The market for gold consists of a physical gold market, in which gold bullion or coin is transferred between market agents, and a paper gold market, which involves trading in claims to physical stocks rather than in the stocks themselves.4 Both markets are closely linked by arbitrage and the possibility of participants being forced to satisfy the claims of paper gold physically, and paper gold prices are keenly affected by developments in the market for physical gold, where unanticipated changes in fundamental demand and supply are first detected.
Agents and Instruments of the Physical Gold Market
Physical gold is principally traded in the form of bullion, but official and imitation gold coins, medallions, and jewelry (especially of low fabrication quality but of high gold content) are also actively traded. However, because gold must first be formed into bullion and later transformed for these other markets, this study is concerned solely with the market for gold bullion.5 Gold bullion is assumed to refer to gold that has been formed into bars, either in crude dore form (80 percent fine) as treated at the mine site, or as defined by weight and greater fineness and authenticated by the stamp of a recognized refinery. Each of the major markets defines an acceptable measure of weight and fineness for “good delivery” in that market, with some variations. Weights range from 1 kilogram (32.151 troy ounces) to 400 ounces. When refined, gold bars generally consist of between 995 and 999 parts of gold per thousand (i.e., between 99.5 and 99.9 percent fine). (One carat is 41.667 parts of gold per thousand parts of alloy, so that refined bullion is close to 24 carats.)
Bullion markets generally serve as a conduit between large gold suppliers (such as producers, refiners, and central banks) and smaller investors and fabricators (see Kettell (1982, chap. 6) and Sarnoff (1987, chap. 5)). The physical gold market is essentially a spot market, but it is complemented by the use of forward trading for the hedging of physical positions.6 Trading is interoffice (or off the floor), with prices quoted by individual traders (except in the case of a fixing, when agents come together to agree on a price). Market participants comprise bullion dealers, who act as principals, adopting open positions in the market; brokers, who close their positions by either matching transactions for a commission or simultaneously buying and selling on a spread; and bullion bankers, who finance these transactions. However, many gold houses combine these functions. Also, dealers generally either have their own refining capacity or one that is available to them.
Bullion dealers usually put a floor on the price offered to their suppliers from the mining industry, whether it is the spot price or some mutually agreed forward price, with the funds being made available to the mining company as refined gold is issued to the dealer’s account. These positions are normally hedged by the dealer through forward sales near the spot price or by short sales on the futures market, depending on the floor price offered. Forward sales, in turn, guarantee a price ceiling for the dealer’s customer, and the dealer may require that a margin be paid if the gold price drops prior to delivery. However, dealers and bullion banks also provide gold to their customers in the wholesale jewelry industry on consignment, whereby the jeweler buys the bullion content of the finished goods only when the goods are received from the fabricator and priced to retailers, rather than prior to fabrication. This allows jewelry wholesalers to avoid tying up capital during fabrication and to hedge their bullion transactions while guaranteeing a value added in fabrication.
Two of the main disadvantages of investing in and holding gold (as opposed to a financial instrument) are the significant storage and security costs involved and the fact that holding gold does not bear interest. For these reasons, many large-scale gold holders who do not wish to liquidate their stocks, but do want to make better financial use of them, arrange to relinquish them temporarily. In the interim, these erstwhile gold holders can use the funds secured in parting with their gold to acquire and hold interest-bearing instruments. One obvious method for accomplishing this is to sell gold on the spot market and then buy gold back on the same market at some time in the future. However, since this strategy leaves open the possibility of an interim increase in the gold price, it is usually regarded as being too risky. Another strategy that can be used in the physical gold market is to hedge against adverse price movements by making a spot sale and forward purchase simultaneously. This approach guarantees protection from the effects of a price rise prior to repurchase, but does not allow for a windfall gain if prices fall.
The disadvantage of these strategies is that they involve the relinquishinment of ownership of gold stocks, albeit with the intention of replacing them. For those holders of gold, principally central banks, that may be constrained in their latitude to sell reserves but want to use their gold stocks without relinquishing ownership, a market in gold loans has developed since the mid-1980s. These loans involve a transfer of bullion to the borrower and earn a relatively low rate of interest for the lender, who is repaid in physical stocks over time at a predetermined maturity (usually of four to six years, with an initial grace period of one to two years).
The borrowers in this market are typically gold producers who immediately sell the gold they have acquired on the spot market and thereby gain the cash to finance production at a relatively low rate of interest while securing a natural hedge against any future reduction in gold prices. Producers have greater access to capital in this form because their ability to repay a loan denominated in terms of units of gold will not be diminished by adverse movements in the price of gold. Central banks and other lending institutions, which have a primary interest in having gold stocks returned and do not want to adopt an open position in the market, feel more secure in the knowledge that the quality of their physical loans is not affected by price movements in the spot market. This is because the bullion banks, which act as intermediaries in this market, take exactly offsetting long and short positions in terms of physical gold.7 There is also a market in short-term loans in which bullion dealers sometimes obtain loans from bullion banks in order to cover the interval between delivery to a market and an expected inflow from another source.
Some large-volume holders of gold, who have an interest in using some of their stocks but whose direct participation in the spot market could have an adverse effect on prices, have chosen instead to engage in gold swaps. This type of transaction applies in particular to the former U.S.S.R. and the South African Reserve Bank. Gold swaps involve the transfer of bullion to a dealer in exchange for currency, with an agreed forward price at which the gold will be repurchased when the swap comes due (usually 12–13 months). At that time, the swap can either be renewed or terminated (in which case the bullion is returned to the original owner) or the gold can be transferred to the bullion dealer and either added to the dealer’s reserve or sold on the spot market. Although the net effect of this transaction is similar to a simultaneous spot sale and forward purchase of gold, the difference is that the counterparties on each side are the same, so that an inter-dealer market transaction is avoided, with no direct effect on the market. An implicit interest rate is charged because of the difference between the agreed spot and forward rates, but, in return, the gold holder is able to acquire cash against gold collateral.
The term “gold swap” has become synonymous with the type of transaction described above, but it may also be used to describe swaps of gold of different fineness or at a different location between dealers and others engaged in the market. Such swaps are relatively easy to effect, and they significantly reduce the transaction costs involved in meeting the different needs of customers and the requirements of markets. In particular, loco-swaps allow gold that is physically situated in one market to be sold on another, with “delivery” being accomplished through a swap.
Paper Gold Instruments
Paper gold instruments represent claims to a specified quantity and fineness of gold. Transactions in these instruments are generally performed for speculative and hedging purposes, and they rarely involve the actual transfer of physical gold. On the New York Commodity Exchange (COMEX), for example, 8.4 million futures contracts of 100 ounces each were traded in 1986, but only 1.2 percent of the gold involved actually changed hands.8 Nevertheless, these transactions represent an integral part of the gold market, especially because of gold’s role as an investment instrument.
Gold Futures
Gold futures contracts represent commitments to deliver, on the one hand, and to accept and purchase, on the other, a specified amount of gold at some time during the month for which the contract is defined. Contracts are defined by the relevant exchange. They are usually traded by open outcry, with members of the exchange representing the ultimate buyers (who have assumed long positions) and sellers (who have short positions). Performance is guaranteed by an exchange clearinghouse, which registers the names of the buyer and seller and assumes the opposite side of the trade for both. The clearinghouse receives margin payments from both parties to the contract in order to assure compliance; an original margin is supplemented by a maintenance margin if the price moves against the trader’s position. However, both buyer and seller can liquidate their contracts on the exchange at any time up to the delivery date (and usually do so, at least prior to the expiration of the contract at the end of the quoted month). The current month for which a futures contract is quoted is called the spot month.
A trader may close out (or exit) a position by making an opposite transaction for the same delivery month, and by instructing the broker to offset the earlier contract (through the clearinghouse). Any contracts that are not liquidated by either party in such a manner are still open, and the total of such contracts is the open interest (that is, the equal number of longs and shorts). Should one of the parties close out a position (for example, the long), but the other (the short) does not close out, the contract is traded, with another (long) counter-party being obtained and registered so that the open interest is unchanged. Market participants regard measures of open interest as an important indication of market conditions. Proponents of technical trading consider that if open interest is increasing, there is still room for the price to continue to move in the same direction in which it has been moving; if open interest is falling, the current trend is viewed as likely to end.
Gold Options
Gold options differ from futures contracts, in that the buyer receives the right to exercise the option rather than incurring an obligation to perform—that is, a right to sell or buy physical gold (or a gold futures contract) at a specified price called the strike price (or exercise price). An option is a unilateral contingent contract, however, with the writer (or seller) obliged to perform on demand of the holder. The holder of a call option has the right to purchase gold from the option writer, while the holder of a put option has the right to sell gold. On a European-style option, the right may be exercised at the maturity date—that is, the date on which the contract is terminated; on an American-style option, the right may be exercised either at the maturity date or at any time prior to that date. Recent innovations in options include the average option, on which a settlement payment is made if the average price over the life of the option exceeds the strike price (for a call) or is less than the strike price (for a put); and the look-back option, which sets the strike price at expiration as the optimal price that occurred over the life of the contract (that is, the lowest for a call and the highest for a put).
The buyer of an option pays a premium to the dealer, as well as a commission, and his risk is limited to this amount. The writer, however, is exposed to the risk that the option will be exercised at a spot market price above the strike price in the case of a call, or below it for a put. The loss is measured by the extent of this difference, minus the premium. Options on physical gold may be offered by individual dealers (a dealer or over-the-counter option), in which case a premium is agreed and any subsequent sale of the option must be performed through that dealer.
Alternatively, options are traded on a commodity exchange as cash contracts, with a specified strike price and a clearinghouse system similar to that described above for futures contracts. Options on futures contracts are traded through the relevant futures exchange for specified months. When an option has been defined for a particular strike price and date, the premium is the quoted price that will change so as to clear the market. Contracts for a range of strike prices for any given month are normally offered, with the strike prices being determined on the basis of prevailing spot prices and the differentials above and below the rounded spot price being determined by the exchange.9 The option premium (the “price” of the option) can be broken down into the option’s intrinsic value and its time value, where the intrinsic value is the amount that can be realized on the physical gold or futures contract if the option were exercised immediately. The time value is then the residual, reflecting the probability that the option will be exercised, the length of time remaining to expiration, the riskless rate of interest, and market volatility and risk.
Gold Warrants
A gold warrant is essentially a gold option (usually a call option) that is secured by the existence or promise of gold stocks and that can be exercised by the holder in a manner similar to a regular option. Warrants, as usually issued, are attached to a share or bond issue by mining companies that want to attract investment. The warrant specifies an amount of gold that the holder is entitled to purchase or sell at maturity, usually five years hence. A naked warrant is backed by a gold stock, but it is issued without attachment to another financial instrument. Although warrants are traded on some stock exchanges, they are not permitted on U.S. exchanges.
Gold Leverage Contracts
A gold leverage contract is similar to a long position on a futures contract, but the customer can take delivery of the gold at any time up to the contract expiration date. Payment of an initial margin secures title to the gold, but the contracting firm holds a lien against it until payment is made in full at the spot rate quoted on the initial contract date. The contracting firm effectively loans the balance outstanding on the contract to the customer, who pays interest and storage charges on the unpaid balance. If the spot price rises, the margin is considered to have increased, but if the price drops, a maintenance margin must be paid. The contract can be terminated by the customer at the spot price on any date, at which time any outstanding balances are settled. This instrument allows investors to assume a highly leveraged long position in gold, whereby an initial investment can quickly be multiplied (or wiped out).
Other Forms of Spot Paper Gold
Investors in bullion (and coin) often do not want to take delivery of their gold because of the risks and costs involved in transportation and storage. Accordingly, most dealers and brokers undertake to store the bullion and issue a gold certificate, which is a warehouse receipt evidencing ownership of a specific amount of bullion. The gold is receivable on demand, or the investor may cash in the certificate for current market value or sell it by endorsing the back. The Montreal Exchange now trades gold certificates in U.S. dollars, with a minimum of five ounces, for good delivery within the time limits, weight, and standards of Canadian gold. In addition to being liquid, these are free of the issuer costs usually payable on certificates. Depository orders (or delivery orders) are similar to gold certificates, except that they are issued as claims to gold held in a depository not controlled by the issuer, usually in some tax haven.
Most large gold banks (in particular, in Switzerland) offer bullion accounts, which operate as bank accounts denominated in ounces of gold but usually have a much higher minimum transaction size than certificates. In this case, also, the bank physically holds the bullion in a pool or on consignment for the depositor and reflects it in the account’s balance. Gold accumulation accounts allow smaller investors to acquire gold over time, but deposits are made in monetary units instead of units of gold. The amount of the monetary deposit is then translated into a gold deposit at the prevailing spot price.