotation is ten 400 oz. bars, or
4000 ozs. of gold. Thus if one purchased the standard amount at the dealer's asked
rate listed above, one would pay:

10 x 400 x $1292.80 = $5,171,200

in two working days to the seller, and receive in return 4000 ozs. of gold at one of the
bullion clearing houses.

LONDON CLEARING HOUSES




A bullion clearing house nets out gold transactions, much as banks do in trading
foreign exchange. Only the net difference between total purchases and total sales vis-
a-vis a counterparty is actually transferred. But a bullion clearing bank may take
physical delivery of bullion, whereas a foreign exchange clearing bank only takes
delivery of foreign exchange in the form of accounting entries (a checking balance at
some foreign bank).

LMBA clearing houses include the Bank of England, the five dealers at the gold fixing,
and a few other houses whose identities have varied from time to time. The number of
clearing members is smaller than the number of market making members (8 versus
14), because the financial and other requirements are much stricter for clearing
members.

The volume of precious metals cleared by the members of the LBMA has traditionally
been kept confidential, but in January 1997 the LBMA released figures for the final
(December) quarter of 1996. The average daily volume cleared between the (then) 14
market making members of the LBMA was approximately 933 tons (about $10 billion
at prices then current), compared with annual global mine production of
approximately 2,300 tons. That is, an amount equal to total annual gold production
was cleared every 2.5 days. (The total amount of silver cleared daily was approximately
7,775 tons.)

Of course, because most gold is traded loco London, these clearing figures represent
the result of worldwide gold trading, not just trading in London. Of the 933 tons
cleared daily, it was estimated that about 218 tons represented London trades, while of
the 7,775 tons of silver cleared daily, about 3,732 tons represented London trades.

Gold accounts at a bullion house may be allocated or unallocated. The unallocated
account is most typical. One holds on deposit a specific number of ounces of gold, but
these ounces of gold are not identified with any individual physical gold bars. These
unallocated accounts may or may not bear interest, and may or may not have
insurance and storage charges. All clearing accounts are unallocated accounts, and
contain identical (hypothetical) 400 oz. bars.

Most gold trading takes place by paper transfers between unallocated accounts.
Bookkeeping entries avoid the transactions costs and security risks of moving the
actual metal. Traders clear their trades with one another through book entry transfers
in or out of accounts at one or more clearing members, while clearing members clear
their net trades with one another through their gold accounts at the Bank of England,
as well as by physical gold transfers.




Allocated accounts, by contrast, contain individual gold bars with given serial
numbers. In effect, allocated accounts are safe-keeping or custody accounts. Such
accounts do not bear interest, are normally subject to charges, and may not be used as
clearing accounts.

TRANSACTIONS AT THE FIX

The London daily price fixings allow everyone to deal on equal terms, and large
volumes to be transacted at a single price. In addition, the price is widely publicized,
so it is undisputed. Once a price has been found such that net gold for sale (in 5 bar
denominations--i.e., units of 2000 oz.) is equal to net gold for purchase, transactions
then take place according to the following formula.

A seller on the fix receives the fixing price plus $.05 per ounce of gold (fix+.05). A
buyer on the fix pays the fixing price plus $.25 per ounce of gold (fix+.25). This is
equivalent to a market bid price of fix+.05, and a market asked price of fix+.25, for a
total spread of $.20. This spread is narrower than the normal dealing spread, which is
typically $.30 or higher.

Fixing orders may be placed in various ways.

Example 1: A market order. A client leaves an order to sell 20,000 ozs. at the PM fix.

Example 2: A price limit order. The client places an order to buy 25,000 ozs. at the
AM fix, if the fixing price is at or lower than $1290/oz.

Example 3: An average rate order. A client places at order to buy 10,000 ozs. at the
average of the AM fixing price for July 2011. (Simple question in risk management:
How will the firm manage this order?)

Example 4: Dynamic order. The client stays on the horn, listening to the fixing
commentary, and changes his order according to the new fixing price being tried

Now that we have seen how spot gold is priced "loco London," we can examine how
other local markets, and other types of gold contracts, are priced in reference to the
London spot market. This includes other spot delivery locations, gold forward and
futures contracts--such as the gold futures contract at the NYMEX in New York-- and




gold swaps, forward rate agreements, and options. (In 1994 the COMEX merged with
the NYMEX, and the principal gold futures contract now trades there.)

London is only one of many important centers for gold trading. The second principal
center for spot or physical gold trading, for example, is Zurich. For eight hours a day,
trading occurs simultaneously in London and Zurich--with Zurich normally opening,
and closing, an hour earlier than London. During these hours Zurich closely rivals
London in its influence over the spot price, because of the importance of the three
major Swiss banks--Credit Suisse, Swiss Bank Corporation, and Union Bank of
Switzerland--in the physical gold market. Each of these banks has long maintained its
own refinery, often taking physical delivery of gold and processing it for other regional
markets.

In addition to other gold delivery locations, there are other weight and quality
standards which create differential prices. Examples include the London and Tokyo
kilo bars (which are 32.148 ozs., instead of the circa 400 oz. "large bars"), the 10 tola
bars (3.75 ozs.) popular in India and the Middle East, the 1, 5 and 10 tael bars
(respectively 1.203, 6.017, and 12.034 ozs.) found in Hong Kong and Taiwan, and the
baht bar (0.47 ozs) of Thailand. Gold content is another difference. The London good
delivery bar is only required to have a minimum of 995 parts gold to 1000 parts total.
But a gold content of 9,999 parts gold to 10,000 parts total ("four nines") is commonly
traded, as is a content of 990 parts to 1,000 total (the baht bar being an example of the
latter ratio). Gold purity is important to industry. Jewellers might want gold in the
form of grain for alloying, while electronics firms may require "five nines"--meaning .
99999 purity.




PRICING NONSTANDARD CONTRACTS

Nonstandard contracts can be priced by reference to the standard loco London good
delivery bar, by taking into account the simple arbitrage relationships that would turn
one into another. The primary variables to keep track of are the costs of shipping gold
from one location to another, the cost of refining gold to different purity levels, and
the interest or financing cost for the time required to accomplish these activities.

Suppose a dealer is offered non-good delivery bars of .995 purity loco Panama City.
Here is one chain of calculations the dealer might go through to come up with a price
quotation. First the dealer notes that London good delivery bars of .9999 purity can be
sold in Tokyo for $.50/oz premium to the standard loco London price. He knows that
if he buys the bars in Panama, he could sell them in Tokyo, but first he would have to
ship them to an appropriate location to upgrade their purity.

The dealer also knows that he can upgrade to London large bars for good delivery, and
have the gold content refined to .9999 purity, for $.50/oz at the Johnson Matthey
refinery in Salt Lake City, Utah. There is a two-week turnaround time for the upgrade.
Shipping time is one day from Panama City to Salt Lake, and two days from Salt Lake
to Tokyo.

The dealer calculates the cost of shipping and insurance from Panama to Salt Lake as
$.40/oz, while shipping from Salt Lake to Tokyo is $.70/oz. The total time consumed
would be 15 days, which at 6 percent interest and spot gold at, say, $300/oz amounts to
300 x .06 (15/360) = $.75/oz.

So the dealer adds up: shipping costs $1.10, plus interest cost $.75, plus refining cost
$.50, minus selling premium in Tokyo of $.50. The net cost to the dealer to sell the
Panama bars in Tokyo is $1.85/oz.

Therefore the dealer's best, or break-even, quotation to the person offering him non-
standard gold bars in Panama City would be the spot price for good delivery loco
London minus $1.85. If spot gold were at $300/oz. bid, the most the dealer could afford
to bid for the Panama bars would be $298.15/oz.




THE GOLD LEASE OR GOLD LIBOR RATES

Gold bears interest. Positive interest. Many people do not know this. They are used to
the notion of storing their gold with some bank or warehouse, and paying for storage
cost. They then view the storage and insurance cost as a negative interest rate. But this
has little to do with the way gold is priced or traded in the wholesale market.

The forward price of gold--the price agreed now for gold to be purchased or sold at
some time in the future--is a function of the gold spot price, and the interest rates
representing alternative uses of resources over the forward time period. So before we
discuss gold forward prices, we should discuss gold and dollar interest rates.

This brings us to the gold lease rate, or the gold interest rate paid on gold deposits.
Another term that is used is gold libor, by analogy with the London Interbank
Offered Rate for Eurocurrencies traded in London. Despite the apparent literal
connotation of each of these labels, "gold libor rates" and "gold lease rates" are
alternative descriptions that refer to the bid-asked gold interest rates paid on gold.
The bid rate (deposit rate, borrowing rate) is the gold interest rate paid for borrowing
gold (that is, on gold deposits), while the asked or offered rate is the gold interest rate
quoted for lending gold. The expressions "bid-asked gold lease rates" or "bid-asked
gold libor rates" are thus interchangeable.

If the gold borrowing rate is 2 percent per annum, for example, then 100 ozs of gold
borrowed for 360 days must be repaid as 102 ozs of gold. (Gold interest rates, like most
money market rates, are nearly always quoted on the basis of a 360-day year.) In the
early 1980s gold deposits rarely yielded over 1 percent, but in recent years have rarely
yielded less than 1 percent.

Because of large central bank gold holdings, gold loans are one of the cheapest
financing sources for the gold mining industry. A mining company borrows gold and
sells it on the spot market to obtain funds for gold production. The interest
installments on the gold loan are payable in gold. And when the loan matures, the
principal (and any final interest due) is repaid directly from mine production.

Central banks are the major lenders of gold. They accounted for around 75 percent of
the gold on loan, estimated at around 2,750 tonnes, at the end of 1996. Central banks
in recent years have been under pressure to earn a return on their gold holdings, and




therefore lend to, for example, gold dealers who have mismatched books between gold
deposits and gold loans. (The practice of central bank gold lending first became
newsworthy in 1990, when the investment banking firm Drexel, Burnham, Lambert
went bankrupt while owing borrowed gold to the Central Bank of Portugal.)

The gold lending (or borrowing) rate, then, is one of the components that determine
the gold forward price. Let's see how this works.




4. GOLD PRODUCTS AVAILABLE IN INTERNATIONAL MARKET

THE GOLD FORWARD PRICE

Suppose the spot price of gold is $300/oz. The gold lease rate for 180 days is 2 percent
per annum. And the Euro-Dollar rate for 180 days is 6 percent per annum. (For
simplicity here, we ignore all bid-asked spreads. But they are easily included in the
following calculations.)

I borrow $300 at the Euro-Dollar rate. In 180 days I will have to repay the dollar
borrowing with interest in the amount $300 (1+.06(180/360)) = $300 (1.03) = $309.

With the borrowed money I can buy 1 oz. of gold, and place it on deposit for 180 days.
The amount of gold I will get back is 1 (1+.02(180/360) = 1 (1.01) = 1.01 oz.

Thus, 1 oz. of gold with a spot price of $300 has grown into 1.01 ounces in 180 days,
with a value of $309. This translates into a 180-day forward value of $309/1.01 = $305.94.

Spot price: $300.00

180-day Forward Price: $305.94

Notice that both the gold lease and the Euro-Dollar rate have gone into this
calculation. Specifically:

$305.94 = $300 [1+.06 (180/360)] / [1+.02 (180/360)].

In general, if the spot price is S, the forward price is F(T) for a time-horizon of T days
(up to a year), the Euro-Dollar rate is r, and the gold lease rate is r*, we have the
relation

F(T) = S [1 + r (T/360)] / [1 + r* (T/360)].

Notice that in the numerical example we just used, the forward price $305.94 is
approximately 2 percent higher than the spot price of $300. That is, the 180- day
forward premium of $5.94 is approximate 2 percent of the spot price of $300. (An exact
2 percent would be $6.) Why is this?




To see what is involved, let's subtract the spot rate S from both sides of the above
equation. The left- hand side will be the forward premium F(T) - S. Simplifying the
right-hand side, we obtain:

F(T) - S = S [( r - r*)( T/360)] / [1 + r* (T/360)].

That is, the forward premium (F(T)-S) is approximately equal to the spot rate S
multiplied by the difference between the Eurodollar rate r and the gold lease rate r*
(once we have adjusted this rate for the fraction of a year: T/360).

Since in the numerical example the Euro-Dollar rate was 6 percent, while the least rate
was 2 percent, the forward premium at an annual rate is approximately 6-2 = 4
percent. For 180 days, or half a year, it is approximately 2 percent.

So, as long as we are talking about an annual rate- -that is, before we do the days
adjustment--the gold forward premium in percentage terms is approximately the
difference between the Euro-Dollar rate and the gold lease rate.

We can view this same relationship in other ways: given a Euro-Dollar rate and a gold
forward premium (in percentage terms), we can back out the implied lease rate.

Looking back at the chart from Kitco, above, it is easy to see that subtracting the gold
lease rate from the "prime rate" gives us approximately the gold forward rate. (Note
that "prime rate" is a misleading term to use: the relevant interest rate in the gold
market is the Euro-Dollar rate by which banks borrow and lend among themselves,
not the commercial "prime" lending rate--which is often an administered, rather than
a market, interest rate.)

Gold forward rates are sometimes referred to as "GOFO" rates, because GOFO was the
Reuters page that showed gold forward rates.

GOLD SWAPS

There are many different hedging and trading operations in the gold market, all of
which bring us back to the same relationship between forward and spot rates we saw
in the previous section.




For example, gold dealers will buy gold forward from mining companies. The mining
companies, thus assured of a fixed forward price at which to sell their production, go
to work producing. Meanwhile, the gold dealers, to hedge themselves against
movements in the gold price, borrow gold and sell it in the spot market. (To repeat,
dealers "borrow" gold by taking in gold deposits, and paying out the gold lease rate.)

Restated, gold dealers buy gold forward from mining companies at a price F(T). To
hedge themselves, the dealers borrow gold at an interest rate r*, and sell it in the
market at a price S. They earn interest on the dollar proceeds of the spot gold sale at
an interest rate r.

Thus, for each ounce of gold purchased, the dealer must pay

F(T) [1+ r* (T/360) ] .

While for each ounce of gold sold, the dealer earns:

S [1 + r (T/360)].

All excess profit (beyond bid-asked spread) gets eliminated when these amounts are
equal. Which gives

F(T) [1+ r* (T/360) ] = S [1 + r (T/360)] .

This is, of course, exactly the same formula as before.

Generally speaking, gold dealers will quote forward prices to their customers (these
are called "outright" forwards), but forward trades between dealers mostly take place
in connection with a simultaneous spot transaction. That is, in the form of "swaps." A
swap transaction is a spot sale of gold combined with a forward repurchase, or a spot
purchase of gold combined with a forward sale. This type of trading requires less
capital and is subject to less price risk. The swap rate is F(T)-S, and as we saw before,
this difference is (when quoted as a percentage of the spot price) essentially the
difference between the Euro-Dollar rate and the gold lease rate.

A spot sale of gold combined with a forward purchase is also called a cash-and-carry
transaction. The transaction provides immediate cash, the cost of which is the carry,
or the difference between forward and spot rates. The dollar lender (who buys the
gold), meanwhile has possession of the gold as security. So a cash-and-carry (one form
of a swap) boils down to a dollar loan collateralized with gold.




The typical dealing spread between Euro-Dollar deposits is 1/8 of 1 percent, or .125
percent, while the typical spread between gold deposit and loan rates is .20 percent.
This translates into bid-asked swap rate, or cash-and-carry, spreads of about .30
percent. For example:

Euro-Dollar rates Gold lease rates Gold swap rates

1 month 3.0625-3.1875 0.50-0.70 2.35-2.65

3 months 3.1250-3.2500 0.55-0.75 2.40-2.70

6 months 3.3125-3.4375 0.70-0.90 2.45-2.75

12 months 3.5625-3.6875 1.00-1.20 2.35-2.65

Note that the gold swap rate can be independently viewed as the collateralized
borrowing rate. A small central bank, for example, with plenty of gold to spare, could
borrow dollars for 3 months and pay--not the 3-month asked Euro-Dollar rate of 3.25
percent--but rather the gold swap rate of 2.70 percent.




GOLD FUTURES

Gold futures are traded at the COMEX in New York (which merged with the NYMEX
on August 3, 1994, and is now known as the "COMEX Division" of the New York
Mercantile Exchange), at the TOCOM in Tokyo, and--until recently-- at the SIMEX in
Singapore. Gold futures are also traded at the Chicago Board of Trade (CBOT) and at
the Istanbul Gold Exchange. (The latter is mostly a market for spot gold. For example,
over 8 million ounces of gold were traded spot at the Istanbul Gold Exchange in 1997,
but only about 43,000 ounces were traded through the futures market.)

Forward gold is traded for contract settlement at standardized intervals from spot
settlement, in intervals that correspond to foreign exchange forward contracts: 1, 2, 3,
6, and 12-month forwards are typical. Spot gold traded on Wednesday June 24 will
settle on Friday, June 26. A one-month forward trade on June 24 will take us to July 26,
which is a Sunday, so settlement of a one-month forward will be on Monday, July 27. A
two-month forward trade on June 24 will take us to August 26, which is a Wednesday,
so settlement of a two-month forward contract will be on August 26. And so on.

Futures, by contrast, are traded for fixed dates in the future. At the COMEX and
CBOT, gold is traded for settlement in February, April, June, August, October, and
December, as well as the current and next two calendar months. Istanbul trades the
next six months for Turkish lira-denominated contracts, or the next 12 months for U.S.
dollar-denominated contracts. The last trading day for a futures contract is the fourth
to last business day in the delivery month (at the CBOT or Istanbul), or the third to
last business day (at the COMEX). That is, the August 2008 COMEX gold future trades
until the third to last business day in August 2008. At the TOCOM, there are futures
for the current or next odd month, and all even months within a year. The last trading
day is the third to last business day, except for December, when the last trading day is
December 24.

Despite the different trade date conventions, however, if futures and forward
settlement dates happen to correspond, forward and futures prices are the same,
subject to slight differences related to delivery grade or location (Manhattan, say,
versus London).




HOW FUTURES MARKETS DEAL WITH CREDIT RISK

The main different between futures and forwards is the way futures markets handle
credit risk. In the forward market, a credit evaluation must be made of the
counterparty--evaluating the counterparty's ability to pay cash if gold was purchased
forward, or the ability to deliver the gold, if gold was sold forward.

The futures market doesn’t worry about such customer credit evaluations. Instead, a
futures contract is configured as a pure bet, based on price change. So one is asked to
post a security bond, called "margin", which covers the typical variation in the value
of a contract for several days. Going long a futures contract is a bet that the price is
going up, while going short is a bet the price is going down. Cash flows from price
changes take place daily. So those who post the required margin against possible
losses (and who replenish this margin if necessary) are considered credit-worthy,
while those who can't post margin aren't credit-worthy. Customers post margin with
member firms of the futures exchange, who in turn post margin with clearing
member firms. The clearing member firms post margin (on the customer's behalf) at
a clearinghouse. This way of dealing with credit risk is a much cleaner structure than
in the forward market world of customer credit evaluations, accounting reports, and
other types of intrusive financial reporting. (Of course, exchange member firms and,
especially, clearing member firms still have to undergo the usual sorts of credit
checks.)

To close out a long position, one sells (goes short) an off-setting contract. To close out
a short position, one buys (goes long) an off-setting contract. The opening and
subsequent closing of a futures position is referred to as a "round turn". Brokerage
fees are usually charged per round turn, at the time the future contract is closed out.

At discount brokerage firms in the U.S., in June 2008, the typical customer margin on
a 100 oz. gold futures contract was about $1350, while there was a typical brokerage
charge of $25 per round turn.

The size of the futures bet depends on the stated size of the futures contract. The cash
flow will be the change in price multiplied by the contract size.

At the COMEX, CBOT, and the SIMEX, the contract size is 100 ozs of gold with a
fineness of .995. So if gold (of that fineness) went from $1299/oz at contract opening to




$1297.50/oz as the day's futures settlement price, a long contract would lose $150, while
a short contract would gain $150. (The calculation on the short position is $1299 minus
$1297.50, multiplied by 100.)

The TOCOM trades 1 kilo bars (32.148 ozs) of .9999 fineness. The price is stated as
yen/gram. So the daily change in value of a single contract is the change in the yen
price per gram, multiplied by 1000 grams.

The Istanbul gold futures contract is for 3 kilograms of gold of .995 fineness, quoted
either in terms of U.S. dollars per ounce, or Turkish lira per gram. The daily change in
value of a U.S. dollar- denominated contract is the change in dollars per oz, multiplied
by 96.444 ozs. The daily change in value of a Turkish lira-denominated contract is the
change in the Turkish lira price per gram, multiplied by 3000 grams.

The "initial" margin that must be posted as a security bond is large enough to cover
several days expected/loss or gain, and is thus related to the standard deviation of
daily contract value changes. The margin is held by a clearinghouse which thus
"guarantees" that the losing side of the daily futures bet pays the winning side. For
every customer that goes long a contract, the clearinghouse takes the other side, going
short. For every customer that goes short a contract, the clearinghouse takes the other
side, going long. The clearinghouse thus is in a position to move cash from the losing
side of any futures bet to the winning side.

If the initial margin is depleted by losses, it eventually reaches a "maintenance"
margin level, below which the customer is required to replenish the margin to its
initial level. For example, at discount brokerage firms in the U.S. in June 2008, a
typical maintenance margin level for gold futures contracts at the COMEX was $1000
per contract. So if the posted margin dropped below $1000 per futures contract,
additional margin had to be posted to bring the total back to at least $1350 per
contract (the typical initial margin level).

Customers typically may post margin in the form of cash, or U.S. government
securities with less than 10 years to maturity. Clearing members may post cash,
government securities, or letters of credit with the clearinghouse. The details differ at
different exchanges.

THE EQUILIBRIUM FUTURES PRICE




The equilibrium futures price is that point where the market clears between longs and
shorts. Arbitrage, however, forces the futures price to track the forward price (and
vice-versa). Similarly, arbitrage between the futures market and the spot market on
the final day of trading forces the futures price to converge to the spot price. On the
final trading day at the SIMEX, where no gold can actually be delivered on a futures
contract, the settlement price is set as the loco London price of the A.M. London price
fix. These forces convergent of the futures price to the price in the London spot
market. At the COMEX and CBOT, the open longs take delivery of spot gold, which
accomplishes the same thing.

Delivery at the COMEX and the CBOT is one 100-oz bar (plus or minus 5 percent) or
three 1-kilogram gold bars, assaying not less than .995 fineness. (Note that 3 kilo bars
is about 96 ounces of gold. The dollar amount actually paid at delivery depends, of
course, on the specific amount of gold delivered, which must be within 5 percent of
the hypothetical 100 ozs per contract.) Delivery at the CBOT takes place by a vault
receipt drawn on gold deposits made in CBOT-approved vaults in Chicago or New
York. Gold delivered against futures contracts at the COMEX must bear a serial
number and identifying stamp of a refiner approved by the COMEX, and made from a
depository located in the Borough of Manhattan, City of New York, and licensed by
the COMEX. As noted previously, there is no delivery at the SIMEX. The futures
contract is purely cash- settled, with the final settlement price determined by the
London A.M. gold fix.

The U.S. dollar forward price of gold would be related to the U.S. dollar spot price of
gold by the relationship

F(T) = S [1 + r (T/360)] / [1 + r* (T/360)].

where the spot price is S, the forward (or futures) price is F(T) for a time-horizon of T
days, the Euro-Dollar rate is r, and the gold lease rate is r*. If the Euro-Dollar rate r is
higher than the gold lease rate r*, then the forward (futures) gold price will be higher
than the spot gold price. Historically gold lease rates have always been lower than
Euro-Dollar rates, so forward gold (or a gold futures contract) always trades at a
higher price than spot gold. The same is not true, for example, in the silver market.
During the year 1998, silver lease rates have frequently exceeded Euro-Dollar rates, so
forward silver has traded at a cheaper price than spot silver.

Different terms are used to refer to the relationship between forward or futures prices
and spot prices. If forward gold (or a gold future) has a higher price than spot gold, the
forward gold or gold future is said to be at a premium, or (in the London market) in




contango. If forward gold has a lower price than spot gold, the forward gold or gold
future is at a discount, or (in the London market) in backwardation.

As we noted before, forward gold has in recent history always been in contango, or at a
premium, because dollar interest rates have always been above gold lease rates. We
saw in part 3 that the difference between the forward price and the spot price, F(T)-S,
is the swap rate. Since the forward price of gold has always been at a premium in
recent years (since 1980, in particular), the swap rate has always been positive. A
related term that is used in the U.S. futures markets is basis. Basis is the spot price
minus the futures price, or S-F(T), which is just the swap rate with the sign reversed.
The gold basis has always been negative in recent years. The Federal Reserve Bank of
Cleveland, for example, publishes monthly charts of the gold basis. Reverse the sign on
their chart, and you are looking at the swap rate.




EXCHANGE FOR PHYSICALS

While forward gold is traded in the form of swaps, which combines a spot trade (buy
or sell) with the reverse forward trade (sell or buy), gold futures can be traded in the
form of EFPs (exchange for physicals), which combine a futures trade with the
reverse spot trade. EFPs are traded for the same months as gold futures. The EFP price
represents the difference between the futures price and the spot price for the
combined trade.

For example, a market maker may quote the August EFP at the COMEX as $1.10-$1.30
in 100 lots. This means the market maker’s prices are good for a standard trade
involving 100 futures contracts (10,000 ozs of gold). The market maker will "buy" the
EFP at $1.10/oz, or "sell" the EFP for $1.30/oz.

This quotation implies that for $1.10/oz. the market maker offers to buy from you 100
gold futures contracts, while simultaneously selling to you 10,000 ozs of spot gold. For
$1.30/oz. the market maker will sell to you 100 gold futures contracts, while
simultaneously purchasing 10,000 ozs of spot gold. To summarize: the market maker’s
bid price is the price he will buy futures versus selling spot, while the market maker’s
asked price is the price he will sell futures versus buying spot. The EFP price is thus
simply a different way of looking at the basis or the swap rate.

On June 24, 1998, the mid-market price (average of bid and asked prices) of the EFP
associated with the August 1998 COMEX gold contract was a positive $1.25, while the
mid-market price associated with the Dec 1998 COMEX gold contract was a positive
$5.60. By contrast, the EFP associate with the July 1998 COMEX silver contract was a
negative $2.00. This reflected the fact that gold lease rates were below Euro-Dollar
rates, while silver lease rates were above.

Interest rates in the gold market are a principal concern of gold dealers and gold
mining companies.

In the forward market, these two interest rates give rise to the swap rate, while in the
futures market they determine the EFP price. Both swaps and EFPs involve a spot sale
or purchase of gold, along with the reverse trade in the forward market (if a swap) or
futures market (if an EFP).




Because Euro-Dollar rates have historically always exceeded gold lease rates, gold
forward and futures have always traded at a premium (have always been in contango).
There is nothing inevitable about this relationship, however.

But there are many contracts in the gold market that do not involve the spot, forward
or future price of gold, but rather are simply written in terms of gold interest rates.
These include gold forward rate agreements (FRAs), gold interest rate swaps,
and gold interest rate guarantees (IRGs). Let's examine each of these contracts in
turn.

GOLD FORWARD RATE AGREEMENT (FRA)

A gold forward rate agreement (FRA) is a contract whose payout depends on
whether the market interest rate diverges from an agreed "contract rate". It is called a
"forward rate" agreement, because the interest rate applies to a gold deposit or loan
starting at some time period in the future. That is, the interest rate in question is the
gold lease rate (also called gold libor). Recall that we used the gold "lease" rate as a
generic term to refer to both the bid rate for taking in gold deposits and the offer rate
for making gold loans. Recall also that the interest in this case is typically paid or
received as so many ounces of gold. Similarly, a gold FRA will be typically settled with
one party paying the other in gold.

A typical FRA contract in this regard might be a gold deposit that begins three months
from today, and lasts for three months (ending six months from today). This would be
called a 3 vs. 6 FRA. The terminology "3 vs. 6" implies the contract starts in 3 months
and ends in 6 months.

What is agreed to is a contractual interest rate: the FRA rate. If the actual realized
market rate turns out to differ from the FRA rate (as it almost inevitably will), then
one makes or receives payment depending on the terms of the contract.

There are five principal parts to an FRA contract: the contract rate, the notional
amount of gold in a contract, the fixing date when the market interest rate is
compared to the contract rate, the start date of the deposit (or loan), and the
maturity date of the deposit (loan).




One can buy or sell this contract. The settlement amount S paid to the buyer of the
FRA from the seller is calculated as follows:

S = notional amount x (market rate - contract rate) x (days in period)/360.

If the market rate is below the contract rate, so that the sign on the amount S is
negative, then the FRA buyer pays the FRA seller the absolute value of S.

The calculation above assumes that payment is made at the end of the FRA period (on
the maturity date). But if (as is normally the case) payment is made on the start date
instead, the settlement amount S given above is discounted by the market rate at
which the contract was settled:

S/[1 + market rate x (days in period)/360].

Example: Consider a depositor who will have one ton (32,000 ounces) of gold
available in 3 months, but will not be utilizing the gold for another 3 months after
that. He wants to lock in the interest rate he will receive on his gold deposit now. He
asks for a quote of the 3 vs. 6 months FRA, and receives the quotation:

3 vs. 6 FRA 1.50-1.80 %

This quotation means he can "sell" the FRA at a contract rate of 1.50 percent (.015), or
"buy" the FRA at a contract rate of 1.80 percent.

So, in this case, he sells the FRA with a contract rate of 1.50, and a notional amount of
32,000 ounces of gold.

Three months from today, on the fixing date, he will determine the best market rate
available, and this will be compared to the contract rate to determine the FRA
settlement amount. (The fixing date will typically be two business days prior to the
conceptual start date of the deposit or loan.) Suppose the best deposit rate at that time
is 1.00 percent (.01). Suppose also that the three- month deposit period from start date
to maturity date is 92 days. The settlement amount S is then calculated as:

S = 32,000 x (.01-.015) x (92/360) = - 40.889 oz.

The sign here is negative, which means the FRA buyer pays the FRA seller (our
hypothetical depositor) 40.889 oz. of gold on the maturity date (if payment is made
then). If payment is made on the start date, it is discounted by the time period of the
deposit:




40.889/[1+.01 x (92/360)] = 40.785 oz.

So in this event the FRA buyer pays the FRA seller 40.785 oz. of gold on the start date.

Now if the depositor deposits his ton of gold at the market rate of 1.00 percent for
three months, he will end up with an equivalent interest rate of 1.50 percent, the FRA
rate, because the difference has been paid out on the FRA contract.

The same would have been true if the depositor had lost, rather than gained, from the
FRA contract. For in that case the market rate paid on deposits would be higher than
1.50 percent, but the depositor would lose the difference on the FRA contract.

Similar examples could be done for gold borrowers. Gold borrowers typically borrow
at the gold lease (gold libor) rate plus a margin: say

market rate + .75%

and make periodic gold interest payments at intervals of 6 months. By using FRAs for
6 month intervals (such as 6 vs. 12, 12 vs. 18, 18 vs. 24, etc.), the next few interest
payments on this loan can be locked in as

FRA rate + .75%

if that seems desirable.




GOLD INTEREST RATE SWAPS

It is important not to get the word "swap" as used here confused with "swap" in the
gold forward market. There the term referred to the relationship between spot and
forward prices. Here, in "interest rate swap," we are referring to a trade of a fixed
interest rate for a floating interest rate.

The swap "buyer" in an interest rate swap agrees to pay a fixed interest rate to another
party, and in return receives at periodic intervals an interest rate that fluctuates
(floats) with the market. That is, the buyer pays a fixed gold rate and receives the
market- determined gold lease rate (or some equivalent).

The other side of the interest rate swap contract is the seller who receives fixed and
pays floating.

If, for example, the floating rate is the 3-month gold lease rate, then every 3 months
there will be a net interest payment whenever the market lease rate diverges from the
fixed rate. If the market rate is above the fixed rate, then the swap buyer (who pays
fixed) will receive an interest payment representing the positive net difference of
floating minus fixed. If the market rate is below the fixed rate, then the swap seller
(who receives fixed) will receive an interest payment representing the positive net
difference of fixed minus floating.

In essence, then, a gold interest rate swap is just a series of gold FRAs. If the
floating rate in the market is above the fixed rate, the swap buyer (who pays fixed) is
in the same position as the buyer of an FRA. If we equate the "fixed rate" with the
"contract rate" in an FRA, then the FRA buyer receives a positive cash flow if the
market rate is above the fixed rate.

So buying a gold interest rate swap represents the purchase of a series of gold FRAs at
a single contract rate (fixed rate), while selling a gold interest rate swap represents the
sale of a series of gold FRAs at a single contract rate (fixed rate).

Why would someone want to do this? Let's consider an example.

Example: Consolidated Gold Nuggets has an existing loan of 1 million ozs. of gold
with two years remaining to maturity. It pays floating interest at the 3-month gold




lease rate plus a margin of 1.75 percent. However, gold lease rates have fallen, and the
treasurer wishes to lock in a low fixed rate. Renegotiating the loan will involve
contractual penalties. The treasurer shops the market and determines she can buy a
two- year gold interest rate swap, paying 2 percent fixed against the floating 3-month
gold lease rate flat. She does the swap.

Her swap payments are

2% - 3-month gold lease.

Her loan payments are

3-month gold lease + 1.75%.

The net interest payment is the sum of these:

2% + 1.75% = 3.75% .

So by doing the gold interest rate swap, she has turned the floating rate loan into a
fixed rate loan of 3.75 percent.




GOLD INTEREST RATE GUARANTEES

Gold IRGs are a form of insurance. Typically they take the form of a floating rate, with
a guaranteed maximum or minimum. The gold borrower might prefer to borrow
floating, and hence have the ability to profit from falling interest rates, but
nevertheless want a guarantee that the floating rate paid will not rise above some
maximum or ceiling level.

In a similar vein, a gold lender might prefer to lend at floating rates, in order to profit
from rising interest rates, but desire a guarantee that the rate received will not fall
below some minimum or floor level.

These types of guarantee contracts are analytically equivalent to interest rate options.
Hence we will defer their discussion until we have discussed options in general in the
context of options on the gold price.

Hedging is the process of substituting certain, or known, outcome for an uncertain
one. A gold producer, for example, does not know what the spot price of gold will be a
year from now. But he can hedge future gold sales by selling gold forward at the
known one-year forward price. This will enable him to determine his cash flow in
advance-- at least that part of it that depends on the fluctuating price of spot gold. It
will simplify financial planning.

The actual spot price of gold a year from now may be higher than the preagreed
forward rate, or it may be lower. Thus, by hedging and substituting a known price for
an unknown one, the gold producer could just as easily suffer an opportunity loss as
an opportunity gain.

Many in the gold market are looking not for a fixed forward price, but rather for a
boundary guarantee. A future seller of gold might want a guarantee that the sales price
will not fall beyond a minimum level below which he could not tolerably live, but
otherwise prefer to remain unhedged in hopes the market price will rise. Similarly, a
future gold buyer might look for a guarantee that the purchase price will not rise
above a tolerable maximum level, but otherwise prefer to remain unhedged in hopes
the market price will fall.


The gold market v1.0

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