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Complex financial instruments such as swaps are not only found in films such as "The Big Short"; Gold is also traded with all kinds of contracts. Jan Nieuwenhuijs provides in his recent blog on Gainesvillecoins.com An interesting insight into this complex market. How do different parties in the Gold Wholesale Market make use of lease, swap and forward contracts?
On the gold market, different parties can offer or ask for gold. For example, a party can lease gold, which is basically the same as borrowing. This is of interest to central banks, among others, which can offer their gold reserves in order to receive interest on them. Nomaliter, no interest is paid on gold, but if the central bank lends bullion, it does receive a fee for it; the gold lease rate. On the other hand, parties such as a jewellery manufacturer can borrow gold. By borrowing gold instead of buying it, the manufacturer has a lower initial cost and does not have to take out a loan for the purchase of gold. When the jewellery is sold, the manufacturer has made a profit. The gold is then repaid to the central bank, including the gold lease rate.
This transaction often goes through a bullion bank, which acts as an intermediary in the gold market. This bank takes care of the Bids and sacrifices. One Pray is the price at which one can borrow gold, a sacrifice is the price at which gold can be lent. The difference between the Bids and sacrifices is for the bullion bank. In this way, each party benefits from the transaction. The central bank receives the interest, the manufacturer easily obtains precious metals, and the market maker also gets a piece of the pie.
But if the manufacturer needs gold not at the moment, but in a few months, he can also fix the price. This is possible with a forward contract. The manufacturer then enters into an agreement with the bullion bank to buy a certain amount of gold at a certain price at a future date. This means that the price in the forward contract may differ from the current spot price of the precious metal. In this way, the manufacturer hedges against further price increases. These contracts can also be used for speculation. If the price of gold ends up being higher than the price in the forward contract, then the value of the contract increases.
That means that the bullion bank itself also has to deal with risks. If a customer takes a large forward position, it is quite possible that the bank will not be able to buy the same amount of gold 12 months in advance from another customer. In such a case, the bank must cover itself. There is a risk that the gold price has risen above the forward price and that the bullion bank will make a loss on the trade. To hedge themselves, the dealer will borrow dollars, use those dollars to buy gold on the spot market, and lend the gold for 12 months. Twelve months later, the dealer gets the gold back and can fulfill his forward obligation to the customer. In the forward transaction, the dealer sells gold, the proceeds are used to repay the dollar loan.
Forwards are similar to futures contracts, but there are differences. Futures are standardized contracts that are traded on the stock exchange. Forwards are bilateral contracts and are therefore not traded on the stock exchange. This has the advantage that they can be set up more flexibly. Special arrangements can be made, depending on the wishes of the two parties. But since an agreement is made between two parties (in this example the manufacturer and the bullion bank, which is now not an intermediary), a credit risk does arise. If one of the parties goes bankrupt, this has consequences for the other. The differences between forwards and futures are further elaborated below.
Let's say the bullion bank offers a forward to buy 1,000 ounces of gold at a price of $2,050 per troy ounce, while the current spot price is $2,000 per troy ounce. The forward rate is then ((2050–2000)/2000*100)/(180/360) = 5 percent. But if the forward price changes, it can be reinstated by arbitrage. This means that certain parties take advantage of price differences between markets by buying in one market and selling in another.
Suppose the bullion bank then offers a forward of $2040 per troy ounce. A trader smells an opportunity. The trader borrows 1,000 troy ounces of gold at 2 percent interest, which he immediately exchanges for two million dollars and lends out at 7 percent interest. At the same time, the trader enters into a forward contract, so that in 6 months he buys 1010 troy ounces of gold for 2040 dollars per troy ounce. For this, the trader pays $2,060,400 when he receives the gold six months later, while he receives $2,070,000 on the dollars he lent at 7 percent interest. Thus, the trader's profit amounts to 9600 dollars. As the trader increases the demand for gold, this process can be repeated until the price of the forward is back to $2050.
Based on the interest rate parity, Nieuwenhuijs formulates the following formula: Forward rate = dollar interest rate – gold lease rate, in this case 5% = 7% - 2%. If one of the tariffs is not satisfactory, arbitrators intervene to restore the ratios. This means that they will do the opposite if the forward rate is too high in their opinion. Then they buy gold and sell it through a forward contract.
But gold can also be used as collateral for loans, as is the case with swaps. With a swap, a party can negotiate a lower interest rate. Let's say a trader wants to borrow two million dollars. The interest rate is 7 percent, but the trader thinks it is too high. In that case, the trader can enter into a swap with the bullion bank. In this swap, the trader's gold, in this case a thousand ounces, acts as collateral for the loan. If the trader is unable to repay the loan, the bullion bank receives the collateral. If the trader repays the loan with interest, he will receive the gold back.
As a provider of money, the bullion bank therefore runs much less risk than with a normal loan. Also, the bullion bank can lend out the gold it receives as collateral. Suppose that money can normally be lent out at seven percent interest, the same dollar interest rate as in the previous example. The bullion bank lends the gold to another party at two percent interest, the gold lease rate. The interest rate on the loan can therefore be reduced by two percentage points as a result of the swap. As a result, the interest rate of the loan is at the same level as the forward rate.
Jan Nieuwenhuijs' article shows how complex the derivatives market is. Nevertheless, it is indeed interesting to understand how derivatives work. Derivatives can also be used to better understand the gold market.
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