gold derivatives the market impact

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The market impact

Anthony Neuberger, London Business School

Report prepared for the World Gold Council, May 2001

GoldDerivatives:

W O R L D G O L D C O U N C I LO R L D G O L D C O U N CI L

GoldDerivatives:

LondonBusinessSchool



Gold Derivatives: The market impact

The views expressed in this study are those of the author and not necessarily theviews of the World Gold Council or the London Business School. While everycare has been taken, neither the World Gold Council nor the London BusinessSchool nor the author can guarantee the accuracy of any statement or representa-tions made.

Published by Centre for Public Policy Studies,World Gold Council, 45 Pall Mall, London SW1Y 5JG, UK.Tel +44(0)20 7930 5171 Fax + 44(0)20 7839 6561E-mail: [email protected] Website www.gold.org

Gold Derivati ves: The market impact by Anthony Neuberger, London BusinessSchool, advised by a Steering Group comprising Ian Cooper, Julian Franks andStephen Schaefer of London Business School.



Gold Derivatives: The market impact 3

CONTENTSForeword by Haruko Fukuda, Chief Executi ve, World Gold Council ..... ... ... ... ... ...7

About the author ........ ........ ......... ........ ......... ........ ......... ......... ........ ......... ......8

The steering group ......... ........ ......... ........ ......... ........ ......... ........ ......... ......... ...8

Executive summary .....................................................................................9

Chapter 1 The physical gold market ...........................................................151.1 Production...............................................................................15

1.2 Consumption...........................................................................211.3 Investment ...............................................................................231.4 Data Issues ..............................................................................28

Chapter 2 The paper market ......................................................................292.1 What makes gold special? .........................................................302.2 Gold derivative contracts ..........................................................322.3 The market ..............................................................................372.4 Downstream hedging ...............................................................402.5 Speculative traders....................................................................41

2.6 The banking sector...................................................................432.7 Producer hedging.....................................................................46

Chapter 3 The debate................................................................................533.1 The debate outlined .................................................................543.2 The impact of derivatives generally............................................563.3 What is special about gold ........................................................573.4 The simple consumption model ................................................583.5 Other effects of derivative markets.............................................60

Chapter 4 The empirical evidence..............................................................634.1 The impact of short-selling on the price of gold .........................634.2 The impact of hedging policy announcements...........................68

Chapter 5 The gold lending market and its stabil ity ...................................735.1 Scenario 1: A cutback in lending..............................................745.2 Scenario 2: A cutback in demand for borrowing........................805.3 The empirical evidenc from lease rates.......................................82




Appendices

Appendix 1

Overview ..............................................................................................87

1 The economic role of forward markets ..............................................88

2 Derivatives and market quali ty: theoretical considerations..................95

3 Derivatives and market quali ty: empirical evidence..........................102

4 Conclusions..................................................................................109

References ........................................................................................111

Appendix 2

A detailed analysis of producer hedge books....................................115

Appendix 3

The Washington Agreement on Gold .............................................118




FOREWORD

There has been much debate about the impact of the derivatives market on thespot market for gold. Some people attribute the decline in the dollar price of goldover the last decade to the rapid growth of the gold derivatives market. Othersclaim that the impact of derivatives has been largely beneficial for the gold mar-ket, improving liquidity and helping efficient risk management.

Despite the extent and often ferocity of this debate, there have been few system-atic studies of this important subject. To rectify this, the World Gold Council

asked Professor Anthony Neuberger, a leading expert on derivatives markets, andhis team from the London Business School, to analyse the arguments, present theevidence and reach conclusions on these issues.

This study forms the second part of a major research project on derivatives mar-kets sponsored by the World Gold Council. The first part, ‘Gold Derivatives: Themarket view’, by Jessica Cross was published in September 2000 and was widelyseen as the most comprehensive and detailed factual review of the market thus far.Professor Neuberger’s analysis draws heavily on Dr Cross’s empirical findings, inparticular her estimate of the size of the lending market.

The World Gold Council is grateful to the London Business School for the con-siderable care and effort that has gone into ‘Gold Derivatives: The market im-pact’. I do not believe it will answer all the questions or end all the disputes.Nevertheless I think that with this rigorously researched report Professor Neubergerand his colleagues have made an invaluable contribution to our understanding of how the market works, the impact derivatives have had so far and could have inthe future.

Haruko Fukuda

Chief Executive




About the author Anthony Neuberger is Associate Professor of Finance at London Business Schoolwhere he is also Associate Dean of the Masters in Finance programme (full-t ime).His published academic research includes work on hedging long-term commod-ity exposures using short-dated futures contracts, and the impact of trade disclo-sure requirements on market liquidity. Before joining the faculty at LBS in 1985he worked in the UK Civil Service, first in the Cabinet Office and latterly as aPrincipal in the Department of Energy.

The steering group

Ian Cooper is Professor of Finance at London Business School. He has publishedmany papers in the field of international finance, default risk in financial con-tracts, and corporate finance. He has held visiting appointments at the Universi-ties of Chicago and the Australian Graduate School of Management, and hasserved on the editorial boards of a number of academic and practitioner journals.

Julian Franks is Corporation of London Professor of Finance at London BusinessSchool where he has served as Director of the Institute of Finance and Account-ing, and Director of the MBA programme. He has held visiting appointments at

the Universities of North Carolina, Berkeley and UCLA. He has published widelyin the field of bankruptcy, corporate restructuring and corporate control, and hasserved on the editorial boards of many academic journals.

Stephen Schaefer is Tokai Bank Professor of Finance at London Business School,where he has served as Director of the Institute of Finance and Accounting andas Research Dean. He has held visiting appointments at the Universities of Bergamo,Chicago, Berkeley, British Columbia, Cape Town and Venezia, and has served onthe editorial board of numerous academic journals. He has published widely onthe term structure of interest rates, the pricing of derivatives, financial regulationand risk management.




When the derivative contract matures, the spot market hedge is removed, and thebank buys back the gold. Thus the effect of hedging by producers and fabricatorsis to bring forward or accelerate sales in the spot market. The volume of salesbrought forward is equal to the net short position of hedgers and speculators.

So long as the net short position is stable, with the initiation of new contractsbeing offset by the maturing of old contracts, the effect on the spot market isneutral. But over the decade of the 1990s the amount of hedging increased rap-idly, with much of the increase occurring in the second half of the period. The netshort position increased by a total of some 4,000 tonnes, or around 400 tonnes/

year on average. To put the point another way, to meet the demands of the deriva-tive markets, holders of gold increased their lending of gold to the market bysome 4,000 tonnes. The presence of this gold increased physical supply. Thevolume is significant, being equal to around 12% of non-investment demand forgold over the same period.

The impact of accelerated supply on price

The derivatives market does give rise to accelerated supply. The key issue is whatimpact this accelerated supply has on the spot price. Physical demand and supplymust match each period. New mined supply is inelastic in the short term. Theimpact of accelerated supply depends entirely on how demand respondsto price.

One view is that demand each period responds to the price level in the way it doeswith most consumable commodities. The incremental supply depresses the spotprice sufficiently so as to create the additional demand which will absorb it. Theprice impact can be computed using a price elasticity of demand in the conven-tional way.

Analysis on these lines suggests that the spot price of gold may have been de-pressed on average by something of the order of 10-15% below the level which itwould otherwise have attained over the decade. This model goes on to predictthat if and when the size of the aggregate short position stabilises, the price of gold will revert to the level it would have reached in the absence of short selling,

since the net addition to supply will disappear. This physical supply model of thegold market also suggests that central bank net selling, which added about 3,000tonnes to net supply over the decade, and the increased level of gold production,which was responsible for another 2,000 tonnes, must also have played a signifi-cant role alongside the 4,000 tonnes from the derivatives market.

However, there are reasons, both theoretical and empirical, for believing that thismodel greatly overstates the impact of the accelerated supply. I t ignores the factthat gold is held as a store of value and an investment as well as bought as a




consumption good. The net demand for gold is the result of the decisions of many individuals to increase or reduce their holdings of gold. From this perspec-tive, the accelerated supply of 4,000 tonnes should be compared with the stock of gold which exists (estimated at some 140,000 tonnes) rather than just with newlymined gold. Net investment demand for gold, like that for any other investmentgood, will be sensitive, not so much to the level of the gold price, but to smallvariations in the expected rate of return from holding it.

If accelerated supply does depress the spot price, and if the depression is tempo-rary because the size of paper short positions is not expected to increase indefi-nitely, then the market should expect the price to return in due course to the

levels it would have had in the absence of a derivatives market. Thus investorsshould see the temporary depression in the gold price as a buying opportunity.This increased investment demand would offset at least in part the acceleratedsupply from the paper market.

The theory suggests the impact of accelerated supply on the price should belimited. The empirical evidence broadly supports this position. We find nocorrelation between quarterly changes in the paper short position (as measuredby the aggregate short position of gold producers) and changes in the spotprice of gold. We looked to see whether the gold price rises when a goldproducer announces a reduction in hedging and falls when an increase is an-nounced. While such an effect is visible in the data, it is only marginallysignificant statistically.

While the evidence both theoretical and empirical is not conclusive, it does sug-gest that the accelerated supply due to increased forward selling in the lastdecade probably did depress the gold price, but the magnitude of the effect ismuch too small to explain all the real decline in the gold price seen over the lastdecade. The lack of transparency in the gold market may have led to an exagger-ated sense of the role played by derivatives in the decline. Market part icipantsmay have interpreted transactions generated by hedging demands as one com-ponent of a very much larger speculative order flow, and this may have had animpact on the gold price.

The wider impact of the derivatives market

There are a number of other ways in which the derivatives market has an impacton the spot market apart from through accelerated supply. The existence of thederivatives market is likely to affect the behaviour of those who use it, and there-fore indirectly affect the spot market. These indirect effects of derivative marketstend to increase both demand and supply for gold. Their impact on the spot priceis ambiguous.




Owners of gold can use the derivatives market to get extra income from theirholdings. Derivatives greatly widen the range of strategies available, particularlyto large holders, for managing their gold holdings. By increasing flexibility andreturn, they make gold a more attractive asset to hold.

The ability to borrow gold easily and at low rates is of benefit to all those involvedin downstream activities (refiners, fabricators and distributors). By reducing thecosts and risks associated with holding of large stocks, it allows the widespreaddistribution and availabil ity of gold and thus facilitates the marketing of gold tocustomers.

Derivatives also reduce the cost of capital for producers, and so tend to encourageproduction. Project finance for new mines is often conditional on output beingsold forward. There is evidence that producers who have sold their productionforward may be slower to cut production as spot prices fall.

The stability of the derivatives market and its impact on the spot market

The growth of the derivatives market has been made possible by the existence of large stocks of gold, largely in the official sector. For some official holders physicalpossession of their gold is important but for others the convenience yield onholding gold is small, and they are prepared to lend gold at very low lease rates,similarly to the way they might lend their bonds or other financial assets. This

ready supply of liquidity has led to lease rates for gold which are low and stablerelative to other commodities. Without that, there would be no long-term for-ward market. Forward prices and spot prices would decouple. Producers wouldbe unable to hedge the price risk on future production except in the short term.Fabricators would not be able to predict the cost of holding inventory more thana few months ahead. The amount of hedging would fall. The derivatives market ingold would resemble much more closely that in other commodities.

The future stability of the derivatives market depends on the continuing readi-ness of the official sector to lend its gold. Most lenders lend their gold for rela-tively short periods, typically three months at a time, though in general these

loans are then rolled over. It takes time for lending policies to be changed, and thesupply of lending at least in the short term is not very sensitive to lease rates.These factors make the lending market vulnerable to shocks, particularly if lend-ers are close to their current lending limits.

For example, if a number of central banks decided to withdraw their gold fromthe market, it would cause a serious squeeze. Lease rates and spot prices wouldrise sharply as borrowers tried to repay their loans. A large and sustained rise inlease rates would cause substantial losses to producers who have sold gold forwardand retained the lease rate risk, to fabricators and distributors, and to commercial




banks who are active in the market. The rise in lease rates and spot prices wouldattract holders of physical gold to lend or sell their gold into the market.

Some indication of the possible magnitudes can be gained from the behaviour of lease rates following the Washington Agreement in September 1999. This wascaused not by a cut in lending but only by a ceiling on future lending.

The shape of the term structure of gold lease rates historically suggests that themarket has perceived little risk of a crisis in the lending market. Had the per-ceived risk been substantial, this should have manifested itself through a spreador security premium between short- and long-term lending rates. The evidence

suggests that term premia in the gold lending market have been no higher thanthey are in the (US dollar) money market.

It is indeed hard to visualise circumstances under which several lenders decide towithdraw their gold from the market simultaneously. Credit risk is not a majorconcern since most of the borrowers are major commercial banks for whom gold isonly a small part of their portfolio. It is unlikely that many holders of gold willdecide to sell their gold at the same time, and seek to recover their lent gold forthat reason. They also have an interest in acting in a way which maintains anorderly market.

Concerns have also been expressed about the consequences for the derivativesmarket of a sudden reduction in the size of producer hedging books. However,there seems little reason for a concerted withdrawal from hedging, and indeed itwould be very costly for individual producers to cut back their hedge book at thesame time as others are doing it. So while it is possible that a sharp rise in the goldprice could lead to the sudden liquidation of short positions, it is unlikely to beon a larger scale than we have already seen.

The size of the derivatives market in future

There are reasons for believing that the rapid expansion in the size of the goldderivatives market is likely to slacken or indeed reverse. The Cross report esti-

mates that, given current policies, the scope for additional official sector lendingis no more than 1,000 tonnes. The private sector could become a major source of lending, but that is likely to require a substantial increase in the level of lease rates.

Underlying hedging demand by producers is likely to slacken given the decline innew mining developments. There is no reason why hedging demand downstreamshould grow other than broadly in line with any increase in demand. The maincontingent factors which will determine the size of hedging demand in futurewill therefore be the level and volatility of lease rates, and expectations aboutfuture returns on holding gold.




The level and volatility of lease rates is likely to have a significant impact in de-mand for hedging. Higher lease rates increase the cost of holding inventory, andtherefore tend to depress downstream demand for hedging. Greater volatility inlease rates reduces the effectiveness of long-term hedges by making them morerisky, and therefore reduces producers’ willingness to sell their production forward.

Conclusions

The main conclusions of this study are that:

1) the derivatives market has played an important role in reducing the cost of

capital for producers, in helping finance large downstream inventories, and ingiving holders of gold the possibility of earning income on their gold holdingsand managing them more flexibly;

2) the rapid growth of the derivatives market over the last decade has acceleratedthe physical supply of gold, and probably led to the gold price being some-what lower than it would otherwise have been, but the magnitude of the effectis much too small to explain all the real decline in the gold price seen over thelast decade;

3) the supply of liquidity from increased central bank lending has been indispen-sable to the growth of the derivatives market. The constraints on lending underthe Washington Agreement, together with weakness in demand for borrowinggold, provide reasons for believing that the period of rapid growth in the size of the derivatives market is now over. If this is indeed the case, then derivativeswill not provide accelerated supply to the spot market in the future, and what-ever impact this has had on the gold price in the past should be reversed.




CHAPTER 1 THE PHYSICAL GOLDMARKET

This chapter describes the various elements of the physical market and their characteris-

ti cs. T he main points made are:

· most of the gold which has ever been mined has been accumulated rather than con-

sumed; much of i t could return to the market again. The level of producti on, though

it has increased substantially over the last century, at 2,500 tonnes/year, i s small

compared wi th the stock of gold already produced (estimated at 140,000 tonnes).

Producti on does respond to the level of the gold price, but the full effects take several

years to work through (1.1).· demand for industrial and dental gold accounts for 400 tonnes/year, or around

17% of producti on. The great bulk of the demand for gold is for jewellery. Gold

jewellery is often an investment good, or a store of value, as well as a consumption

good. Demand is therefore likely to depend on expectati ons about future returns from

holding gold as well as on the current level of the price. I ncome, cultural and social

and other factors are also important determinants (1.2).

· pri vate investment holdings of gold are substantial (around 25,000 tonnes). Invest-

ment demand i s sensitive to economic conditions in the M iddle and Far East where it

is most widely held, and to confi dence in the fi nancial system. Net investment de-

mand i s likely to be much more sensitive to expectati ons about future returns than to

the price level. Official sector holdings (35,000 tonnes) have been fairly stable over

the last twenty years, though worries about the possibi li ty of future sales have been a

major influence on the market in the second half of the 1990s (1.3).

1.1 ProductionGold has been mined since time immemorial, but levels of production have in-creased rapidly since the mid-1800s. At the beginning of the twentieth century,total production amounted to 450 tonnes per year1 . By the end of it, productionexceeded 2,500 tonnes/year2 . With this growth in production, more than a thirdof all the gold that has ever been mined has been extracted in the last thirty

years3 .

The comparison of production levels with the total quantity ever produced is

relevant to gold in a way that is quite unlike other commodities. M ost of the gold

which has been produced has not been permanently consumed; much of it could

at some time come back to the market. Much of it will be traded largely on the

1 Central Bank Gold Reserves: An hi stori cal perspective since 1845 by Timothy Green, World Gold Council,Research Study No. 23, London 1999.2 Gold Survey 2000, Gold Fields Mineral Services Ltd (GFMS), London, 2000.3 Gold Survey 2000, GFMS, London, 2000.




The Real Price of Gold 1900-2000

in 1900 $

0.00

10.00

20.00

30.00

40.00

50.00

60.00

1 9 0 0

1 9 0 7

1 9 1 4

1 9 2 1

1 9 2 8

1 9 3 5

1 9 4 2

1 9 4 9

1 9 5 6

1 9 6 3

1 9 7 0

1 9 7 7

1 9 8 4

1 9 9 1

1 9 9 8

The rise in the gold price to $35 per oz in 1934 caused a surge in productionuntil the disruption of the Second World War. Production grew slowly during the1950s and 1960s but with the price fixed at $35 per oz growth was restrainedonce again by a decline in the real price. The consequent lack of explorationmeant that output fell during the 1970s, despite the price explosion, as existingmines were exhausted; while exploration was resumed the time lag between ex-ploration and production meant that it was not until the 1980s that this wasreflected in a rise in output. During the 1980s and 1990s output was on a largelyuninterrupted rising trend. In addition to the results of the renewed round of

exploration in the 1970s, this was spurred by two other factors. There were sub-stantial improvements in exploration, drilling and mining techniques with themost important innovation being heap leaching. This permitted economic ex-traction of gold from low grades of ore which would previously have been consid-ered as waste. In addition a more welcoming attitude of many developing coun-tries to foreign direct investment, coupled with improved economic management,meant that they started to offer a viable operating environment for internationalmining companies enabling their gold and other mineral reserves to be exploited.

Together the innovations in technology and the improved operating environmentsin many countries meant that over recent decades the number of gold producing

countries has expanded significantly. In 1970 South African output reached itspeak level of 1,000 tonnes which accounted for 79% of non-communist output.In 1981 it was responsible for 658 tonnes out of a global figure of 1,302 tonnes,

just over 50%. In 1999 it was sti ll the largest producer but relatively high costsand the mining out of earlier discoveries had reduced output to 450 tonnes, 17%of (much increased) world production. In contrast the next larger producers sawsubstantial increases in production between 1981 and 1999: US output up 677%;Australian up 1545% Canadian up 198% and Chinese up 195%. There has alsobeen rising output from developing countries as the business environment inmany of these improved.

Source: Bannock Consulting, World Gold Council




Breakdown of Production in 1999

17%

13%

12%

6%6%6%

5%

5%

10%

20%South Africa

USA

Australia

CanadaChinaIndonesia

Russia

Peru

Other Latin America

Rest of World

Total Production =2,571 Tonnes

Breakdown of Production in 1968

13%

6%

3%

3%

2% 6%

67%South Africa

USSR

Cananda

USA

Asia

Latin America Rest of World

Total Production =1,450 Tonnes

The rise in output in the 1980s and 1990s has, however, halted with output in2000 expected to be close to, or even slightly below, that in 1999. In part this isdue to the increase in output generated from the exploration of the 1970s and thetechnological improvements coming to a natural end. But the more serious factoris the effect of the fall in the real price of gold in the 1990s, a fall which wasaccelerated (at least in dollar terms) from the second half of 1996 when the nomi-nal price plunged as well. This has restricted output and resulted in a sharpdecline in exploration.

Source: Gold Fields Mineral Services





Gold Exploration Expenditure 1997-1999

$billion % Change

1997 2.621998 1.56 -40.61999 1.09 -30.3

Source: Calculated from Metal Economic Group as reported in theFinancial T imes , 6 January 2000

The unfavourable price trends of the second half of the 1990s did not result in animmediate fall in output although the growth in output was less buoyant than itwould have been had real prices remained stable. The owner of an operating mine

has some flexibility in responding to changes in gold prices. If the price of goldfalls below marginal production costs, and the situation appears to be permanent,the mine can be closed. But closure brings forward termination and reclamationcosts which may be large. It is therefore most attractive for mines which are any-way reaching the end of their reserves.

But there is much that can be done short of closure. Production can concentrateon the highest quality, most accessible reserves. Economic pressures may make iteasier to cut costs. According to Gold Fields Mineral Services Ltd (GFMS)4 , aver-age cash costs of mining in the Western world have fallen by some 22% in dollarterms over the last two years although some of this is due to the fall in the curren-

cies of key producer countries relative to the dollar. And the increasing ability tohedge future output has also improved the financial conditions of mining compa-nies and hence helped to cushion marginal production. Use of such methods bymining companies meant that output only ceased growing in 2000.

4 Gold Survey 2000 , GFMS, London, 2000.

Gold Price, Total Costs and Cash Costs*

100

150

200

250

300

350

400

450

1991 1992 1993 1994 1995 1996 1997 1998 1999

Gold Price

Total Costs

Cash Costs

* weighted average of mining cash and total costs.





Thus while output responds to price changes it does so only after a number of years. The unfavourable price trends of the 1990s, and in particular of the lastfour years of the decade, are only now starting to cause a fall in output. In theother direction, when exploration has been sharply cut it takes at least 7-8 yearsfor a rise in price to generate not just exploration but the subsequent exploitationof the results, let alone sufficient new output to compensate in addition for theexhaustion of existing mines.

Gold is found in a variety of geological formations and, to varying degrees, in allcontinents. It is at times found in conjunction with other exploitable metals,notably copper. Substantial quantities of gold can even be found in the oceans

although not, at the moment, economically exploitable. Mining companies’gold reserves below ground – which are defined as gold deposits economicallyexploitable at current prices and with current technology – are to a large de-gree, therefore, a function of price. While comprehensive data are not available,such reserves are known to have fallen in recent years due to the fall in price andthe cutback in exploration.

Throughout this section – and necessarily through most of this report – theanalysis has concentrated on the dollar price. While it is convenient to describethe price of gold in nominal or real US dollars, this is not necessarily the appro-priate measure for producers and consumers outside the US. With the very sub-stantial changes in real exchange rates that have been experienced over the last fewyears, the real price of gold as seen by a South African miner, or an Indian buyerof jewellery, may look very different. Indeed the recent fall in the dollar price of gold has been mitigated in a number of producer countries by the depreciation of a national currency against the dollar halting or limiting the decline in the na-tional currency gold price. However the real price of gold has fallen since 1990 inall the four main producer countries although the fall occurred at different times.In South Africa the real price fell in the early 1990s but has fluctuated around afairly stable level since. I n Australia the real price fell at the beginning of thedecade, recovered in 1993, then fell until September 1999 after which therehas been a very l imited recovery. In Canada, the real price fell at the start of the decade, recovered partly in 1994, then has been on a downward trend

since late 1996.




Source: World Gold Council

1.2 Consumption

It is common to distinguish between consumption and investment demand forgold, but it is important to understand that the distinction is blurred. In con-formity with normal practice we distinguish according to the form of the gold:gold bars and coins will be treated as investment and discussed in the followingsection, while all jewellery uses are treated as consumption and discussed inthis section.

Consumption of gold also differs according to type. Some of the gold used inindustrial and dental applications will not be salvaged and thus be truly con-sumed. In 1999, these uses accounted for around 400 tonnes per year5 . Electron-ics demand in 1999 was estimated at 243 tonnes, up 12.7% from 216 tonnes in

1990. Miniaturisation and the desire to use cheaper materials in industries whichare often highly price competitive have meant that the use of gold has not keptpace with the growth in the output of electronics products despite gold’s effec-tiveness and reliability as an conductor of electricity. In 1999 dentistry demandwas 65 tonnes, up marginally from 62 tonnes in 1990. Other industrial anddecorative applications were estimated to be responsible for 102 tonnes, up from73 tonnes in 1990.

5 Gold Survey 2000, Gold Fields Mineral Services, London, 2000.6 Gold Survey 2000, Gold Fields Mineral Services, London, 2000.

Real Price of Gold in USD, CAD, Rand, and AUD

50

60

70

80

90

100

110

120

130

140

J a n - 9 0

J a n - 9 1

J a n - 9 2

J a n - 9 3

J a n - 9 4

J a n - 9 5

J a n - 9 6

J a n - 9 7

J a n - 9 8

J a n - 9 9

J a n - 0 0

Rand

AUD

CAD

USD




Of the approximately 140,000 tonnes of gold which has been produced it isestimated that around 67,000 tonnes is in the form of jewellery6 . However, theterm jewellery covers a wide range of products with different characteristics vary-ing from market to market. In Asia and the Middle East much gold jewellery ishigh carat with a low mark-up. Such jewellery can readily be converted back intogold. In western developed markets gold jewellery is normally lower carat with amuch higher mark-up to cover the cost of design and distribution. Such items areless readily convertible back into pure gold.

Distribution of Global Above-Ground Gold (Tonnes)

Jewellery

(67,300)

Official Holdings*

(30,500)

Private

Investment

(25,200)

Other Fabrication

(15,700)

Unaccounted

(1,300)

Above-ground Stocks,

end-1999 = 140,000

* Excluding lent gold


While jewellery in western developed countries is primari ly bought purely asadornment, the high carat jewellery of Asia and the Middle East frequently has adual purpose and is considered also as a means of saving and a store of wealth.While gold is bought by all sections of society, this function of gold is particularlyimportant for the poorer and rural populations, who often do not have access to,or trust in, bank accounts and more sophisticated financial instruments; or whomay wish to save in a medium other than their national currency. It is also par-ticularly important to women in a number of cultures. Gold jewellery is consid-ered the woman’s personal property and therefore is her safeguard against divorceor other misfortunes. Gold giving is often therefore associated with weddings.

Demand for such gold is affected in the short term by price movements but lessin the long term; indeed the savings characteristic of gold means that a long-termrising trend in the price against the national currency wil l not deter purchase. Aswell as price and social and cultural factors gold demand is normally elastic withrespect to incomes, rising as incomes increase (indeed studies suggest gold ismore income than price elastic). As in the case of production, movements in thereal price of gold have varied substantially between consuming countries. Chinaand a number of key consuming countries in the Middle East have exchange ratesfixed in effect to the dollar, with occasional devaluations.





Real Price of Gold in Selected Key Gold Consuming

Countries

30

80

130

180

230

280

J a n - 9 0

J a n - 9 1

J a n - 9 2

J a n - 9 3

J a n - 9 4

J a n - 9 5

J a n - 9 6

J a n - 9 7

J a n - 9 8

J a n - 9 9

J a n - 0 0

Indonesia

Japan

ChinaIndia

1995=100


Real Price of Gold in Selected Key Gold

Consuming Countries

50

70

90

110

130

150

J a n - 9 0

J a n - 9 1

J a n - 9 2

J a n - 9 3

J a n - 9 4

J a n - 9 5

J a n - 9 6

J a n - 9 7

J a n - 9 8

J a n - 9 9

J a n - 0 0

Turkey

USA

Italy

1995=100

Although scrap is normally treated as a source of supply, it is more natural tocover it in this section since it is really a form of negative demand. Most scrap is

jewellery; the piece of jewellery is melted down and the gold recovered, often tobe used in another piece of jewellery. Other things being equal a rise in the na-tional price of gold normally increases scrap supply. One result of the Asian crisisin 1997/98 was a substantial temporary rise in the amount of scrap from affectedcountries, partly as distress sales and partly as a result of a sharp rise in the national




price of gold following substantial currency depreciation. The most spectacu-lar increase was due to the national gold collection campaign in South Koreawhere citizens were encouraged to turn in their gold in exchange for nationalcurrency bonds.

1.3 Investment

Investment demand can be split broadly into two, private and public-sectorholdings.

Private sector holdings come in the form of bars and coins. Unlike jewellery, whichis held at least in part for decorative purposes, these holdings are purely a store of value, although in the Middle East coins and small bars are often incorporatedinto jewellery. According to GFMS, private investment holdings amount to justunder 25,000 tonnes, a figure that has been growing slowly over t ime. Moreinterestingly the location of the bulk of these holdings is believed to have shifted.Whereas thirty years ago, a substantial portion of this was held by Westerninvestors, the overwhelming majority is now thought to be held in other partsof the world.

Reasons for holding physical gold vary widely. In markets with poorly developedfinancial systems, inaccessible or insecure banks, or where trust in the govern-ment is low, gold is attractive as a store of value which is portable, anonymous andreadily marketable anywhere. In countries with a stable political and financialsystem, the prime attraction of gold is as an investment which has very low, ornegative, correlation with other assets, and which may hold or increase its value if for some reason investors flee from purely financial assets like bonds and equities.

If gold is held primari ly as an investment asset, it does not need to be held inphysical form. The investor could hold gold-linked paper assets or could lend outthe physical gold on the market. While proper discussion of the gold lendingmarket is reserved to the second chapter of the report, suffice to observe here that

an investor who wants exposure to gold, particularly if his position is more than,say, 10,000 ounces, will normally be able to achieve an increase in return of perhaps 1% by lending out his gold over the return he would gain by holdingphysical gold. In addition he wil l save on the storage costs.

Investors who hold their gold with a bank in unallocated form (where they have aclaim on the bank for a fixed quantity of gold, but they have no claim to specificbars) allow the bank to lend out ‘their’ gold. The bank normally retains anyinterest on lending the gold, but passes on some of the benefit to its customers byremitting storage charges.




Total Official Sector Gold Holdings, 1970-1999

(Tonnes)

Institutions

Western Europe

North America

Developing

countries

Other developed

countries

0

5000

10000

15000

20000

25000

30000

35000

40000

1 9 7 0

1 9 7 2

1 9 7 4

1 9 7 6

1 9 7 8

1 9 8 0

1 9 8 2

1 9 8 4

1 9 8 6

1 9 8 8

1 9 9 0

1 9 9 2

1 9 9 4

1 9 9 6

1 9 9 8

2 0 0 0

Around 35,000 tonnes of gold is held by the official sector, the bulk of it beingwith central banks or national treasuries, but with substantial amounts also heldby international agencies. The reasons normally given for holding gold as a reserveasset are varied – it is not a claim on another state and is therefore not affected bythe actions of any other state; it increases public confidence in the currency in theway that foreign currency reserves may not; in extremis it may retain its valuebetter than foreign currencies; as returns are little correlated with other reservesholding a certain quantity may improve the risk/return trade-off of the reserveportfolio as a whole. On the other hand, it is an asset which pays little or nointerest, and whose price has not performed particularly well in recent years.

Note: From 1978 to 1998 EU member countries deposited 20% of their gold with the EuropeanMonetary Institute in exchange for ecus. In January 1999, eurozone members transferred a total 747tonnes to the European Central Bank.

Source: World Gold Council, based on IMF data.

Current holdings by different countries are quite diverse both in terms of abso-lute quantity and as a proportion of their total external reserves. Gold holdingstwenty years ago are a good predictor of a central bank’s holding today7 . Thestability has been particularly marked among the larger holders - including theUnited States, Germany, the International Monetary Fund and France. Therehave been substantial sales, most notably by Argentina, Australia, Belgium, Canada,the Netherlands, Switzerland and the UK. There have also been confirmed buy-ers, the largest being Taiwan and Poland. These differences can partly be explained

7 The stability may be slightly overstated because this analysis is based on IMF data. There are known tobe many gold sales and purchases by central banks that are never publicised, and are not included in thedata.




by the way in which reserves are viewed nationally, and the way in which deci-sions on reserve policy are taken, and also by the very large size of reserves relativeto the underlying flow of production and consumption.

Central Bank Gold Holdings, 1978 and 1998

1

10

100

1,000

10,000

1 10 100 1,000 10,000

1978 tonnes

1998 tonnes

Dots below he linerepresent countries whosereserves fell between 1978

and 1998

Dots above the line

represent countries whose

reserves rose between 1978

and 1998

(Logarithmic Scale)

Source: IMF; World Gold Council calculations

Given the size of official reserves relative to consumption levels, the possibility of changes in policy have had a substantial impact on the gold price. Fears of sub-stantial official sector sales are thought to be one of the main factors behind thefall in the gold price since late 1996 – fears given credence by a small numberof substantial sales. In 1999 the UK gold sales together with the possibility of further gold sales by other parts of the official sector were thought to be majorfactors behind the extreme weakness of the gold price, which fell to $252/oz inAugust 1999.




The price subsequently recovered in September 1999 after the announce-ment of a pact between fifteen central banks8 to limit sales and lending, widelyknown as the ‘Washington Agreement on Gold’ (See Appendix 2). The signa-tories held between them about half of all official gold, and other large hold-

ers, such as the Uni ted States, IMF and Japan, unofficially associated them-selves with the agreement.

8 The European Central Bank, and the central banks of Austria, Belgium, France, Finland, Germany,Irish Republic, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, Switzerland and the UK.

Source: IMF, World Gold Council

Largest Official Gold Holdings (end 2000)

Tonnes Gold as a % of foreign exchangeholdings

1 United States 8,137 57%2 Germany 3,469 35%3 IMF 3,217 n/a4 France 3,025 42%5 Italy 2,452 40%6 Switzerland 2,420 40%7 Netherlands 912 46%8 Japan 764 2%9 ECB 747 14%10 Portugal 607 39%11 Spain 523 13%12 United Kingdom 480 9%13 Taiwan 421 3%14 China 395 2%15 Russia 382 12%16 Austria 377 19%17 India 358 9%18 Venezuela 319 16%19 Lebanon 287 30%20 Belgium 258 19%

All countries 28,871 12%

WAG 15,603 29%Euro-System 12,427 30%




1.4 Data issues

Published statistics on certain areas of physical supply and demand are well de-veloped but there remain gaps such as inventories, the extent of private institu-tional gold holdings, and the extent of below-ground reserves. Analytical prob-lems arise from informal or illegal activity. Some mining is still carried out byindividuals, notably in Latin America and Africa, and their activity is difficult totrack. Gold is easy to smuggle since small quantities have high value. Smugglingis generally declining as the gradual liberalisation and reduction in taxes underwayin many countries make it less worthwhile but where taxes are high or the marketheavily regulated it remains an important element of supply and one which is

inherently difficult to analyse.

One important form of demand for gold which is less easy to analyse is gold asinventory. Gold which is produced at the minehead does not immediately turninto jewellery around the neck of a customer. Quite substantial amounts of goldare held as inventory at various stages of the process and data on quantities do notexist. The existence of this stockpile is important because of its sensitivity to goldlease rates. So long as lease rates are very low, it is neither expensive nor risky tohold substantial quantities of gold in inventory because the gold can be borrowedcheaply. I f lease rates were to rise sharply (and we consider this possibility in moredetail later in the report), the immediate sources of additional supply of physical

gold would be from these inventories.




CHAPTER 2 THE PAPER MARKET

The chapter describes the nature and operati on of the derivati ves market in gold. The

main conclusions from the chapter are set out below, while the subsequent sections set out

the reasoning in more detail:

· gold supports a large and active derivatives market. I n part this is because of the very

qualities whi ch made it so widely used as money – its high value per unit weight, i ts

indestructibili ty, the ease wi th which i ts quali ty can be standardised and veri fied. But

more important than this has been the existence of large stocks of gold, and the

readiness of its owners – largely in the offi cial sector – to lend i t. The availabi lity of

abundant stocks for borrowing at low and generally stable rates, has made it possible

to design derivative products which meet the requi rements of producers, fabricators,

speculators and other market participants (2.1).

· the most important deri vative product is the forward contract. A forward sale is

equivalent to borrowing gold, selling it on the spot market, and depositi ng the sale

proceeds in a bank account. The forward dollar pr ice of gold i s determined by the

spot price of gold, the cost of borrowing dollars and the cost of borrowing gold (II .2.1).

· there is a wide variety of more complex derivati ves traded. Modern option pri cing

theory shows how such contracts can be replicated or hedged by dynamic trading of

forward contracts – that is strategies where the number of forward contracts held

depends on the level of the gold pr ice (2.2.2).

· the exchange traded market COMEX provides a good indi cati on of sentiment. But most derivatives trading takes place over-the-counter (OTC). The notional value of

banks’ derivati ve positi on in gold, though large relati ve to their other commodity

exposures, does not look large relati ve to derivative positions in other fi nancial mar-

kets. The evidence is consistent wi th the estimates in the Cross Report of the size of the

gold lending market (2.3).

· for downstream users and processors of gold (e.g. fabricators, refi ners and wholesal-

ers) the benefi ts of being able to borrow gold are straightforward. Their profi t mar-

gins are low relati ve to the value of gold inventory they hold, and can easi ly be wiped

out by adverse pri ce movements. Borrowing gold, or fi nancing their inventory through

gold l inked borrowing, can largely remove exposure to gold price risk. The fact that

lease rates are low and stable means that the cost and risks associated with carrying

high levels of inventory can be kept small (2.4).

· for speculators, the derivative market has made it cheap and easy to sell gold short.

One of the ri sks facing a short seller of commodi ties is a squeeze in the cash market

which raises borrowing rates for the commodi ty steeply, and thus forces premature

and costly liquidati on of a potentially profitable positi on. In the case of gold, the

existence of substantial stocks available for lending makes borrowing costs fai rly pre-

dictable and a squeeze unl ikely (2.5).

· commercial banks perform the standard economic functi ons of a fi nancial interme-

diary in any market. They manage the mismatch between lenders and borrowers –




mismatch of maturi ty, of lendi ng rates and of credi t. They also design and create

complex structures whi ch they hedge into the market. While they do take risk, they are

not well set up to take market r isk (e.g. on the level of the gold price) and are likely

to hedge much market risk back i nto the market (2.6).

· the derivative markets provide producers wi th a rich array of ri sk management in-

struments. Risk management has a number of di fferent objectives – hedging value,

hedging earni ngs and hedging cash flow – and the balance between them is a matter

of judgement. The size of a producer’s hedge book is likely to be influenced heavi ly by

management’s view of the likely profi tabi lity of the transacti on (2.7.1).

· accounting rules affect the size and composition of hedge books. Whi le the newly

introduced US Accounti ng Standard (FAS133) wi ll probably not affect the amount

of hedging, it may well influence the instruments used. Cash flow and fi nancing considerati ons wi ll limi t the size of hedge books for more highly leveraged producers

(2.7.2-3).

· the complexity of indi vidual producer hedge books and their long maturities may give

a misleading idea of the economic impact of producer hedging as a whole. M uch of

the optionali ty nets out; over-simplifying somewhat, the options bought by one pro-

ducer are effecti vely written by another producer, albeit wi th slightly different terms.

The long maturi ties of producer hedge books are more of a reflection of an accounting

decision to defer recogni tion of the profi ts or losses from particular transactions years

into the future rather than of the transfer of long-term forward price risk. From an

economic perspective, the main impact of the hedge book is fai rly well reflected by the

effecti ve short positi on or delta of the book (2.7.3).

2.1 What makes gold special?

Gold supports a very active derivatives market. In no other commodity do pro-ducers routinely sell their output five years ahead or more. According to the Bankfor International Settlements, gold derivatives account for 45% of the com-modity derivatives exposure of banks in the G10 countries. What features makegold so special?

Gold has certain qualities which have made it synonymous with money for manygenerations, and these go some way to explaining the flourishing derivatives mar-ket. Gold is valuable – 50,000 t imes as valuable tonne for tonne as oil for example– and does not deteriorate over time. Quality is easy to verify, and it is cheap totransform one traded form into another. Costs of storage and transport are smallwhen expressed as a percentage of value. This means that the gold market is asingle integrated market, with price differentials for location or quality being farless significant and less variable than they are for most other commodities.A change in the price of London good delivery gold bars has a direct and




propor tionate effect on the value of the inventory of a Far Eastern jeweller. Shocksin one part of the market are transmitted and absorbed throughout the world.Users and producers can all hedge or manage the same risk using the same con-tract; liquidity is pooled.

But at least as important has been a second distinguishing feature of gold: theextent of above ground stocks, and the reasons for which they are held. In othercommodities stocks are held either because they are necessary work in progress, oras a safeguard against a future shortage. The holders of these stocks place substan-tial value on having physical possession of the commodity. As the likelihood of ashortage looms and recedes, so does the value of the stock as a safeguard. When

there is a glut, stocks become a nuisance. This means that the lease rate for mostcommodities is extremely volatile.

Gold is different. For many holders of gold, physical possession of the metal is notimportant. The difference between possession of the gold and a warrant givingentitlement to delivery of the gold in a month or two is mainly a question of credit risk. The actual convenience yield – the benefit they ascribe to holdingphysical gold – is low or even slightly negative once storage costs are taken intoaccount.

For other holders of gold, both in the official sector and the private sector, physi-cal possession is central to the reason for holding gold. They want to hold goldprecisely because it is an asset which is no one else’s liability, and this advantagewould be lost by lending the gold.

The behaviour of the gold lending market over the course of the 1990s suggeststhat once a central bank has put in place a policy of lending gold, the amount of gold it is prepared to lend within its predetermined policy limits is largely insen-sitive to the level of lease rates. But it does take time for a new policy to be put inplace, or for an existing policy to be revised. Whether it is reasonable to expectgold interest rates to remain as low and stable in the future as they have been inthe past is a matter we turn to later (in Chapter 5). But, as we will argue in thenext section, it is the stability and predictability of gold interest rates that has

underpinned the development of the paper market and the growth in particularof very long-dated contracts.




2.2 Gold derivative contracts

The variety and complexity of derivative products and hedge books is consider-able. They are designed to achieve a variety of objectives – economic, financial,accounting, regulatory. In this section we focus particularly on the economic analysisof these products. We look at the types of risk which are transferred from thebuyers of derivatives to the sellers. We show that, however complex the structure,the main gold specific risks which are transferred can be decomposed into spotgold price risk, gold interest rate risk and gold price volatility risk. In additiongold derivatives often transfer currency interest rate and exchange rate risks, butthese risks are of less relevance to this study.

The simplest derivative contract is the fixed price forward contract. After showinghow it can be decomposed into a spot transaction and gold and cash borrowingand lending, we consider the nature and magnitude of the risks transferred be-tween the buyer and the seller. Then we extend the analysis to more complexproducts such as options, and examine the link between complex derivatives andtrading strategies involving simple forward contracts.

2.2.1 Forward contracts

The relation between forward markets and lending markets

In a forward contract one party contracts with another to deliver a fixed quantityof the commodity at some fixed price and date to a second party. The party whois delivering is short the contract and the one who is buying is long the contract.A forward sale is equivalent to borrowing the commodity, selling it on the spotmarket and investing the cash proceeds.

So for example a producer who wants to sell 1 million ounces of gold forward oneyear, when the spot price is currently $300/oz, could instead search for an inves-tor who has gold and is prepared to lend 1 million ounces for one year at a cashinterest rate of 2%. The producer borrows the gold and sells it on the spot mar-ket. He invests the proceeds of $300m in a 1 year US Treasury bond, yielding say

7%. In one year the bond matures giving $321m. The producer then gives theinvestor 1 million ounces of gold and $6m interest to repay the loan. The neteffect is that the gold producer hands over 1 million ounces of gold in one year’stime, and receives cash of $321 - 6 = $315 million. The producer has created asynthetic forward contract at $315/oz. The forward price is the spot price plusthe dollar interest rate, less the gold interest rate.

The equivalence of the two transactions is important because it ties the forwardmarket to the gold lending market. With a deep and liquid gold lending market




there is a deep and liquid forward market, going out at least as far as the goldlending market. Much of the lending of gold by central banks is short-term –typically out to three months, though the average tenor has been increasing. Theexistence of a long-term gold forward market in the absence of a long-term goldlending market depends on the expectation that gold interest rates will remainlow and stable.

To see this, suppose the producer wants to sell gold five years forward, andthe gold lending market only extends one year. H e decides to create a syn-thetic forward contract by borrowing the gold for one year at a time, usingthe new gold loan to pay back the old. The final price he gets for the gold will

equal the ini tial spot price plus the five year dollar interest rate less the cost of borrowing the gold for the five years. If the cost of borrowing is unpredict-able, the price is very uncertain. But the uncertainty about the average levelof the one year gold interest rate over the next five years is probably of theorder of ½%, so the uncertainty in the realised forward price is around 2-3%.The gold producer can create a synthetic long-term forward contract usingthe short term lending market, and thereby get rid of the great bulk of theprice risk he otherwise faces.

The idea of a producer using a synthetic forward contract may seem unrealistic.In practice, the producer is more likely to seek to sell the gold forward to a bank.But the hedging issue does not disappear. In the absence of a counterparty whowants to buy the gold forward five years, the bank will hedge its risk by shortterm gold borrowing. The bank then takes on the risk that gold interest rates willrise. A producer who wants to sell production forward therefore faces a choice: hecan pass the gold lease rate risk on to the bank and get a fixed price forwardcontract, or he can accept a forward contract where the price is adjusted in linewith lease rates, and he bears the lease rate risk. The fixed price deal will probablyprove more expensive since long-term lease rates are on average higher than short-term lease rates.

Whether the bank wri tes a contract with a fixed lease rate, taking on the lease raterisk, or whether the producer agrees to keep the risk by accepting a floating lease

rate, the point is the same. It is only because the risk is small, because goldinterest rates are so stable, that it makes sense to do the transaction at all in theabsence of a long-term forward buyer of gold. Were gold interest rates as volatileas oil interest rates, the final price on a long-term floating lease rate forward salecontract would be so uncertain that it would be quite ineffective in hedging fu-ture revenues. The premium a bank would charge to offer a fixed rate deal wouldtend to be so large as to make hedging unattractive. It follows that if the goldlending market were expected to become much more volatile, the long maturityderivatives market would shrink.




The value of a forward contract

A forward contract written at market prices has zero financial value initially. Some-one who has sold production forward can negate the contract either by cancella-tion or by buying gold forward on the same terms. But as time passes, and thegold spot price and gold and dollar interest rates move, the forward price of goldchanges and the contract becomes an asset to one side and a liability to the other.From the perspective of a producer who has sold known production forward thischange in value may not seem significant. Any change in value of the forwardcontract is exactly offset by a change in the value of his future output.

But there are at least three reasons why the change in the value of the forwardcontract is important. First, it represents the effect of hedging as opposed to nothedging. Second, it may create financing problems. Suppose the forward pricehas risen since the inception of the contract, so the hedge is loss-making from theproducer’s perspective. From the bank’s perspective, the contract with the pro-ducer is now an asset, while the hedging transaction it has entered into to offsetthe risk is an equal and opposite liability. If the producer were to get into financialdifficulties and be unable to honour the forward sale, the value of the contract isthe amount which the bank stands to lose. To protect itself, the bank may de-mand margin (a financial payment on account), or collateral (the posting of someasset as security) or even the right to terminate the contract prematurely.

The third reason that the value is important is that it can actually be realised. Itis far easier and cheaper to buy gold forward and then sell it than it is to buy agold mine and then sell it. It is the low level of transactions costs which allowsproducers to modify their hedges rapidly. The value of a forward sale contract canbe realised by terminating it or by entering into an offsetting purchase contract.To get some idea of the sensitivity of a forward contract to changes in marketconditions, consider the case of a producer who has sold gold forward five years ata fixed price when the spot price is $300/oz, and gold and dollar interest rates are2% and 7% respectively. The fair forward price is $381/oz. If the spot gold pricerises by $30/oz (a typical annual move) then the fair forward price in five yearsrises to 330x(1.07/1.02)5 = $419/oz. The producer is committed to selling his

gold in five years at $381/oz when the fair forward price today is $419/oz. Tocancel the hedge, the producer would have to agree today to buy the gold back at$419/oz, locking in a loss of $38/oz in five years’ time. Discounting the $38/ oz, the hedge has a negative value of $27/oz today. Of course, if the gold pricehad fallen $30/oz, the hedge contract would have a positive value of $27/oz tothe producer.

But it is not only the gold price that can affect the value of the contract. If dollarinterest rates go up 1% (again, a typical annual move) while spot gold stays at$300/oz, the fair forward price rises to $399/oz, and the hedge contract’s value




goes to +$12/oz. The mark-to-market value of a long-dated fixed dollar rate for-ward has a sensitivity to interest rates which is not much less than its sensitivity tothe gold price. If the dollar rate is floating, the sensitivity of value to interest ratesbecomes virtually zero, in exactly the same way as the sensitivity of value of abond to interest rates is large for long-dated fixed rate bonds, but small for float-ing rate bonds.

An increase in the long-term gold interest rate would have an effect similar inmagnitude but opposite in sign to an increase in interest rates. The mark-to-market value of a forward contract with a floating gold interest rate would havevirtually no sensitivity to gold lease rates. Thus looking from the perspective of

the value of the hedge book as opposed to the realised price at maturity, thefloating rate forwards may be less risky than the fixed rate forwards.

2.2.2 Options

In addition to simple forward contracts, there are many more complex productswhich are used by participants in the market. We have argued that long-datedforward contracts would not exist if they could not be hedged or synthesisedreasonably accurately using the spot and short-term gold lending market. Thesame holds true of more complex products.

Hedging options

Consider the case of a producer who wants to buy a put option, giving the rightto sell gold in five years’ time at $300/oz. The bank writing the option will onlybe able to offer a good price if it can either find some other party who is preparedto sell the bank a similar option, or if the bank can hedge itself. Writing theoption and taking the risk on its own books makes no economic sense; the bankhas no advantages and some disadvantages relative to a gold producer in takingthis risk on itself.

To hedge the risk, the bank will follow what is called a delta hedging strategy. Thevalue of the put option depends on the level of the gold price. If the gold price is

very low, the option is deep in the money, and very likely to be exercised, so a $1change in the gold price causes a $1 change in the value of the put. As the goldprice rises, the chance of the option being exercised falls, so the sensitivity to thegold price (or delta) is smaller. When the gold price is very high, the put optionis nearly worthless and its price barely changes with the gold price; its delta goesto zero.

If the bank sells gold forward, and varies the amount with the delta, then it canensure that profits or losses on i ts option position occasioned by movements inthe underlying gold price are offset by profits or losses on its gold forward




position. In an ideal world, if the hedge is executed properly, the bank should beperfectly hedged. All the risk that the producer is transferring to the bank is trans-ferred into the forward market, and thence into the spot and lending market.

Another way of looking at the transaction is to observe that a producer who wantsto create a floor on sale proceeds while remaining exposed to the upside could buya put option from a bank. Alternatively he could follow a suitable trading strategyin the forward market. He should sell some of his production forward; as the goldprice rises, he should buy forward, and as it falls he should sell forward. If thegold price falls sufficiently, he should sell all his production forward, thus lockingin a floor price for his production. If the gold price rises sufficiently he should buy

back all the forward contracts he had sold at the outset, and thus be fully exposedto the gold price. In this way the producer could create a synthetic put option.

The producer then has the choice between this synthetic put option and buyinga real put option from a bank which will then create a synthetic put to hedgeitself. I t is possible to see the producer, through the put option contract, in effectdelegating the operation of the dynamic trading strategy to the bank. Whether itbuys the put options or synthesises it, the net effect on the forward market is thesame. When the position is put on, the producer is directly or indirectly selling aquantity of gold forward equal to the product of the amount optioned and thedelta. As the gold price rises or falls, the forward sale position declines or increaseswith the delta.

Hedge error

In theory, given certain assumptions1 , the delta hedging strategy works perfectly.But in practice the assumptions do not hold perfectly, and there can be substan-tial hedge error. In particular, the efficacy of the strategy depends on the volatilityin the gold price. If the price turns out to be very volatile, the synthetic strategy,which involves buying whenever the price rises, and selling whenever it falls, willbe very expensive. A bank which writes a put option and hedges itself prices in acertain assumption about volatility. It makes a profi t or loss on the hedge depend-ing on whether the actual volatility is lower or higher than that factored into the

original price (the ‘implied volatility’).

For this reason, the writer of a put option is said to be selling volatility, and thebuyer of the option is buying volatility. A similar analysis holds for call options,except that the buyer of a call option is long gold, whereas a buyer of a put is shortgold. But both put and call option buyers are buying volatility, for in both casesthe replicating strategy involves buying as prices rise and selling as they fall.

1 The standard assumptions include the absence of transaction costs, constant interest rates on both thecurrency and the commodity, markets always open, no constraints on borrowing either cash or thecommodity, and the spot price of the commodity following a diffusion process with constant volati li ty.




Volatility is not the only factor which gives rise to hedge error. The error is alsoaffected by the detailed way the forward gold price behaves. Large jumps in theprice for example can throw out the hedge. But volatility is the main determinantof how well the hedge works.

Although we have looked at the particular example of a simple put strategy, thesame is true of any option, whether a vanilla option like a put or call, or a moreexotic structure such as one where the pay-out is conditioned by the price of goldhitting some critical level. To every option there corresponds a delta hedgingstrategy which replicates the option. The existence of the strategy makes it possi-

ble for the bank to offer the complex option, and also determines the price it mustcharge to cover i ts costs. I f the bank is fully hedged into the spot gold market atall times then the existence of the option gives rise to a corresponding position onthe spot market equal in size to the option’s delta.

2.3 The markets

2.3.1 Exchanges

Trading in gold derivatives takes place both over the counter and on organisedexchanges. The majority of exchange traded volume is on the New York Mercan-

ti le Exchange (NYMEX) in i ts COM EX division. Both futures and options aretraded with maturities going out as far as five years for the futures and two yearsfor the options. Actual delivery consists of the transfer of a COMEX warehousereceipt. The next largest exchange for gold derivatives is the Tokyo CommodityExchange which has about one third the volume of COMEX.

As is typical of futures markets the great majority of contracts are closed outbefore delivery. Virtually all trading takes place in the near-dated contracts –those with up to six months to maturi ty. Average daily futures volume on COMEXis some 35,000 contracts, corresponding to 100 tonnes per day or 25,000 tonnesper year. Average volume in the options market is around 20% of that in the

futures in terms of numbers of contracts or quantity of underlying metal.

While this may sound large relative to annual new mined production of just over2,000 tonnes, very high volumes as a result of incessant short-term trading are afeature of all derivatives markets. A somewhat better indicator of the economicsignificance of the market is given by the open interest – the number of contractsin existence at any one point in time. This averages around 150,000 contracts inthe futures market, or 450 tonnes. It should not be assumed that this means thatthere are longs who are collectively long 450 tonnes of gold and shorts who arecollectively short 450 tonnes. Some traders will hold both long and short positions




(in different maturities) to exploit movements in calendar spreads. Others willhave an offsetting position in the options market or the over-the-counter market,or in one of the other commodity markets. The open interest in the optionsmarket is around twice as large as in the futures when measured in terms of numbers of contracts; in terms of delta of the underlying it is of the same order asthe futures.

A widely followed indicator is the net position of non-commercial traders in theoptions and futures market. This is often interpreted as being the aggregate positionof individuals and hedge funds who are using the exchange to speculate on gold.The other side of the market, the commercial interest, is then assumed to be taken

by hedgers who transmit the net demand to the spot market. If this interpretationis taken at face value then the change in the net non-commercial position representsa source of supply or demand for gold. Since annual swings in the net positionrarely exceed 50 tonnes, the futures market can best be seen as an indicator of market sentiment rather than an important source of supply in its own right.

Source:CFTC/World Gold Council

It is noteworthy that the volume of gold futures trading on COMEX, measuredin contracts, has not changed significantly over the last decade. I t has not beenaffected by the large rise in producer hedging.

2.3.2 Over-the-counter market

Much the greater part of derivatives activity in gold takes place in the over-the-counter market. The Bank for International Settlements produces a report on the

-90

-70

-50

-30

-10

10

30

50

70

Jan-97 Jan-98 Jan-99 Jan-00

250

270

290

310

330

350

370

390

410

Net positions on COMEX

Contracts '000s

Gold Price

US$/oz

Gold price

Contracts

Speculative Positions and Gold Price

Short

Long




aggregate derivatives position of the major banks in the G10 group of countries atthe end of each half year. Gold derivatives are separately identified.

The report shows that the notional value of outstanding contracts in gold at endJune 2000 was $262 billion. This corresponds to about 27,000 tonnes of gold.The notional value of outstanding contracts is a similar concept to the open inter-est in an exchange traded market. It gives no indication of the net long- or short-position of the banking sector. But it does highlight the important role of theOTC market relative to the exchange traded market.

It is not possible to compare this notional value figure of 27,000 tonnes directly

with the estimate in the Cross Report that 5,230 tonnes of gold were lent at theend of 1999. But the two figures do not appear inconsistent. Most of the deriva-tives market is intermediated by G10 banks. A forward sale of one tonne wouldcount once; a strategy of buying a put option on one tonne and writing a call onone tonne would count twice. But then the bank writing the contract has tomanage the position. This might well involve a forward contract with anotherbank, or a lease rate swap to manage the lease rate risk. Each of these would add tothe notional value figure even though all that is happening is that risk is beingtransferred within the banking sector. The bank writing the original contract maywell need to trade subsequently just to manage its changing risk over time. Thusa derivative contract between a bank and a customer may generate trades in theinter-bank market with a notional value which is several times the value of theoriginal contract. Thus a ratio of 5:1 between gold lending and the notional valueof banks’ derivative exposure is not at all implausible.

Further insight into the magnitude can be obtained by comparing banks’ deriva-tive exposure in gold and in other markets:

2 This excludes the BIS ‘other’ category which is their estimate of the position in all markets of non-reporting institutions. This amounted to $12,163 billion. There is no reason to believe that gold figuresmore importantly in the positions of non-reporting institutions than in those which report to BIS.

Global Over-the-Counter Derivatives Markets end-June 2000

Notional amount

(US$ billion)

Gold 262 0.32%

Other commodities 323 0.39%

Foreign exchange 15,494 18.92%

Interest rate 64,125 78.32%

Equity 1,671 2.04%

Total2 81,875 100%

Source: BIS, November 2000




However the presence of a liquid lending market with low costs of borrowing goldmeans that holding large inventories is relatively cheap and low risk. The CrossReport estimates the amount of gold borrowed by the downstream sector in Juneand December 1999 to be 1,135 and 1,465 tonnes respectively, with the bulk of the change reflecting the seasonally higher gold demand in the fourth and firstquarters of the year.

While there are few reliable figures in this area, one would expect the level of inventories to be sensitive to the level of lease rates. I f lease rates rise from say 1%to 4%, the cost of holding inventory quadruples, and demand for inventory shouldfall back sharply. This is certainly what seems to have happened in the immediate

aftermath of the Washington Agreement. To a lesser extent, one would expectinventories to be sensitive to the volatility of lease rates. A processor who hassubstantial gold inventories can insulate himself from the volatility of the goldprice by borrowing the gold, but is then subject to the volatility of lease rates.

2.5 Speculative traders

In this report we use the term ‘speculator’ to refer to anybody who takes a long orshort position in gold with a view to making money from the change in the goldprice. Thus we distinguish speculators from producers or users of gold who are

hedging to reduce risk, from banks who act as intermediaries, offering derivativeproducts to customers and hedging the gold price risk, and from end users whobuy or hold gold as a convenient store of value.

In most commodity markets, the speculator is at risk from corners and squeezes.The risks are much reduced in the case of gold. Suppose for example that specu-lators are convinced that the price of a particular commodity is too high, anddecide to sell it short. They borrow the commodity and sell it, waiting for theprice to go down. If the price remains high, they roll their commodity loans, andmaintain their positions until the price falls, or they close out their positions if they recognise that the price is not likely to fall. However, they face commodityborrowing risk. If the amount of the commodity available for borrowing is cutback, borrowing rates will rise until many of the speculators are forced to closeout their positions. They will be forced to realise losses in the short term even if their views about the spot price in the long term are correct.

In the gold market, the cost of borrowing is relatively stable, so speculators do nothave to worry too much about commodity borrowing risk. Indeed the existence of aliquid short-term gold lending market means that banks and other intermediariescan offer long-term as well as short-term forward contracts at prices which allowspeculators to lock in expectations about future wholesale gold lending rates.




Gold futures and forward contracts provide a cheap and efficient means to specu-late on the price of gold. Transaction costs are low, and the basis risk (divergencein returns between the future and the spot price) is small. Short selling is as easyas going long. The pricing of derivatives already implicitly reflects the wholesalemarket gold and dollar interest rates.

Some commentators talk about a distinct type of speculator who indulges in ‘thecarry trade’. Carry traders observe that the cost of borrowing gold is much lowerthan the cost of borrowing dollars. They therefore borrow gold, sell it for dollars,use the dollars to finance their other activities, and use the dollars at the end of the period to buy gold and repay the gold loan. On this analysis, these specula-

tors have no particular view on gold but are using it as a form of cheap financing.It does not seem useful to distinguish the carry trade from speculators who shortgold because they believe that its price in future wil l be below the current forwardprice. The full cost of finance in the carry transaction is not just the gold interestrate but the gold interest rate plus any appreciation in the spot price of gold. It ischeaper than borrowing in dollars if and only if the rise in the dollar gold price isless than the difference between the interest rate on dollars and the interestrate on gold. But this is exactly the same condition under which short sellinggold is profitable.

It could be argued that borrowing gold is particularly attractive to a highly leveragedspeculator such as a hedge fund because of the low servicing cost of a gold loan.But it is not plausible that a fund could get significantly more credit from a bankby borrowing in gold rather than in dollars.

It is the combination of low lease rates with a declining gold price which hasmade shorting gold, or financing by borrowing gold rather than dollars, attractiveto speculators, in exactly the same way that hedging has been profitable to pro-ducers and fabricators. One additional feature of the gold market has made itparticularly attractive to speculators, and that is gold’s low volatility. Historically,in the five years up until September 1999, gold based financing has not onlybeen on average profitable, but it has appeared to be relatively low risk.

A speculator funding himself each month from August 1994 to August 1999 byborrowing gold would on average have saved 1% per month compared with dol-lar borrowing4. In only 17 of the 60 months was gold borrowing more expensivethan dollar borrowing, and even in the worst month the additional cost was lim-ited to 7%.

4 A speculator could create a synthetic gold loan by borrowing dollars and shorting gold futures; thesaving is the return on the gold futures contract. The numbers given in the text assume that thespeculator shorts the nearest maturity COMEX futures at the beginning of each month, and holds theposition for one month. Transaction costs are ignored.




The risk of such a strategy became apparent in September 1999 when, followingthe Washington Agreement, the gold price jumped by over 20%. For a speculatorwith short-term horizons and limited risk capital, such a large loss coupled withthe prospects of far increased future risks may well have prompted a rapid cutbackin short positions.

Over the week of the announcement the net long position of non-commercialtraders on COM EX rose by under 100 tonnes. Market part icipants did not de-tect very large purchases by speculators covering their short positions on the cashmarket either. This is consistent with the view expressed in the Cross Report thatthese short positions did not exceed a few hundred tonnes in the first place.

2.6: The banking sector

As with any other financial market, the smooth and efficient operation of themarket requires the services of a variety of financial intermediaries who act asbrokers, dealers, advisers, market-makers, analysts, underwriters and so on. Manyof these functions are straightforward and well understood. In this section wefocus on the risk-bearing functions of financial intermediaries – on the differencebetween a bank’s assets and its liabilities.

It is worth emphasising that banks are not well set up to take risk; they are much

more highly leveraged than other companies, and more tightly regulated. Theydo of course take risk, but they tend to take those risks which they are particularlywell placed to quantify, assess or manage. They will normally try to get rid of orhedge any risks which they have no comparative advantage in bearing. To illus-trate the role they play, it is useful to consider the way in which a bank bringstogether a producer’s desire to hedge with a central bank’s5 desire to earn a returnon its gold. To fix and simplify the example, suppose the producer wants to hedgethe output from a mine which is expected to produce just one ton of gold in fiveyears’ time.

It is not essential to involve a financial intermediary in this deal. In theory the

central bank could lend the gold to the producer for a five year term. The pro-ducer could sell the gold on the spot market and invest the proceeds. The pro-ducer could then repay the central bank out of its own production. In this waythe producer in effect sells his production forward at today’s spot price plus theinterest on the deposit less any interest paid to the central bank.

5 The term central bank is used to mean the holder of the off icial reserves, whether they are formally thecentral bank or not. The term commercial bank covers any bank active in the wholesale trading of goldor gold related derivatives for commercial ends, whether it is an investment bank, a specialised bullionbank or a commercial bank in the narrow sense of the Glass-Steagall Act.




In practice, the transaction is most unlikely to be structured in this way. Thereare a number of distinct reasons why the central bank and the producer wouldnot want to deal with each other direct. It is worth enumerating them so as toelucidate the different roles played by the intermediary.

One reason is the maturity of the deal. Many central banks are not prepared tolend beyond three months. Yet the producer needs a five-year deal. A bank isneeded to deal with the maturity mismatch. Maturity intermediation is a stand-ard function of the banking system; banks typically support their long term loansusing short term deposits. In this case, the commercial bank borrows gold forthree months from a central bank and concludes a five year deal with the pro-

ducer. The commercial bank expects to roll over the deal with the central bankevery three months, or else to find an alternative lender if the first is unwilling toroll forward its loan. I t is taking on a risk here; if the gold lending market dries upor if the bank is not able to access it (perhaps because its own credit lines areexhausted), it could potentially face a serious problem.

A second reason for intermediation is to deal with rate mismatch. If the centralbank is only committed for three months at a time, the gold lending rate willmove with the market every three months. Even if the central bank were preparedto commit itself to a five-year loan, it may be unwilling to agree to a fixed lendingrate. I t may demand that it get paid during the life of the loan an interest rate setaccording to the market rate at the time. The producer ideally wants a rate fixedfor the life of the transaction. Again, managing rate mismatch is a standard func-tion of the banking system.

There are a number of ways of dealing with rate mismatch. The intermediatingbank can take the risk i tself, charging the producer a sufficiently high fixed rate tocompensate itself for the risk that the rate it will have to pay for borrowing thegold will rise. It can pass the risk on to the producer: instead of offering a fixedprice for future production, the price paid to the producer can be varied as thegold interest rate varies. A third way is to find some third party who is prepared totake the rate risk. This could be done through a lease rate swap. This third partypays the bank the difference between the fixed and floating lease rates, paying the

floating and receiving the fixed.

In practice, in many of the longer-dated transactions, the producer keeps the goldinterest rate risk. This will make sense because a bank is likely to charge a heavypremium for bearing the risk, whereas the producer may achieve little risk reduc-tion by passing it on to the bank. To see this, go back to the example of a five yeardeal. The uncertainty about the gold price in five years time is about 30%6 . Afixed lease rate deal would get rid of all this uncertainty. If the standard deviation

6 More formally, suppose that the annual volati li ty of gold is 12%. Then the actual gold price in fiveyears’ time will be distributed around its expected level with a standard deviation of 30%.




of the average lease rate over the next five years is ½%, then the producer takingon a floating lease rate deal would face an uncertainty in the price it receives infive years of 2½%. The producer may be hedging half its production. It does notmake a great deal of sense for it to pay a heavy premium to get rid of a 2½% riskon half its production when it is content to take a 30% risk on the other half.

However, lease rate swaps are increasing in populari ty. They may for example beattractive to central banks who do not wish to lend their gold for more than threemonths but would like to benefit from the generally higher rates for longermaturities. By lending the gold for three months, and entering into a pay threemonths/receive fixed swap they get the financial benefits of a longer-term loan

while avoiding the credit risk of a long-term loan and by having the right to getphysical gold in three months without having to trade on the market.

But the most important drawback of the direct transaction between the centralbank and the mining house is not maturity or rate risk but credit risk. Centralbanks are generally very reluctant to bear credit risk. If the central bank lendsgold directly to a miner and the miner defaults after a large rise in the gold price,the central bank may well suffer substantial losses even if it has taken collateral.Credit intermediation is a standard function of the banking system, and there area number of ways of dealing with it. Instead of the central bank dealing directlywith the producer, a commercial bank with a high credit rating could act ascounterparty to both sides.

There is no reason to stop at one layer of intermediation. Central banks maychoose to deposit their gold with only a very small number of commercial banks.There are many other banks who are able and willing to structure deals for min-ing clients, and who have particularly close relationships with and knowledge of particular producers. Bank A could buy the gold forward from the producer, andsell the gold forward to Bank B, where Bank B receives gold deposits from thecentral bank. Bank B could then hedge itself by selling the gold into the market.The central bank would then be exposed only to the credit of Bank B. Bank Awould be exposed to the producer’s credit. The credit risks between Banks A andB would be dealt with in the normal way, involving monitoring of credit expo-

sures, netting agreements, imposition of credit limits, and posting of margin.

Finally, banks play a crucial role in putting together complex structures. We haveseen how complex derivative structures can be created by dynamic trading strat-egies. The intermediary who sells such a structure and hedges by carrying out theappropriate trading strategy is thus doing two things: trading on behalf of hisclient, and bearing the risk that the hedge will not match the structure exactly.




2.7: Producer hedging

We have seen why the gold market supports a deep and active long-term forwardmarket. Commercial banks have become very skilled at designing risk manage-ment products and strategies to meet the requirements of their clients. M iningcompanies use the derivatives market to hedge their production, often many yearsinto the future.

The principal motive is risk reduction or risk control. But risk reduction hasmany dimensions including: increasing predictability of earnings, reducing the

volatility of earnings, increasing the predictability of cash flow, ensuring the prof-itability of existing developments, reducing the sensitivity of the share price tothe price of gold. These different concepts of risk have very different implicationsfor the size, composition and management of the hedge book.

The design of the hedge book will therefore reflect some balance between thesedifferent concerns. These judgements will vary between companies and over time7.It is likely that these judgements will reflect not only risk management prioritiesbut also perceptions about the expected profitability of different hedging strate-gies. If a producer believes that the gold price at the time the gold is mined islikely to be above today’s forward price, he is more likely not to hedge the price

risk; conversely if he believes the forward price is higher than the likely futureprice he will be more inclined to sell forward. Thus the same sentiments thatcause large speculative flows into or out of the gold market are also likely to causevery substantial shifts in producer hedging.

Indeed one might well expect these shifts in producer hedging driven by percep-tions of the future gold price to dominate speculative flows. In many ways, pro-ducers are better placed than speculators such as hedge funds to speculate on goldprices; they are better capitalised, their short positions are written against a largenatural long position, they know the gold market well and they follow its devel-opments closely.

In this section we will explore the impact of hedging on company value, earningsand cash flow and show how these different dimensions affect the volume anddesign of the hedge book.

7 The view that risk management practices reflect the judgements and priorities of management as muchas the economics of the mining operation receives powerful support from Peter Tufano’s paper ‘WhoManages Risk?An Empirical Examination of Risk Management Practices in the Gold Mining Industry’Journal of Finance (September 1996).




2.7.1 Value

At first sight, the objective of hedging appears to be to get rid of all gold pricerisk. But this would lead to a strategy which is far removed from what companiesactually do. The value of a gold producer can be seen as the value of its goldreserves, less the future costs of extraction, plus the value of the hedge book. Toremove gold price risk entirely, the company should sell forward its entire eco-nomically recoverable reserves.

But in practice few companies sell more than a fraction of their reserves forward8 .On average, forward sales amount to less than two years future production. Also,

there is no case in theory for believing that a full hedge is in shareholders’ interest.Gold price risk has to be carried by someone. Transferring it all from the equitymarket to the gold market only makes sense if there is reason to believe thatshareholders charge more for bearing it than do gold bullion investors. That maybe the case in some particular instances where the shareholders are undiversified,but is less relevant where the shares are widely held. For many shareholders, goldprice exposure is an important attraction of gold mining shares. If investors wantto invest in gold mining companies but do not want to face gold price risk, theydo not need the company to hedge on their behalf. They can themselves hedgeusing the gold futures market.

There are good reasons why producers do not sell 100% of their reserves forward.Management knows that it will be judged after the event and compared with itsnon-hedging competitors. A strategy of forward selling which looks like prudentrisk management over a period in which the gold price has fallen would look veryfoolish in a period in which the gold price has risen sharply, and the fully hedgedproducer derives no benefit from the improvement in the price of its main prod-uct. A very large risk management programme which reduces value volatility canalso create volatility in earnings and in cash flow.

2.7.2 Earnings

Much hedging is motivated by earnings management – avoiding rapid year to

year fluctuations in the realised price, and ensuring that the realised price can bepredicted into the future. The amount of hedging which takes place and the kindof instruments used are strongly related to the accounting rules which determinewhen the profits or losses from the hedge book are recognised in the company’saccounts.8 One measure of this is the sensitivity of the aggregate market capitalisation of gold companies to thegold price. Regressing monthly changes in the one against the other over the last five years suggests thatthe market capitalisation of the fourteen largest quoted US, Canadian, Australian and South Africancompanies rises by about $240m for every $1/oz rise in the spot price of gold. This suggests that theywould need to sell at least a further 7,000 tonnes of gold if they wished to remove gold price risk fromtheir shares.




FAS 133 does allow hedge accounting, but only under rather strict conditions.The hedge has to be shown to be effective, and there are some tests for this. FAS133 has made a decisive break with previous practice in demanding that thehedge book be recognised on the balance sheet at fair value. Changes in the fairvalue of the hedge book each year will appear in the income statement. To avoidthe volatility this would cause to reported earnings, these gains and losses willappear not in the earnings stream, but rather as ‘other comprehensive income’. Asthe hedged production is sold, the hedge gains or losses are taken out of thebalance sheet and fed into earnings.

FAS 138 makes it clear that forward sales for physical delivery do not need to be

treated as derivative contracts (subject to certain conditions). They continue toqualify for hedge accounting, but their fair value does not need to be recognisedin the balance sheet.

The changes in accounting standards in the US and elsewhere are likely to affectproducer hedging in a variety of ways. While they are unlikely to have a majorimpact on the total amount of hedging which takes place, they will tend to favourstrategies which give rise to least volatility in the balance sheet and in reportedearnings. In part icular they will encourage forward sales with physical deliveryover cash settled forward contracts, because the former will not impact on thebalance sheet until they mature. And they will tend to favour simpler derivativestrategies over more complex ones which fail to qualify for hedge accounting un-der the stricter standards which are now being applied.

By taking the value of the hedge book out of the notes and onto the balance sheet,the standard is likely to encourage greater interest in changes in the value of thehedge book. This may in turn lead shareholders to see the hedge book as a sourceof risk rather than as part of a risk reduction strategy. I t may also encourageproducers to design hedge books whose change in value is easily explicable (for-wards with floating dollar and gold interest rates) rather than those which areharder to explain (fixed rate, long maturity contracts; options and exotics). Onthe assumption that similar rules are eventually included in international stand-ards, the impact will ultimately be felt among all gold producers, and not just

those subject to US standards.

2.7.3 Cash flow

Hedging can have a substantial impact on cash flow as well as on earnings. Con-sider a company which has sold forward its production several years ahead. Sup-pose that the spot price of gold then rises sharply. In one sense the company isindifferent: it has a substantial loss on its hedge book, but the value of its goldreserves has risen.




their risk. Of course this protection comes at a price – the premium paid forbuying the option. Others will argue that they should be sellers of options be-cause their own gold reserves constitute an option on gold; in return for payingthe costs of extraction, the producer receives the gold.

Whatever the merits of each argument, there are good reasons for believing thatproducers collectively are unlikely to be either large buyers or large sellers at leastof long maturity options. To every option buyer there must be an option seller. Itseems unlikely that banks would want to be large net buyers or net sellers of options. As discussed in 2.2.2, it would mean that they would be heavily exposedto the volatility of the gold price over the life of the option. This is not a risk they

can hedge. Nor is volatility easy to predict. Banks have to mark their positions tomarket and provide capital in accordance with the risk of their trading book.Whi le they may have strong views about whether the market price of volatility isexcessively high or low, they would need to make a substantial return to inducethem to bear long-dated volatility risk. In these circumstances, i t is not clear whyproducers should find it beneficial to pass this risk to the banking sector.

The only other parties which might be interested in having a large net optionexposure are holders of gold. They might write long-dated calls against their hold-ings. But there seems little evidence of this occurring on a large scale.

The empirical evidence bears out the view that most of the risk is borne withinthe sector. While standards of disclosure make it very hard know in detail whateach company’s book looks like – there is too much aggregation and not enoughdetail about important features of contracts – it is possible to get a rough picture,as set out in the table below which shows the volume of options bought and soldbroken down by producer region, with the top figure representing options (bothputs and calls) bought, and the lower figure showing options sold.

Long and Short Positions of Producers in Options, Measured in Mn OzUnderlying Gold, Broken Down by Maturity.

Maturity 2000 2001 2002 2003 2004 + Total

2.72 2.87 2.57 2.81 11.82 22.78Australia0.80 0.87 0.72 0.96 3.78 7.136.60 4.70 0.68 0.75 1.15 13.89N. America2.24 1.34 1.20 0.80 7.88 13.453.85 0.91 1.06 2.67 3.20 11.69Africa3.50 2.22 2.40 1.52 2.28 11.92

13.17 8.48 4.32 6.23 16.17 48.36Total6.54 4.43 4.32 3.27 13.93 32.50

Source: figures in the table are drawn fromGold and Silver Hedging Out look, Fourth Quarter 1999 (Scotia

Capital)




The gross numbers are impressive – the total nominal volume of options boughtand sold by producers is 80 million ounces (some 2,400 tonnes) – but the netvolume is far smaller at 16 million ounces. In part this is because producers oftenbuy protective puts and finance them by writing calls. While this strategy makesheavy use of options, it is not very different in its impact on the market from anordinary forward sale, particularly when the exercise prices of the bought andwritten puts are reasonably close to each other.

But the table strongly suggests the importance of a second factor – some produc-ers are net buyers of options and others are net sellers of options. I f one looks atthe longer dated options, where banks would find it hardest to hedge a large net

position, it is striking that Australian producers are large net purchasers of op-tions, while North American producers are large net sellers, and the net positionis close to zero.

The analysis is quite crude. It aggregates options without much regard to strike ormaturity. It aggregates producers by continent. Appendix 3 contains a far moredetailed analysis which bears out the conclusion that options bought by oneproducer tend to be sold by another producer. The banking sector and otherplayers bear very little of the gross volatility exposure.

It would be interesting to know whether the same is true of lease rate risk. Mostof the gold lending by central banks is of short maturity. Fixing a forward pricemeans fixing a lease rate for the maturity of the contract. If most of the forwardcontracts sold by producers were fixed rate, some other sector – presumably thebanking sector – would have to bear substantial lease rate risk. Unfortunately,company accounts reveal little about lease rate risk. But it seems reasonable toassume that, as with volatility risk, and for much the same reason, much of thelease rate risk is borne by producers rather than by banks.

This analysis suggests that the appearance and the reality of the producer hedgebook in aggregate may be very different. The book contains many puts, calls andmuch more complex instruments; the hedging instruments have very longmaturi ties. But the economic reality may be rather different. The optionality may

largely net out. The long maturities may be more of a reflection of an accountingdecision to defer recognition of the profits or losses from particular transactionssome years into the future rather than of the transfer of long-term forward pricerisk. From an economic perspective, the main impact of the hedge book is fairlywell reflected by the effective short position or delta of the book.




CHAPTER 3: THE DEBATE

I t is believed by many that the weakness in the gold price over the last decade has been

due, at least in part, to the growth of the derivati ves market. In this chapter, we review

the arguments and the theoretical evidence. The empirical evidence is reviewed in the

following chapter.

The pri ncipal conclusions are:

· The fal l in the price of gold over the last decade has coincided wi th the growth of the

paper market. Short selling by producers and others has added substantiall y to the supply of gold from new producti on. But it does not necessari ly follow that the fall in

the gold price was caused by the paper market or that the acceleration of supply has

had a substant ial impact on price (3.1).

· The debate about the impact of paper markets on cash markets is neither new nor

confi ned to gold. M any studi es have been carried out in both financial and commod-

ity markets. The empirical evidence suggests that derivative markets fulfi l a valuable

role in promoti ng the efficient sharing of risk; that while they could in theory destabi lise

the price of the underlying assets, i t has not been a problem in other markets; and

that they make the underlying market more liquid (3.2).

· Gold demand has both a consumption and an i nvestment aspect. The elastici ty of

demand for fi nancial assets is generally extremely high; small changes in pr ice and

expected returns cause large shi fts in portfolio composition. But investment demand

for gold may be rather less elastic since the gold has part icular attributes (such as

resilience to financial and economic shocks) which make it hard to substi tute (3.3).

· Assuming that supply of gold is inelastic and that demand i s consumption rather

than investment demand and assuming demand has a uni t price elastici ty, the

accelerated supply of gold from the derivatives market may have depressed the pri ce of

gold over the last decade by 10-15%. But this model almost certainly over-estimates

the impact because it takes no account either of supply elasticity, or the response of

holders of gold to the expected return from holding it (3.4).

· The derivatives market has also increased the att ractions of holding gold, made it less

costly for fabricators and other downstream users to hold large inventories of gold,

and reduced the cost of capital for producers. I n expandi ng both supply and demand,

the impact on the gold price is ambiguous (3.5).




3.1 The debate outlined

The argument that derivatives have had a damaging effect on the gold price canbe illustrated by the chart below. I t shows the way in which the protracted weak-ness in the gold price over the 1990s has been accompanied by a dramatic in-crease in the size of the derivatives market. The line is the real price of gold overthe decade (average annual price, deflated by the US consumer price index, and

Source: Own calculations based on Gold Fields Mineral Services Ltd

reported in constant 1999 US dollars). The columns show the aggregate shortposition of producers – the more negative, the larger the short position1 .

The apparent close connection between the increasing volume of derivatives ac-tivity and a falling real gold price suggests or implies a causal link between thetwo. The existence of a causal link is supported by an analysis of the supply anddemand for physical gold. GFMS figures show that fabrication demand, which

averaged 3,287 tonnes/year over the decade, comfortably exceeded new mine supplyat 2,332 tonnes/year. It also grew faster (3.7% against 2.1% per annum). As thetable below shows, sales of borrowed gold to hedge producer forward sales haveplayed a key role in bridging the gap between supply and demand:

1 Ideally the chart would have shown the total volume of gold lending over time, rather than just that

portion of lending required to support producer hedging. But no reliable time series data are available forthe former. Since the producer position accounts currently for over half the total, it should give areasonably accurate picture of trends in the market as a whole.

-4000

-3500

-3000

-2500

-2000

-1500

-1000

-500

0

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

260

300

340

380

420

460

500

540

580

Producer Short Position (rhs) Real Gold Price (rhs)

Producer Short Positions and Real Gold Price




Supply/Demand Balance for Physical Gold 1990/99(tonnes/year, average)

Demand Supply

Fabrication 3,287 Mine production 2,332

less Scrap 630 Official sector sales 3092,657 Net producer hedging 238

Bar hoarding 235 Net disinvestment 13

Total 2,892 2,892

Source: Gold Fields Mineral Services Ltd

Indeed, this analysis probably understates the contribution the derivatives mar-ket has made to the supply side since it takes no account of short selling byanyone other than producers. The total volume of gold lending by the officialsector increased by 3,800 tonnes over the decade. In addition private sector lend-ing at the end of the decade amounted to 500 tonnes, though it is not clearwhether this represented any net increase over the decade given the probable fallin institutional private sector gold holdings over the period. Taking 4,300 tonnesas a generous estimate of the increase in gold lending, that is equivalent to 430tonnes per year of additional supply. Not all of this would come to the spotmarket. The availability of cheap gold loans has reduced the cost and increasedthe volume of inventories held downstream. No less than 1,465 tonnes of thegold which was lent as at end 1999 was to downstream users. Much of this musthave been reflected in higher gold inventory levels than were held in 1990, and sodoes not represent increased supply. The true impact of the derivatives market tothe spot market may have averaged 300-400 tonnes/year over the period.

Others would see this argument as simplistic – the fact that short selling hasincreased at a time that the gold price has been falling could be no more than acoincidence. There are many other possible explanations for what was happening,

including worries about substantial central bank sales, and shifts in the marketfor gold towards the less developed countries. Few people would expect to con-vincingly explain large movements in say the value of the euro or the level of theUS stock market by a single supply or demand factor. The fact that net shortselling has increased the supply of physical gold does not prove that it has signifi-cantly depressed the price. The short selling may have been a response to expecta-tions about the price, rather than caused by it.

It is not obvious for an investment good like gold, that flows rather than stocks arethe relevant measure. The increase in gold lending over the decade amounted to




some 4,000 tonnes. This is a small volume of gold to expect people to hold rela-tive to total above ground stocks of gold of some 140,000 tonnes. Given thedepth of international capital markets, it seems plausible that this gold (worth$40 billion at current prices, spread over a decade or more) could have beenabsorbed without much price impact.

It is worth seeing what can be learnt from other markets, and then consideringwhat is special about gold before examining the arguments more deeply.

3.2 The impact of derivatives generally

The debate on the impact of derivatives markets on cash markets is not confinedto gold. The issue has been raised frequently and over many years both in com-modity markets and in financial markets; there have been many scores of papers,both theoretical and empirical, written on the subject.

It has been argued that the existence of derivatives enables short selling whichpushes down prices; that derivatives facilitate speculative trading which increasesvolatility; that the leverage available from derivatives markets creates cycles of boom and bust as momentum traders follow a trend and then are forced to un-

wind their positions rapidly; that derivatives markets fragment order flow divert-ing liquidity away from the cash market; and that derivative markets encouragemarket manipulation.

Defenders of derivative markets argue that they improve liquidity, transparencyand increase possibilities for risk-sharing. It is possible to construct internallyconsistent models of trading in which derivatives markets are beneficial, and alsomodels in which they are harmful. Ultimately, the question of whether derivativemarkets are broadly beneficial or harmful to efficient price formation is an empiri-cal one. There is a considerable body of empirical literature covering both com-modity markets and, in rather more depth, financial markets.

We review the arguments and the empirical evidence at length in the paper atAppendix 1. We conclude that the weight of evidence suggests that:

· derivative markets in general fulfi l a valuable role in promoting the efficientsharing of risk, and in aggregating information;

· while there are ways in which derivatives could in theory destabilise the priceof the underlying assets, there is little evidence that this has been a problem inother markets;

· there is strong evidence that derivatives help make the underlying market more




stock – so many billion dollars – rather than as a flow – so many dollars per year– because investors who currently hold the asset can and will sell their holdings intheir entirety if the expected return is too low.

All these features of financial assets help ensure that the growth of a derivativesmarket is unlikely to have a destabilising effect on prices. Even if the derivativesmarket causes investors to rebalance their portfolios, and buy or sell the under-lying asset, large changes in holdings can be accommodated with very littleshift in prices.

If gold behaves like a typical financial asset one would expect it too to have a very

elastic price schedule. I f a derivatives market does make it easier for producers andspeculators to sell gold short, then a small price reduction would suffice to attractnew investors into the market to take the opposite side of the transaction.

But there are reasons for doubting that the elasticity of demand for gold is sohigh, or that a moderate reduction in expected returns on gold would cause mostholders to liquidate their portfolios. The pattern of investors who hold gold is notlike that for other financial assets. Most private and institutional investors holdlittle or no gold. Investors who hold gold do so at least in part because gold hascertain properties which make it peculiarly attractive in the event of acute politi-cal or financial instability. For these investors, gold is not readily substitutable byother assets. Their response to changes in expected returns may be relatively small.For example, someone who holds all their financial wealth in the form of gold willhave a cash demand for gold which may be largely independent of either the priceof gold or of the expected rate of return on holding gold. This means that theprice elasticity of demand is close to unity, since a 10% increase in the gold pricewill reduce the volume of gold bought by 10%.

Gold is also unlike a financial asset in that there is substantial consumptiondemand for gold. While it is hard to separate consumption and investmentmotives for purchasing jewellery, i t is likely that both the price level of gold (forconsumption) and the expected return on gold (for investment) play a part indetermining demand.

3.4 The simple consumption model

There are good reasons for believing that the growth of the gold derivatives marketcould have depressed gold prices. The reasons have to do with features of goldwhich are specific to gold, and which differentiate it from other commodities andfinancial assets. The negative impact will have come from the build-up in short




positions in the forward market over the decade. A corollary of this is that as and whenthe size of the short position stabilises, the impact on the spot price should disappear.

In any other financial market, an increase in supply is readily absorbed by a smallfall in price, and the corresponding increase in expected returns leads investors tobuy the asset and mop up the extra supply. In the gold market, there is reason tobelieve that the readiness of investors to absorb additional supply might be lim-ited. Much of the adjustment would have to come from consumption demand; asubstantially lower price is required to persuade consumers to buy more gold.

So far the discussion has been largely qualitative; it gives little indication of

whether the price impact of derivatives on the spot price can be measured incents per ounce or hundreds of dollars per ounce. We need to get a feel for thepotential magnitudes.

By starting from a very simple model of the gold market, one can at least putbounds on the likely magnitudes. Model the gold price as reflecting the interplaybetween a supply of gold which is independent of price and a demand for goldwhich depends on the price level. Ignore the impact of prices on gold production.Ignore any adjustments that producers make in their hedging policies, that down-stream users of gold make in their inventory holdings, that speculators make intheir portfolios. Assume that the entire burden of adjustment to any increase insupply falls on consumers. We will call this model the ‘Simple ConsumptionModel’ of the gold market and use it as a benchmark.

In the simple consumption model, the price response is determined by the priceelasticity of demand for gold. It is hard to estimate demand elasticities with anyprecision. Murenbeeld3 estimates an average price elasticity for jewellery demandof about 1. Veneroso4 suggests that a figure for the gold market overall in therange 0.5-1 is plausible. The analysis in 3.1 suggests that ‘accelerated supply’from the derivatives market added some 300-400 tonnes/year on average to sup-ply over the decade at a time when net fabrication demand for gold averaged2,892 tonnes/year. With an elasticity of 1, this suggests an impact of 10-15% onthe gold price.

But the simple consumption model is seriously deficient in at least two impor-tant respects. First, it takes no account of the way in which mine output respondsto price changes. Although, as we have seen in section 1, production is not re-sponsive to price in the short term, it is responsive to price in the longer term. Sowhile output levels continued to rise over the whole of the last decade, produc-

4 The 1998 Gold Book Annual, Frank Veneroso, Jefferson Financial, 1998.

3 ‘Gold Jewellery Demand Models’, a report prepared for the World Gold Council, M . Murenbeeld& Associates, April 1999.




The existence of the lending market allows owners of gold to get extra incomefrom their holdings by lending it. Derivatives also greatly widen the range of strategies available, particular to large holders, for managing their gold holdings.Through lease rate swaps they can get access to higher lending rates; throughwriting calls on their gold they can earn premium, though of course at the cost of giving up some of the upside potential. In general, by increasing the flexibility of managing gold reserves, and increasing the return from holding gold, derivativesmake gold a more attractive asset to hold.

The ability to borrow gold easily and at low rates is of benefit to all those involvedin downstream activities such as refiners, fabricators and distributors. It reduces

the costs of manufacturing and selling gold products. By reducing the costs andrisks associated with holding stocks, it allows very large inventories of gold andlow value-added jewellery to be held in the supply chain. This encourages thewidespread distribution and availability of gold and thus facilitates the marketingof gold to customers.

Derivatives also reduce the cost of capital for producers, and so tend to encourageproduction. A producer may be unwilling to develop a mine which is only mar-ginally economic for fear that the gold price will fall and make the mine unprof-itable. Using derivatives, the producer can lock in a price, or put a floor on theprice so as to insulate the mine from price falls. Project finance for new mines isoften conditional on output being sold forward.

Derivatives may also affect decisions about existing capacity. The Cross Reporthas evidence that producers who have sold their production forward may be slowerto cut production as spot prices fall.

This suggests that while the direct impact of accelerated supply from short sellingare likely to have depressed the price somewhat, the indirect effects of the deriva-tives market through expanding both the demand and the supply side of themarket have had an ambiguous effect on the price.




Impact of Producer Hedging on the Gold Price

-60

-40

-20

0

20

40

60

-300 -200 -100 0 100 200 300 400

∆ Producer Hedge Book (qtly, tes)

1999Q3

We use ordinary least squares regression, regressing the change in the gold price,measured in $/oz (∆ Price), on the change of the producer hedge book delta,measured in hundreds of tonnes (∆Delta). The data are plotted on the chartbelow.

The results are given by the following equation (the figures in parentheses arestandard errors):

This can be interpreted as meaning that on average, if the size of the hedge bookincreases by 100 tonnes in a quarter, the price of gold goes up by $4.70/oz. Sincethe hypothesis we are testing is that short selling reduces the gold price, the resultis unexpected. However, the slope coefficient of 4.70 is not precise; the numberin parentheses is the standard error. An estimate of +4.70 with a standard error of 2.70 is not reliably different from zero. The correlation measure shows that this

∆Price = - 8.55 + 4.70

∆Delta + error

(4.38) (2.70)2 R = 9.31%

Source: Own calculations based on Gold Fields Mineral Services Ltd




model of the behaviour of the gold price succeeds in explaining only 9.31% of the changes which have occurred in the gold price. One might reasonably con-clude from this that there is no evidence that forward selling by producersdepresses prices.

4.1.1 Outliers

If one plots the observations, i t becomes clear that there is one part icular observa-tion which is critical in driving the result, and that is the third quarter of 1999.In that quarter the delta of the producer hedge book rose by 378 tonnes while the

gold price rose by $44/oz. While in general one should be reluctant to throwaway outliers, there seem to be particularly good reasons for doing so in this case.In 1999 Q3, the price of gold was plumbing historical lows, producers wereincreasing their hedges rapidly, and the European central banks decided to act inconcert and issued the Washington Agreement. There is little doubt that thesteep rise in the gold price in the quarter came as a result of the Agreement. I t wasnot caused by the large increase in the volume of hedging (except in the perversesense that the hedging may well have been a factor in driving the price down, andthis in turn encouraged the central banks to act).

It does therefore seem sensible to run the regression without the distortions causedby this one observation. We then get the following result:

By omitting this observation, we have turned a possibly significant positive asso-ciation between delta and price into a statistically quite insignificant but stillpositive association between hedging and the gold price (the negative value of R 2

suggests that the regression equation is not picking up anything). The conclusion

we drew earlier, that there is no evidence here that producer hedging depressesthe gold price, is reinforced.

The simplest explanation for this result is that short selling does not depress thegold price. But it is possible that short selling does depress the gold price, but weare failing to pick it up because our data set is too short. We can investigate this.Earlier (in 3.4) we described the ‘Simple Consumption Model’ which gave us anupper bound on the impact of the derivative market on the spot market. Supposethat model were correct, would we expect it to show up clearly in the data we have?

∆Price = - 7.77 + 0.9 ∆Delta + error

(3.67) (2.6) 2 R = -5.15%




To apply the model to our regression, consider the impact of an increase in deltahedging of 100 tonnes. I t adds to supply, and has to be accommodated by anincrease in demand engendered by a fall in the price. I f the supply is absorbed inone quarter, when average quarterly demand is running at just over 700 tonnes/ quarter, this suggests a 14% fall in the gold price, or about $50/oz, assuming aprice elasticity of 1. The slope coefficient in the regression would be –50. In factit was +0.9 with a standard error of 2.6; we can be 90% confident that the truevalue of the slope coefficient lies between –4.6 and +6.4, and reject with com-plete confidence the hypothesis that it is really -50.

The assumption that an increase in supply each quarter has to be absorbed by

increased demand in the same quarter is extreme. But even assuming that onaverage the extra supply is absorbed over a year the model still gives a predictedslope coefficient of –12.5. It is clear that the observed impact of delta hedging isvery different from what the model predicts.

Before coming to a firm conclusion, it is worth exploring two other possibleexplanations which might reconcile the Simple Consumption Model with theempirical evidence. One is that the impact of an increase in short selling hasbeen missed because we assumed the impact was visible only in the same quar-ter. Another is that there are more complicated links between the two variableswe are measuring.

4.1.2 Timing

We have regressed changes in the gold price on changes in the delta of producers’hedging books over each quarter. But it is possible that the impact is not all felt inthe same quarter. Derivative contracts take some time to negotiate and put inplace. Banks may set their hedge in place before the contract is finalised. Themarket may learn of the derivative contract before it is finalised. But timing issuescould also go the other way. The market may only learn of a hedge after the event.So the price impact may not be contemporaneous with the hedge change.

In an attempt to pick up these effects, we can regress changes in the gold price onchanges in the delta of the hedge book which occurred both in the same quarterand the two neighbouring quarters. The result of the regression is:

∆Pricet = - 2.80 - 3.6 ∆Deltat-1 + 0.7 ∆Deltat - 1.2 ∆Deltat+1 + error

(5.10) (3.0) (3.1) (2.7)2

R = -5.15%




The model as a whole has no explanatory power (the remains negative) and noneof the coefficients individually differs significantly from zero. We do however finallyhave a negative coefficient on the change in the hedge position. Adding the coeffi-cients together the model suggests that a 100 tonne increase in hedging will reduceprices in time by $4.1/oz. The implication that most of the negative impact occursthe quarter after the hedging change has occurred does not seem very plausible. Thestandard error on the estimate is $8.0/oz suggesting we are just picking up noise.

4.1.3 Direction of causation

So far we have interpreted the data as if changes in hedging are exogenous; theyaffect the price of gold, but changes in the price of gold do not affect the level of hedging. But if changes in the price of gold can also affect the delta of producers'hedge books then this could be masking the effects we are looking for.

There are at least two reasons for believing that gold prices may affect hedgebooks. First, i f producers hold options in their hedge books the delta will changewith the price of gold even if the producers do nothing to their hedge books.Second, producers may change their books as a result of a change in prices.

If a producer hedges against a fall in prices by buying put options then the size of the short position will increase as the gold price falls. This will make the slope

coefficient lower; it cannot explain why the coefficients are positive. The sameholds if producers buy call options. The only way that options could be used toexplain the positive coefficients is if producers collectively have written options.But we have seen that in aggregate producers are net buyers of options, and hencethis exacerbates the puzzle rather than solves it.

It is also difficult to develop a convincing argument that while hedging does lower thegold price, the effect is masked by changes in hedging policy induced by changes inthe gold price. One might expect that a fall in the gold price, all other things beingequal, is likely to cause an increase in hedging. Thus GFMS in its review of 1999explains the increase in hedging in the first three quarters of the year as follows: ’in the

first nine months, as prices plunged through successive 20-year lows, producers des-perately tried to establish some price floor and lock in some margin.’ This couldexplain a negative correlation between changes in the gold price and changes in theproducer short position, but that is precisely what we have been unable to find.

4.1.4 Conclusions

We have found no evidence that changes in the size of the producer short positionaffect the gold price. We have considered the possibility that the effect is masked

2 R




by changes in hedging caused by changes in gold prices, but this if anythingseems to worsen the puzzle, rather than solve it. I t is possible that the data set isso limited in frequency and extent, and the effect we are looking for is so small,that it simply does not show up in our analysis. But if the effect were of the magni-tude predicted by the simple consumption model, it should have shown up.

We have only looked at flows caused by producer hedging. We have not lookedat the impact of flows from other users of the market, notably hedge funds andother speculators, simply because we do not have the data. But unless specula-tive trading is very large compared with producer hedging, or unless it is nega-tively correlated with producer hedging, and neither appears to be likely, it is

probable that an analysis which incorporates speculators' positions would cometo similar conclusions.

One major criticism of the simple consumption model is that it completely ig-nores the role of investment and speculative demand. Investors, it is reasonable toassume, may be prepared to accommodate short term changes in flows. On thisanalysis, producer hedging may indeed have an impact on the price of gold, butthat impact is not felt when the short sale actually occurs. Rather the marketresponds to information about changes in future short selling. On this analysis,the main price effect of hedging should be seen when the policy is initiated orchanged, and not when it is implemented. It is to this we now turn.

4.2 The impact of hedging policy announcements

4.2.1 Event study methodology

In a well-functioning financial market, the price should react to an event whenthe news of the event hits the market. I f producer hedging does affect the goldprice, one would expect to see evidence of it in the form of a price reaction to newsabout changes in hedging policy.

The standard statistical technique for doing this type of analysis is the eventstudy. It is widely used in finance, for example for investigating mergers, changesin earnings or dividend policy, changes of capital structure and so on.

The procedure is to identify all events of the specified type which occur in aperiod. The price of the financial asset is then computed in ‘event time’, that isrelative to the moment the event is announced. The price is corrected for marketwide movements, and the abnormal return on each day before and after the eventis measured. The returns are then averaged across all events to provide a typical




price profile. If the event has a price impact this should show at the time of the announcement.

The event study methodology depends on certain assumptions. The event thestudy is examining is unlikely to be the only event which hits the market thatday. So the return over the event day may owe much to extraneous factors. Butby taking a sufficiently large number of events, the assumption is that this noisewill cancel out. The set of events may be of very different magnitudes. Withhedging announcements for example, one is averaging across totally unexpectedchanges in hedging policy by large producers with relatively insignificant changesby much smaller producers. So by averaging one gets an impact from an ‘aver-

age’ hedging announcement.

But perhaps the key assumption in carrying out an event study is that one canidentify with some precision when the event - that is the news about the changein hedging policy - actually hits the market. To the extent that the announcementmerely ratifies what is already well known, the price impact will not be observedin the announcement window.

4.2.2 The event study

To identify the events in our sample we trawled for stories in the period 1992 to

2000 in which companies made announcements about their hedging policies.The sources were theFinancial Times of London and Reuters Business Briefing.We identified a total of twenty events as follows:

18/02/00: Randfontein closes out 55% of its hedging positions11/02/00: Homestake Mining announces it has not made changes to its gold

hedging policy07/02/00: AngloGold announces that it had been reducing its hedge commit-

ments for the past few months and said it would continue to do so07/02/00: Barrick announces that it remains committed to its hedge programme04/02/00: Placer Dome announces suspension of gold hedging activities in be-

lief that price is likely to rise31/01/00: Agnico Eagle Mines Ltd. Confirms its policy of not sell ing any of its

future gold production forward12/11/99: Coeur d'Alene announces that it continues to engage in gold hedg-

ing transactions29/10/99: Cambior Inc. reports that its gold hedging programme has been

reduced21/05/99: Newmont M ining announces that i t is not about to start hedging its

gold production




16/04/99: Gold Fields announces that it has made no new forward sales of goldwhatsoever in 1999

06/10/98: Zimbabwe government minister says that i t may allow gold produc-ers to hedge more of their output

05/08/98: Homestake Mining announces that it has changed a long standingpolicy against hedging and will allow up to 30% of future gold pro-duction to be hedged in forward market

11/06/98: Ross Mining NL announces that it has hedged an additional 253,000ounces of gold

21/07/97: Gengold announces that it does not plan to hedge any more gold inthe near future

06/08/96: Newcrest Mining announces that it had liquidated the bulk of itsgold-hedging position for a pre-tax profit of A$ 270m

12/02/96: Barrick announces that it remains committed to hedging but hasreduced its position

18/01/96: JCI Ltd. announces that i t has entered into a 7.3 million ounce goldhedging programme

18/08/95: Beatrix Mines announces it has hedged 2.9 million ounces22/07/93: Anglo American announces that i t has achieved its hedging targets

and is no longer heavily involved in the market11/10/92: American Barrick Resources announces that it has completed a 1-m

ounce, ten-year gold hedging facility

Ten of these announcements were classified as reduced hedging and ten as in-creased hedging. Two of the events, of opposite type, occurred on the same day (7February 2000) and were eliminated from the test. An event window of five pre-event days and two post-event days is used and the cumulative abnormal returnfor gold is computed for each of the two event categories. The hedging announce-ments generally do not coincide with other announcements, and the results aretherefore not contaminated in this respect.

Given the very short window, the method of computation of abnormal returns isnot critical; we have taken the normal return to be zero. The results are showngraphically below. The key period to examine is the day of the announcement

itself (day 0) and the days immediately before (day -1) and after (day 1).




Abnormal

Return

Increased

Hedging

Decreased

Hedging

Day T -0.66%(0.30%)

+0.51%(0.42%)

Day T-1 to T+1 -1.05%(0.55%)

+1.21%(0.55%)

The figures for the abnormal return on the gold price on the day of the announce-ment, and over the three trading days centred on the announcement, are as fol-lows (figures in parentheses are standard errors1 ):

1 Standard errors are calculated from the average observed volati lity of returns in the gold market in theperiod leading up to each announcement. We calculate one day and three day exponentially weightedsquared returns, with a decay factor of 0.9/day. We followed this procedure to take account of the factthat hedging announcements seem to occur at times of high market volatility, and also to allow for thepossibility of auto-correlation in returns.

The abnormal returns are the sign one would expect if hedging depresses the goldprice – increased hedging is bad for the gold price, while decreased hedging causesit to rise. The wider window (day T-1 to T+1 ) probably gives a fuller picture of the price impact than the one day return because it allows for some news leakage

prior to the announcement as well uncertainty as to when the announcementtook place on day T relative to the gold price fixing.

The estimates for the impact of both an increase and a reduction in hedging aresimilar in magnitude, and they verge on the statistically significant at conventional

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

-6 -5 -4 -3 -2 -1 0 1 2

More Hedging

Less Hedging

Days relative to announcement

Cumulative abnormal return

Impact of Hedging on Gold Price

Source: Own calculations based on Gold and Silver Hedging Outl ook , Scotia Capital.




(5%) significance levels. Closer inspection of the individual data points raisessome questions, particularly about the decreased hedging results. Out of the ninecases of decreased hedging only five show a positive return while four show anegative return. The overall average in these nine cases is dominated by just oneevent – Placer Dome’s announcement of a cessation of hedging on 4 February2000, when the three day return was 10%. The results for increased hedgingappear more robust; eight out of the nine cases show negative three day returnsand only one is positive.

The sample of events is so small that the results must be treated with caution.One major problem is the selection of events. The fact that we are unlikely to have

identified all events is not by itself of concern. A random selection of events willadd noise, not bias to our results. But the results are statistically significant, sonoise is not the key issue. I f the reporting of a hedging announcement is itself influenced by what is happening in the market, the results could be quite mis-leading. For example if a hedging announcement is reported because it explains agold price movement (‘the gold price moved down today following the announce-ment of increased hedging ...’) when it would not have been reported had thegold price moved in the opposite direction, we would pick up a spurious correla-tion between the two.

With all these qualifications, the evidence does suggest that the market believesthat increased producer hedging is bad for the gold price while reductions inhedging are good. The immediate impact of an announcement on the marketmay of course be subsequently corrected. But assuming a degree of market effi-ciency it seems implausible that the market will consistently over-react or under-react. If the market consistently over-reacted for example, it would be possible tomake money by selling after good news had hit the market and the market over-shoots, and buying back after the subsequent decline.

Thus we find some support for the proposition that short selling by producers,and by extension by other people, does depress the gold price. But the impactoccurs at the time when the market learns about the strategies or policies, andthis may happen well before the actual flows hit the market.




CHAPTER 5 THE GOLD LENDINGMARKET AND ITS STABILITY

The existence of an extensive derivatives market in gold depends on there being a deep

lendi ng market. I n this chapter we explore whether shocks in the lendi ng market, caused

either by demand shocks or by supply shocks, could di srupt the derivatives market and

have serious repercussions for the gold market as a whole.

Specifi cally, we consider two types of scenario, one involving a withdrawal of gold from

the lendi ng market by the offi cial sector, the other i nvolving a sharp reducti on in hedg-

ing demand by producers and speculators. Whi le there are other possible causes of dis-

rupt ion, these two scenar ios represent opposite shocks (one leading to a sharp rise in lease

rates, the other leading to a sharp fal l) and together they span the type of events likely to

cause stress in the market. We then examine the term structure of lease rates to see whether

the market, through the relati ve pri cing of short- and longer-dated leases, impli ci tl y

ascribes a high probabil i ty to a crisis occurring.

The analysis is necessarily rather tentati ve. We know little about how lease rate risk is shared

among lenders, borrowers and intermediaries. A crisis such as a run is caused by a sudden

decline in confidence; i t is hard to predict how and when panics wi ll develop. I t should also

be emphasised that the analysis is positive and not normative; we make no assessment of

whether the parties acti ve in the market are fully cognisant of the risks they are running, nor whether the official sector in particular has an interest in stabilising the lending market.

Our conclusions are:

· i t would take a sudden withdrawal of the order of several hundred tonnes to seriously

disrupt the market. A wi thdrawal of thi s magni tude is unl ikely. The most plausible

reason for such a withdrawal is publ ic concern in several lendi ng countries about the

securi ty of gold reserves which are lent out (5.1.1-2).

· the effect of a large wi thdrawal would depend heavi ly on the position at the time of

the signatori es to the Washington Agreement. I f they were close to their self-imposed

lending limit, they would not be able to stabi lise the market. Both the gold price and

lease rates would then rise very sharply, to levels which would cause serious losses both to bullion banks and to hedgers (producers, users of gold, and speculati ve shorts). I f

the signatories were free to lend to the market, they would be likely to mitigate any

crisis to a considerable degree (5.1.3-5).

· should there be a sudden contraction of demand for lending caused by a scali ng back

of producer hedge books, it is unlikely to cause major stress. The price reaction is likely

to be self-correcting, leading some producers to phase in any change of policy over a

longer period. There is a possibili ty of a sharp rise in the gold price bri nging about the

liquidation of some of the short positions held by both speculators and producers, but

there is no reason to expect that it would be on any greater scale than that which




followed the Washington Agreement (5.2).

· evidence from the term structure of lease rates suggests that the market has not at-

tached much probabil i ty to a severe disruption in the gold lending market, apart

from in the period immediately following the Washington Agreement when there

may have been a substantial premium for longer term borrowi ng (5.3).

5.1 Scenario 1: A cutback in lending

There is a striking maturity mismatch at the heart of the gold derivatives market.

Much of the forward selling by producers has a maturity of several years, yet thegold lending which supports and hedges it has a maturity measured in months. I f the official sector suddenly decided not to roll over its gold lending as it matures,the bullion banks would have to find several thousand tonnes of gold within a fewmonths to repay the gold they had borrowed. In the absence of a very large holderof gold stepping in to replace the lending, the pressures on the gold market wouldbe enormous. Indeed it could well be physically impossible to repay all the bor-rowed gold simultaneously.

But maturity mismatches are common in banking; indeed they provide one of the main economic justifications for the existence of banks. Few commercial bankscould deal with the consequences of a run in which all depositors removed their

cash. The real issue is whether the system will be able to cope with a level of withdrawals which might plausibly occur in practice.

We examine in turn what magnitude of withdrawal might destabilise the market,how likely such a withdrawal is, and what the consequences might be. We con-clude that it would take a sudden withdrawal of the order of several hundredtonnes to seriously disrupt the market, that such a withdrawal is unlikely, andthat the most plausible reason for such a withdrawal is widespread public concernabout the security of gold reserves which are lent to a third party. The conse-quences of a withdrawal would depend heavily on the position at the time of thesignatories to the Washington Agreement. If they are close to their self-imposed

lending limit, they would not be able to stabilise the market, and both the goldprice and lease rates might then rise very sharply, to levels which would causeserious losses to both bullion banks and hedgers (producers, users of gold, andspeculative shorts). If the signatories were free to lend to the market, they wouldbe likely to mitigate any crisis to a considerable degree.

5.1.1 What is a ‘substantial’ withdrawal?

How large would a withdrawal from lending be for it to cause serious disruption?The question is, of course, imprecise. There is no exact level at which an orderly




withdrawal turns into a major disruption. The impact of a shock depends on theconditions at the time – what other fears and concerns there are in the market,and the ability and readiness of other parties to join the run or counteract it. Butto provide some focus to the discussion it is useful to have an order of magnitudein mind for the size of shock which could prove hard to absorb.

The demand and supply for borrowed gold does vary as the volume of short-selling and producer hedging changes, and as central banks on occasion withdrawlent gold from the market in order to sell it. To get some indication of the magni-tude of ‘normal’ fluctuations in demand, one can look at the change in the level of producer hedging historically. Over the period 1994-99, the change in the level

of producer hedging on a quarterly basis has had a standard deviation of 135tonnes; the largest change in demand being nearly 400 tonnes over the thirdquarter of 1999.

1999 is quite instructive about the elasticity of the gold lending market. Accord-ing to GFMS, the volume of gold borrowing required to hedge producer forwardselling rose by no less than 715 tonnes in the first three quarters of 1999. Leaserates did rise to historic peaks – by the end of the third quarter the three monthlease rate was at 5.8%, but that was in the immediate aftermath of the Washing-ton Agreement. Even before the Agreement, the lease rate was close to 4%, whichwas very high by historical standards2 .

Another measure of the elasticity of the lending market comes from shocks on thesupply side. The sharp rise in lease rates towards the end of 1992 was associatedwith the withdrawal of gold by the Dutch government prior to a sale of 400tonnes. This is some time ago, and the lending market has grown substantiallysince then.

Putting this evidence together suggests that, with a lending market of around5,000 tonnes, it would take a withdrawal of well over 10% of this amount tocause serious liquidity problems, unless there were other special factors prevailingat the time which made the market particularly sensitive to shocks.

5.1.2 The probability of a substantial withdrawal

While there are no official figures showing how much gold is lent by each coun-try, it appears that there may be a handful of countries – probably less than half a dozen in total – which each account for 5-10% of the lending market. A sudden

2 Trying to generalise this observation by looking for a historical correlation between increases inborrowing demand and the level of lease rates by regressing quarterly data proves fruitless. The regressionis only statistically significant if 1999 Q3 is included.




In the face of a worsening international financial crisis, i t is possible that opposi-tion to lending of national gold reserves fuelled by fears about security and repay-ment might suddenly become powerful. Such opposition could well be interna-tional, leading several countries to cut back their lending simultaneously. Thus alarge sudden withdrawal of gold from the lending market does not seem to be animminent or likely prospect. But nor does it appear to be so unlikely that it is notworth thinking about.

5.1.3 The consequences of a large withdrawal

The impact of a large withdrawal depends on what is then done with the gold. If gold is withdrawn from one bank because of solvency concerns but then depos-ited with another, this may create problems for the individual bank facing a lossof deposits, but does not create substantial problems for the market as a whole. If the gold is withdrawn prior to sale, and is sold to another party who is happy tolend it to the market, there may be short-term liquidity problems, but it is un-likely to cause a major crisis. Problems arise if the lent gold is withdrawn and notlent out again, or if the gold is sold to a body which does not lend gold, as couldbe the case if a country facing a crisis were to sell its gold to the US or IMF.

Suppose that for some reason a number of holders of gold in the official sectorsuddenly decide to reduce their gold lending by, say, 500 or 1,000 tonnes, but

do not sell the gold. The impact would depend heavily on the attitude of otherlenders. I f the signatories to the Washington Agreement are close to their collec-tive lending limits, and if the US, Japan, BIS and IMF adhere to their policy of not lending, the number of other parties in the official sector who would have thedesire or ability to fill the gap at short notice is small. Cross estimates that, ex-cluding these sources, there is currently no more than 1,000 tonnes of gold in theofficial sector which could in principle be available for lending.

The short-term elasticity of supply is likely to be small. Lease rates would need tobe high for a prolonged period to get holders in the official sector to start lendingor to increase their lending limits. The private sector, which accounts for some

10% of lending, may be more responsive to lease rates, but even here there maybe little short-term flexibility. A change in policy may require the upgrading of the bullion and its physical transfer to London. A sharp increase in lease rates,which is likely to be temporary, and which is accompanied by concerns aboutbanks’ ability to satisfy their depositors, does not provide a strong incentive toany institution to relax its lending policies rapidly.

There are only a limited number of ways of accommodating a withdrawal on thisscale if other holders of gold are not prepared to lend. One is through a reductionin commercial banks’ loans to downstream users (jewellery manufacture, refining,




distribution). Since the interest rate on such loans tends to be floating, any changein market rates is likely to be passed on very speedily to borrowers, who are likelyto react strongly to an increase in gold interest rates. Indeed, there was muchevidence in September 1999 of this happening with the jump in lease rates fol-lowing the Washington Agreement. Cross estimates that these stocks were run-ning at some 1,100-1,500 tonnes in 1999, so they could likely offset a substan-tial proportion of the postulated withdrawal.

So far we have omitted the increased requirements of the commercial banks forgold for themselves in the event of a crisis. I f there is a serious fear of a squeeze inthe lending market, the commercial banks will want to have quicker and easier

access to physical gold so as to be sure of being able to satisfy the needs of theirdepositors and customers when there is not a liquid lending market to rely on.The aftermath of the Washington Agreement illustrates the point. The Agree-ment apparently did not lead to any reduction in lending. Indeed there is someevidence that new lending took place. But lease rates rose sharply, leading to asubstantial flow of consignment gold back to London; this was presumably heldby commercial banks seeking increased liquidity.

A large withdrawal and the absence of new lenders is likely to lead to spot marketpurchases of the same order of magnitude as the volume of gold withdrawn, onceaccount has been taken of the reduction in consignment stocks and the increasein banks’ own stocks.

5.1.4 The impact on the gold price and on lease rates

Spot market purchases following a large withdrawal from lending could well forcethe spot gold price to rise sharply. So the withdrawal would be accommodated bya combination of spot purchases (accompanied by a higher spot price), and re-duced gold borrowing downstream (encouraged by a rise in lease rates). Thiswould satisfy the physical supply and demand balance. But it does not necessar-ily lead to an equilibrium in the forward market.

If commercial banks buy gold to repay withdrawn gold deposits and do nothing

else, they will have a longer position in the gold market than previously3

. Thebanks may be happy with this position if they believe that the spot price of goldin future is likely to be higher than the current forward price. But if the immedi-ate crisis leaves the banks’ views about the future gold price unchanged, they willonly be prepared to hold an incremental long position if the forward price is now

3 To see this, consider a bank which has bought one tonne of gold forward f ive years from a producer. Ithedges its exposure by borrowing one tonne of gold from a central bank and sells it on the spot market. If the central bank demands the return of its gold, and no other lender steps in, the commercial bank buysgold spot and delivers it to the central bank. The commercial bank now has a naked long position in thegold market since it is committed to purchasing gold at a fixed price from the producer and has no hedge.




lower than it was previously. This means that any rise in today’s spot price has tobe more than offset by an increase in lease rates.

It may help to give some illustrative numbers. Suppose prior to the crisis the goldprice is $270/oz and the lease rate is low. Suppose that 500 tonnes of lending isthen unexpectedly withdrawn from the market and not replaced. Suppose thatafter allowing for a reduction in consignment stocks, and an increase in gold heldby commercial banks, commercial banks need to buy 500 tonnes of gold on thespot market to meet depositors’ demands. Suppose that these purchases force thegold price to rise to $330/oz. Suppose too that it is generally expected that themarket will revert to its earlier levels within a year. Then the commercial banks

will find themselves long by 500 tonnes at a time when the gold price is high andexpected to decline sharply. Not only will they want to sell gold forward, but sotoo will all their customers.

The market will only be able to reach equilibrium if the one-year forward goldprice is around $270/oz – where the spot price is expected to be at that time. Buta spot price of $330/oz and a one year forward price of $270/oz implies a one-year gold lease rate of about 20%. Clearly all the numbers are just given as exam-ples, but they illustrate the fact that any shock withdrawals which cannot bematched by increased deposits from other holders or reduced lending could forcea surge in the spot price and a very large increase in lease rates.

It could be argued that this informal calculation is excessively alarmist. Goldinterest rates have periodically peaked at around 4% but the peaks have neverlasted long, and rates have then gone down to well under 2% or less. But, follow-ing the Washington Agreement, we are in a different world. With much of theavailable supply of lending being constrained, a shock to lending which occurredwhen the Washington signatories are close to their limits could cause far greatervolatility in lease rates than anything we have seen in the past.

5.1.5 The effect of a spike in lease rates

A spike in lease rates would create immediate and substantial problems for jewel-lers and other downstream borrowers of gold. To some extent they can mitigatethe effects by reducing borrowing levels, but the scope may be small in the short term.The impact on their business is likely to be serious; their business is by its nature lowmargin relative to the levels of gold inventory they carry. A rise in gold financing costsof several percent could threaten the viability of some businesses and do long-termdamage to the whole system which distributes gold to the final consumer.

The major borrowers of gold are commercial banks. However, in many cases theycan pass on any rise in lease rates because of the nature of the forward purchase




contracts they have with producers. In rolling spot or spot deferred contracts theprice the bank is committed to paying for future production is reduced if leaserates rise. Furthermore there is considerable use of products such as lease rate swapswhich shifts the risk between banks, and between banks and producers. There issome evidence also of central banks taking on some of the lease rate risk.

Although producers disclose much more information about their hedge booksthan they used to, it is still not possible in most cases to predict how far anyindividual producer would be affected by a sudden spike in lease rates, nor indeedhow much of the risk is borne by producers collectively as opposed to commercialbanks. But it is possible to make certain general observations. First, that rare large

price moves have in the past, and are likely in the future, to bring about commer-cial failures. Second, that these are more likely to occur among producers thancommercial banks because the commercial banks active in the gold market tendto be far more heavily diversified than are producers. Third, the risk of largemoves in lease rates reduces the attractiveness of hedging since it brings a new riskwhich either the hedger or the seller of the hedging product has to bear, whichwould not exist if there were no hedging.

5.2 Scenario 2: A cutback in demand for

borrowing

While much of the discussion about the stability of the lending market has fo-cused on the possibility of a crisis brought about by a sudden spike in lease rates,concerns have also been expressed about the possible consequences of a suddenreduction in demand for borrowing.

5.2.1 A change in producer hedging policy

Suppose that all producers decide to allow their existing hedges to run to matu-rity, but not to take out any new hedges. The size of the aggregate producer hedgebook would decline by some 800 tonnes in the first year alone. The bankingsector would have that much less in the way of forward sales to hedge and would

reduce its borrowing of gold by a similar amount.

Lease rates would decline sharply. In the short term lenders of gold are not sensitive tolease rates so the impact of the reduction in demand would fall directly on the cost of borrowing. Lease rates are likely to decline to levels where many lenders would notfind it worth while lending at all; this floor level is probably in the region of 0.5%.

The effect on the gold price is not so clear. There is mixed evidence as to whetherthe build up in hedging depressed the gold price; a reversal of the build up mightalso fail to have a clear impact on the gold price. Against this, it could be argued




that the hedge book built up gradually over a decade; a sharp decline in the hedgebook might have a more noticeable impact.But there are good reasons to believe that any impact on the price is likely to beself-limiting. A steep rise in spot prices caused by a scramble for gold to repaygold loaned from the official sector would be widely seen as temporary. A tempo-rary peak in the gold price accompanied by abundant supplies of physical goldavailable for borrowing at low rates creates the ideal environment for short sellersto come into the market. The short sellers could be speculators and hedge funds.They could also include commercial banks, deciding to continue to borrow goldand maintain a short position even when there is no longer an offsetting purchasecontract with a producer to offset the risk. These would all help mitigate the

severity of the price impact.

But there is a more fundamental reason for being sceptical about the possibility of a mass withdrawal from producer hedging triggering a sharp price increase. Anysharp increase in the gold price which is seen as temporary would undermine theincentive for producers to act in concert. A producer with a substantial hedgebook who decides to scale it back will find it very expensive to implement thepolicy at a time of temporarily high spot prices and low lease rates. Cutting backthe size of a hedge book means buying gold forward. But buying at a time whenthe spot price is boosted by the actions of other producers, and the forward priceis very high relative to expected future spot price levels, is expensive. I t makesmore sense to wait until the effect of changes in other producers’ hedge books hasworked its way through the market. A policy of not taking out any new hedgeswould have a less obvious cost, but it would be hard to justify to shareholderschanging a policy of hedging just at the time when hedging looks as if it is mostlikely to be profitable. It seems unlikely then that a voluntary reduction in pro-ducer hedging would occur on such a scale and such a speed as to force a substan-tial spike in the gold price.

5.2.2 Involuntary liquidations of short positions

It is however conceivable that a sharp rise in the spot price of gold, brought on bysome exogenous factor, could force a substantial involuntary4 liquidation of short

positions whether these are held by producers or speculators. Although the mecha-nisms may be slightly different in the two cases, the basic principle is the same.The rise in the spot price will cause a loss in the mark-to-market value of the shortposition. I f the short has limited financial resources, he may be forced to liquidatethe position to avoid potential future losses even though the increase in the spotprice may increase the expected return on a short position in the future.

4 The emphasis on involuntary liquidations is because we are exploring the possibility of distortions inthe market caused by derivatives, and associated financing and other constraints. Trades provoked bynew information or a reappraisal of fundamentals will of course also give rise to price movements –possibly very sharp ones – but this is part of the normal functioning of any market.




In the case of a producer whose market short position exists to offset a naturallong position in physical gold, the threat of premature liquidation might seemsmall since any loss on the short position should be fully offset by gains on thephysical position. But in practice the counterparties to the short position cannotreadily gain t itle to the physical resources in the ground, so a large realised loss onthe short position can create severe financing problems. Such problems have beenapparent not only in the gold market (e.g. Ashanti) but also in other commoditymarkets (e.g Metallgesellschaft’s losses in the oil market in 1993)..So there is some probability that, given a sudden rise in gold prices, some of themore highly leveraged producers might be forced to scale back their hedging purely

because of the losses incurred. Cross finds that only a small fraction of miners aresubject to margin requirements on their hedging; this suggests that such forcedliquidations would only apply to a small part of the overall producer hedge book.

Turning to speculators – hedge funds, commodity trading advisers and commer-cial banks – the Cross Report estimates their net short position currently to be of the order of 400 tonnes. While for our purposes it is the gross short positionwhich is more relevant5 , there have been few indications of many funds havingbeen long gold in recent years. The extent to which they would be forced toliquidate positions depends on their leverage and also how large a part gold formsin their portfolio. While relatively little is known about the composition of thespeculative short position, the response to the enormous price spike in September1999 does give some confidence that only a small fraction of this position is likelyto be liquidated for financial reasons.

This analysis suggests that we are unlikely to see a steep spike in the gold pricebrought about by a number of producers deciding to cut back their hedgingsimultaneously. There is a possibility of a sharp rise in the gold price bringingabout the liquidation of some of the short positions held by both speculators andproducers, but there is no reason to expect in future that it would be on anygreater scale than we saw following the Washington Agreement.

5.3 The empirical evidence from lease rates

The term structure of gold lease rates provides some evidence of the market’sview of the probability of serious disruption to the lending market. I f borrow-ers, hedging a long-term exposure using short-term loans, perceive a real pos-sibility of not being able to roll their loans, they will be prepared to pay a

5 More precisely, it is the sum of the net short positions of each fund which is short which is relevant.




substantial premium for borrowing at longer-term. By extending the maturityof their loans, they reduce the frequency with which they have to return to themarket. Thus when the perceived risk of disruption is high, longer maturitiesshould be priced at a substantial spread over shorter maturities.

Fear of disruption is not the only reason for an upward sloping term structure of gold interest rates. Even in the absence of such fears, borrowing rates for gold varyover time, and longer term rates are likely to reflect the market’s assessment at thetime of future changes in borrowing rates. Also, it is common in money marketsfor the term structure to be on average upward sloping, possibly reflecting lend-ers’ preference for shorter tenors. Thus it would be wrong to attribute the entire

term structure of interest rates in gold to fears of market disruption.

But if market participants do believe that there is a substantial probability thatthe gold market might become illiquid, one would expect to observe a large pre-mium in longer-term rates, and one furthermore which varies substantially withthe perceived probability of a crisis. In this section we therefore examine thebehaviour of the term premium in gold lease rates to understand the probabilitythe market attaches to a crisis occurring.

5.3.1 Is there a term premium in gold lease rates?

Daily averages of mid-rates for 1, 3, 6 and 12 month maturities over the period

1993-99 are shown below:

Maturity: 1 month 3 months 6 months 12 monthsMean rate: 1.34% 1.45% 1.55% 1.73%

Differences:Mean: 0.12% 0.10% 0.18%StandardDeviation:

0.28% 0.22% 0.21%

% < 0: 21.0% 22.9% 15.0%

It can be seen that the lease rate curve is normally upwards sloping – the onemonth rate is higher than the three month rate only 21% of the time for example.The differences in rates for different maturities of loan may not seem very large,lying on average in the range of 0.1% to 0.2%. But they should be seen in thecontext of a level of lease rates which is itself not very high. An owner of gold whochooses to lend his gold just in the one month maturity earns only 1.34% perannum on average. Lending for 12 months the return is 1.73%, or 30% more.




where r(t,1) is the one-month spot rate at time t and f(t,2-3) is the forward ratefor borrowing for two months in one month’s time as measured at time t.

If there is no term premium, so that expected future spot rates are equal to today'sforward rate, and the Expectations Hypothesis holds, then a should be zero, b1should be one and b2 should be zero. I f these parameter values are rejected, thenthere is evidence of the existence of a term premium.

The results of the regression are shown in line A of the table below:

α β1 β2adjR

2

[A] 1993-99: 0.49%(0.14%)

-0.08(0.21)

-0.37(0.08)

20.2%

[B] 1993-97: 0.06(0.16)

1.10(0.34)

-0.15(0.09)

29.0%

(Standard errors in parentheses)

Line A clearly rejects the Expectations Hypothesis. Indeed, i t suggests that theshape of the term structure has no relevance in forecasting future lease rates – the

estimated coefficient is small (-0.08) and is statistically insignificantly differentfrom zero, but far from 1. The significant coefficient on b

2suggests that when

rates are high they are likely to fall and when they are low they are likely to rise.However, these results are heavily influenced by more recent events in the market,most notably in the run up to and following the Washington Agreement. If welook at the first five years of the data, we get a very different picture, as presentedin line B. The coefficient b

1is now strongly significant both statistically and

economically. Indeed it is indistinguishable from 1. The coefficient b2is now not

significant. Line B supports the Expectations Hypothesis. I t implies that the termpremium is small and does not vary significantly over time. The adjusted R 2

implies that nearly 30% of the change in lease rates is actually foreseen by the

market; the forecasting model works substantially better in the first five yearsthan it does over the whole period.

Looking at the period 1993-97 only, it is reasonable to conclude that forwardrates have been a good predictor of future spot rates, and that the term premiumhas been small. The evidence in more recent times is less easy to interpret. The factthat the forward rate has not been such a good predictor of future spot rates couldbe explained in two ways. One explanation is that the Expectations Hypothesis

[ ] )1,()1,()32,()1,(2

)1,2()1,1(21 t r t r t f t r

t r t r ββα +−−+=−

+++

6The results for other maturities are consistent. The advantage of using short maturities is that the dataset is quite short, and the tests have greater statistical power with shorter maturity contracts.




remains valid, that term premia have remained small and stable, but the markethas been highly unpredictable. In part icular, the market failed to foresee theWashington Accord and the associated very steep jump in rates. Forward ratesthen rose almost as much as short rates, reflecting the market’s belief that leaserates would remain high, but the crisis turned out to be very short-lived.

An alternative explanation is that the steep rise in forward rates did not reflect anexpectation about future short-term rates, but rather the fear of disruption suddenlybecame significant, and forward rates started to include a substantial term premium.The difficulty of distinguishing between these two explanations empirically is obvious.

The evidence on term spreads presented earlier does suggest that the term structurein gold does tend to be upward sloping. The regression analysis suggests that theterm premium does not vary in a systematic way with the level or slope of the termstructure. It is still an open question whether the term spread which exists on aver-age does reflect some, albeit small, premium for disruption risk, or whether it can beexplained by other factors. Some light can be shed on this by comparing the size of term spreads in the gold market with the comparable figures from the US$ market:

US$ LIBOR Rates 1993-99 (Gold Lease Rates in parentheses)Maturity: 1 month 3 months 6 months 12 monthsMean rate: 5.08%

(1.34%)5.19%

(1.45%)5.30%

(1.55%)5.52%

(1.73%)Differences:

M ean: 0.11%(0.12%)

0.11%(0.10%)

0.22%(0.18%)

StandardDeviation:

0.17%(0.28%)

0.16%(0.22%)

0.21%(0.21%)

The magnitude and stability of the term spreads in the two markets are strikinglysimilar. Since the spread in the dollar market does not reflect significant concernsabout market breakdown, it does suggest that term spread in the gold market isunlikely to be due primarily to fears of illiquidity or market breakdown.

One can reasonably conclude that in the period prior to the Washington Agree-ment, the market appeared to foresee little difficulty in rolling short-term gold

loans. Longer-term lease rates seem to have been close to market expectations of average short-term rates over the life of the contract. Any premium there mighthave been in long-term rates was comparable with term premia in money marketswhere fears of disruption were negligible.

Since the Washington Agreement was signed, the relationship between the slopeof the term structure of lease rates and expectations of future lease rates has beenmuch less easy to explain. Certainly the evidence is consistent with longer-termrates including a substantial but variable premium, reflecting varying levels of concern about the availability of gold for borrowing.




APPENDIX 1 THE INTERACTION BETWEENDERIVATIVE AND CASH MARKETS

Overview

Derivative markets have long attracted controversy. Some people argue that they have a

powerful distort ionary impact on the underlying physical markets, reducing liquidity,

increasing volati li ty, depressing pri ces and generally damaging the interests of legitimate users of the market. Others have argued for the benefi cial impact of derivati ves, pointing

to the way they facili tate the control of risk, and the efficient allocation of r isk between

di fferent agents, and the role that derivative markets play in ensuring that prices re-

spond to new i nformation speedi ly and accurately.

The controversy has attracted much academic research, both of a theoreti cal and of an

empirical nature. In this report, we review the li terature across both commodity and

fi nancial markets, and seek to identi fy the mechanisms by which the existence of deriva-

tive instruments may affect supply, demand and hence the price of the underlying asset.

We summarise and analyse the evidence for such l inkages.

Derivatives take many different forms; in gold for example they include futures con-

tracts, forward contracts of various designs, gold loans, options wi th more or less exoti c

features and gold-denominated bonds. But the most signi fi cant impacts of derivative

markets come with the introduction of the simplest instruments, forward contracts1 .

The fi rst section of the report discusses the economic function and purpose of forward

markets. I t starts wi th contracts on non-storable commodi ties, extends the analysis to

take account of the effects of storage, and then looks at forward contracts on fi nancial

assets. Commodity forward markets serve two pri ncipal functions: price revelation and

risk sharing. By revealing the price at which the commodi ty can be sold forward the

forward market improves the efficiency of investment in new productive capacity. By

allowing people to buy and sell forward, i t improves the efficiency wi th whi ch stocks are used. Forward markets not only allow risk to be shared more efficiently between produc-

ers and consumers but also facili tate outside capital entering the market and sharing

risk. I n the case of fi nancial assets, the major impact of forward markets is on the

liquidi ty of the market through the reduction of transaction costs, and the concentrati on

of liquidity in standardised products.

1 The term ‘forward’ will be used for a contract for forward sale, with delivery and payment at maturity;the term ‘future’ will be restricted to exchange traded contracts which are marked to market on a dailybasis.




producer faces price risk because of the time which elapses between making theproduction decision and selling the commodity. When the producer decides toinvest in new capacity he incurs known costs, but the revenues are uncertainbecause the price he will eventually receive for his output is unknown. In decid-ing how much to produce (‘the investment decision’), the producer has to de-pend on his own forecast of the future spot price of the commodity and bear therisk of his forecast being wrong.

Suppose now that a forward market is opened. The producer has two decisionsto take: an investment decision (how much, and indeed whether, to produce),and a hedging decision (what proportion of the output to be sold forward rather

than spot). Provided certain conditions are met (the producer is too small toaffect prices, the producer is seeking to maximise the utility of terminal wealth,and the only significant source of uncertainty is the future spot price), then inthe presence of a forward market the investment and hedging decisions areseparable. The investment decision should be taken purely on the basis of theforward price at the time the investment decision is taken. The producer shouldact as if all the output will be sold on the forward market. The forward price of the commodity should determine the production level whether or not the pro-ducer decides to sell his output forward, and whether or not he believes theforward price is reasonable.

That is not to say that the producer should sell all his output forward. If forexample the forward price is far below the producer’s expectation of the futurespot price, and if he believes in his own forecast, he should not sell all his outputforward. Rather he should sell some or all of his output on the spot market.

To put the point another way: in the absence of a forward market, the producernecessarily acts on the basis of his own forecast of future spot prices and takesinvestment decisions which take account of the uncertainty of the price at whichhe will actually sell. With a forward market, investment decisions can be taken onthe basis of the current forward price, and uncertainty about the future price is nolonger a factor in investment decisions.

A number of important consequences flow from this separability result. In a worldwhere producers do not know much about the forecasts and production plans of other producers, the forward price captures valuable information which makesthe investment process more efficient. The forward market makes it difficult forthe infamous ‘hog cycle’, beloved of economics text books, to materialise. In thehog cycle, underproduction one year leads to a shortage with consequent highprices. This attracts new producers into the market, leading to a glut the follow-ing year. The result is a very volatile price. In the presence of a forward market inhogs, this type of behaviour would not occur. With a forward market, the feed-back loop is instantaneous and production plans which in aggregate will lead to




over-production will cause forward prices to fall and plans to be revised beforethey are put into effect.

In addition to providing information which is socially valuable, forward marketsalso lead to more efficient sharing of risk in the economy. In a world withoutforward markets, each producer bears price risk on his own output. With forwardmarkets producers who are risk averse sell their production forward, and therebyreduce or eliminate the risks they have to bear. The long side of the forwardmarket is taken by producers who are readier to bear risk or, more plausibly, byconsumers of the commodity who want to hedge their costs.

But access to the forward market is not restricted to producers and consumers. If the hedging needs of producers who are selling forward are greater than the hedg-ing needs of consumers who are buying forward, the forward price will tend to beforced below the consensus forecast of the future spot price. Long forward posi-tions wil l tend to deliver positive, if risky, returns1 . Speculators2 wil l be attractedinto the market, predominantly on the long side.

If risks are borne by those more prepared to bear them, then the cost of risk borneby the economy as a whole is reduced. The existence of a forward market, byimproving the efficiency with which risk is borne, reduces the effective cost of production of the commodity in much the same way as more efficient productiontechnologies. As with any other cost reduction, the ultimate impact depends onthe degree of competition upstream and downstream. If input and output mar-kets are competitive, the reduction in costs will lead to higher profits for produc-ers, which will in turn attract new investment which will then lead to increasedoutput and lower prices. The technological improvement whether it comes fromimproved production technology or improved risk sharing technology, leads tothe creation of value. The division of this value between producers and consumersdepends on the relative elasticity of supply and demand.

On this traditional view, forward markets reduce the volatility of the underlyingspot price by providing a mechanism for concerting investment decisions, andaggregating information about the future supply/demand balance. Forward mar-

kets will tend to lower commodity prices by reducing the risk which producersare forced to bear. By improving information flows and risk sharing, forward mar-kets will tend to improve welfare in the economy, though how that welfare gain isshared between parties is not clear from the model.

2 The predicted positive expected returning on long forward positions is known as ‘normal backwarda-tion’ and was fi rst discussed by Keynes (1930) in hisTreati se on Money . I t is quite distinct from the otheruse of the term backwardation to signify the situation when the current forward price is trading belowthe spot price.3 The term ‘speculator’ is used in a technical (and morally neutral) sense to signify an agent who has apurely financial interest in the commodity, intending neither to produce it nor consume it.




There is a welfare gain from opening a market in commodity borrowing. In theabsence of a market, the only way to borrow the commodity is to buy spot nowand then sell spot in the future. The cost of borrowing is uncertain. An agent’sassessment of the cost will reflect their own assessment of where the spot pricewill be in future and on their attitude to risk. Different agents will assess the costdifferently, and agents who assign a low cost to borrowing will be holding inven-tories which could be used far more efficiently by other agents who put a highercost on borrowing. With a market in borrowing the commodity, these agents willbe able to trade until they equalise their marginal benefits from holding stock.

The level of borrowing rates affects production decisions as well as storage deci-

sions. Suppose for example that stocks of the commodity are sufficient to meetten years demand, and that storage costs are negligible. Then the cost of borrow-ing the commodity for up to ten years should be negligible, and the forward priceshould equal the spot price plus the riskless interest rate. An agent who contractsto sell one ton of the commodity forward to some timeT (less than ten years) willbe assured of getting today’s spot price plus interest for it. The present value of that ton is thus independent of the particular horizon chosen.

Now consider the position of a producer who has an undeveloped mine. As wehave already argued, in the presence of a forward market the output of the mineshould be valued using today’s forward price whether or not the output is actu-ally to be sold forward. Assume that the producer wishes to maximise the presentvalue of future profits. The present value of future revenues is independent of thetime at which the mine is developed. The present value of future costs is likely tofall the longer production is delayed. This is for two reasons. First, technologicalimprovements will tend to reduce the costs in real terms. Second, provided thatthe appropriate discount rate exceeds the rate of inflation (a very plausible as-sumption) delaying any costs adds to project value. This means that the profitmaximising owner will delay developing the mine4 .

Thus one would expect that when stocks are high and expected to remain high,forward prices will be high relative to spot prices, and producers will tend to deferproduction. Conversely, if stocks are low and commodity borrowing rates are

high, forward rates will be low relative to spot rates, and producers will have anincentive to accelerate production.

4 Indeed there is a further reason for delay. The undeveloped mine has option value. The commodityprice can change for better or worse; if the mine is already under development the owner may have littlealternative but to proceed according to plan. With the mine not yet developed, the owner can respondby bringing forward or delaying development further.




1.3 Financial forwards

There are substantial differences between commodity and financial forward con-tracts. In general financial assets are held for financial reasons, and the only com-pensation the owner will require for lending the asset is the cash flow the assetgenerates (such as interest coupons or dividends). The cost of borrowing a secu-rity over a period when it generates no cash flow is close to zero. There are excep-tions: bonds may be more expensive to borrow if they are ‘on the run’ and there-fore particularly liquid, or if they are the cheapest to deliver into a futures con-tract. Equities may similarly be costly to borrow if there is some corporate eventlike a takeover, and the share has a value because of its voting right.

The cash flows generated by a financial asset are generally highly predictable, atleast in the short term. With negligible borrowing costs and known cash flows,the forward price of a financial asset can be calculated rather precisely. The for-ward price is equal to the spot price, less the present value of any distributions,plus interest. It is not necessary to open a forward market to estimate the forwardprice. Unlike a commodity forward market, a financial forward market provideslittle information not already available from the spot market. Furthermore, trans-actions on the forward market can readily be replicated without the forward mar-ket. A long forward position can be synthesised by a spot purchase financed byborrowing. A short forward position can be synthesised similarly if the underly-

ing can be sold short.

Financial forwards and futures reveal little new information and barely extend therange of feasible trading strategies. Their impact comes from the liquidity andreduction in transaction costs they provide. A long spot position financed byborrowing is an imperfect substitute for a long futures contract for a number of reasons. The packaging of the two in a single instrument makes it much easierand cheaper for traders with poor access to credit markets to get a highly leveragedposition. The standardisation of the terms of the contract means that trading isconcentrated in a single liquid and transparent pool. The ease of netting longand short positions makes futures markets particularly well suited for holdingpositions for very short periods. The fact that traders can go long as easily as

short means that it is particularly attractive in markets where shorting is pro-hibited or costly.

1.4 Long-dated forwards, options and other derivatives

Despite the variety of derivative contracts which are actually used, we have con-centrated so far on a single forward market. It is worth considering briefly theadditional economic functions served by having a richer collection of derivativecontracts. One function they serve is to enable traders to delegate the execution of




a strategy to a specialised intermediary. For example, a producer may want tohedge, but may dislike the unpredictability of cash flows associated withthe mark-to-market on futures contracts. If the producer buys a forwardcontract from an intermediary, and the intermediary then buys futures con-tracts, the intermediary bears no significant risk, but effectively acts as an agentof the producer.

But many derivative contracts allow different risks to be traded. Consider long-dated forward contracts. Forward contracts of different maturities tend to be quitehighly correlated, so a long-dated contract can be replicated reasonably well bytaking out a position in a short-dated contract and rolling it over into a new

contract as the old one matures. The difference between a long contract and arolled over short contract comes because in the former the convenience yield islocked in from the beginning, while in the latter it is determined by the market ateach contract roll.

The existence of long maturity contracts is therefore particularly important incommodities where the convenience yield (or, equivalently, the cost of borrowingthe commodity) is very volatile. In the case where a producer sells gold forwardlong term1 to an intermediary who hedges by selling short dated futures con-tracts, the producer is getting rid of all price risk, the intermediary is takingconvenience yield risk, and the spot price risk is borne by the counterparty in thefutures market.

Many other derivatives are structured with option-like features. The Black andScholes approach to option pricing, which underpins all modern theories of de-rivatives, shows how an option can be replicated exactly (under certain assump-tions) by dynamically trading the underlying forward contract. Inverting thisargument, one can say that options are not redundant from an economic perspec-tive precisely to the extent that those assumptions are not valid. The key assump-tions are that the volatility of the forward price is known, that the price does not

jump and that there is always sufficient liquidity to transact at the market price.

To understand the incremental economic contribution of options contracts over

and above forward contracts, consider the position of a producer who has pur-chased a put option from an intermediary who then hedges in the forwardmarket. The risk left with the intermediary is that the forward price will bemuch more volatile than expected, that the price jumps (part icularly when it isclose to the strike price), and that the market becomes illiquid when prices aremoving rapidly.

5 Some forward contracts with a long maturity, such as rolling spot contracts, are actually structured soas to leave the convenience yield risk with the producer.




The existence of a rich array of derivative contracts beyond a simple forward con-tract allows participants to delegate the execution of trading strategies to financialintermediaries, and to enable them to manage more subtle risks than changes inthe level of the spot price, such as changes in the future commodity lending rate,and changes in the volatility of prices.

2 Derivatives and market quality: theoretical

considerations

Much of the debate about the impact of derivatives markets on the underlyinghas turned on the issue of whether making markets more liquid, reducing barriersto participation and widening the range of risks which can traded is always ben-eficial, or whether it can damage the quality of the underlying market. In generalit seems plausible that the opening of a new market, such as a forward market ora market in options, can only be beneficial. No one is forced to use the market.People who do use the market do so because they believe they get some benefitfrom using it. Even if the new market attracts irrational speculators who trade onwhim or fashion, and they destabilise prices, they cannot exist forever. In the longrun their irrational behaviour will cause them to lose money and they will be

eliminated from the market.

There are also informational benefits from opening new markets. Unless the newmarket is totally redundant, prices on the market will reveal information to thepublic. One might reasonably assume that increasing generally available informa-tion is beneficial.

Yet these general considerations are not compelling. As Hart (1975) demonstrates,it is possible to design theoretical models in which the opening of a new financialmarket is damaging. He shows how in a world of rational utility maximisingtraders opening a new market can diminish welfare. The argument that irrational

investors will be eliminated from the market in the long run is also not verypowerful. The long run may turn out to be very long indeed. I f there is a continu-ing supply of irrational investors into the market, there can well be a significantand persistent population of irrational investors as some die and others are born.

In the rest of this section we explore the main theoretical reasons for believingthat derivatives may affect the cash market: the ease of building a highly leveragedposition, the ease of short-selling, the fragmentation of trading between cash andderivatives markets, the impact of hedging on physical production, and the abil-ity of a large trader or cartel to manipulate prices.




2.1 Derivatives market and leverage

It has often been argued that low transaction costs and, particularly, the availabil-ity of high leverage, encourage speculation and that this speculation damages theunderlying market. While the detailed argument varies somewhat, the generalidea is that there are irrational investors who exhibit their irrationality throughsome kind of herding or trend following behaviour. These irrational investors arecredit constrained so the existence of a futures market6 allows them to enter themarket and build up larger positions than they would otherwise take. Opening afutures market allows more investors to enter the market, which is a good thingsince it improves the risk-sharing activity of the market. But it also reduces the

average level of rationality, which is damaging.

The real damage done, however, by the irrational investors occurs because theirleveraged position tends to induce stampedes. Suppose that irrational investorshave built up a large long position, forcing prices above their natural equilibriumlevel. If the market then starts to move down, their high leverage and limitedaccess to credit forces them to liquidate part of their position. If these irrationalinvestors are large in aggregate, the rest of the market will only be able to absorbthe trades by moving prices still further down. The sales snowball, and pricescrash through the equilibrium level.

This argument seeks to relate the existence of derivatives markets to crashes, but

the argument is symmetrical. I t can be used equally well to explain steep pricerises if the irrational investors start net short, and are forced to cover their shortpositions in a hurry. The conclusion is that easy leverage in general, and futuresmarkets in particular, cause an increase in the volatility of the underlying.

A number of authors have developed formal models to assess the net welfare im-pact of opening a derivative market, but the results depend on the parametersused. Stein (1987) for example has a model where speculators are not allowed totrade on the spot market but are active traders on the futures market. This can beseen as an extreme case of credit constrained speculators, and a spot market withvery high margin requirements. The speculators have noisy information, but are

irrational in the sense that they think their information is better than it really is.This makes the futures market price a noisy signal of supply disturbances. Thenoise is transmitted by arbitrage to the cash market, which reduces the quality of the cash market. The opening of the futures market therefore both increases therisk bearing capacity of the market and also adds noise. Stein shows that thebenefit of the first can be more than offset by the damage done by the second,though this is not the case for what he takes to be realistic parameters.

6 The argument focuses on the way futures markets allow traders to get high leverage. Traders can also getleverage if they are allowed to buy spot on margin, so the arguments apply equally to margin require-ments in the spot market.




The argument that leverage induces volatility was largely endorsed by the BradyCommission (1988) in its report on the 1987 stock market crash. Interestingly,this conclusion was not shared by the Working Group on Financial Markets (1988),which comprised the Secretary of the Treasury, and the Chairmen of the Securi-ties and Exchange Commission, the Federal Reserve Board and the Commoditiesand Futures Trading Commission. The SEC Chairman concluded that raisingmargins would reduce stock market volatility, while the other three members of the working group did not believe this was supported by the evidence.

2.2 Derivative markets and shorting

A separate line of attack focuses on the way that futures markets make short sell-ing easier. In some spot markets short selling is either prohibited or restricted (forexample, on the New York Stock Exchange, stocks can only be sold short on anup-tick). Even where short selling is unrestricted, the seller needs to borrow theasset in order to deliver it to the market, and stock borrowing may be difficult orexpensive for tax or regulatory reasons. By contrast, on a forward or futures marketit is as easy to go short as to go long. Arbitrage then ensures that any selling on theforward market is transmitted to the spot market.

It is tempting to believe that the prevention of short selling will increase prices.For if those with the most negative views are constrained in the degree to whichthey can sell, their weight in determining the market clearing price will be di-

minished. But the argument is not convincing. It ignores the fact that those whosell short must ultimately buy back if they are to realise any profits. It also as-sumes that the trading behaviour of other parties is not affected by the shortselling constraint. I f t raders know that those who are more bearish about the priceare unable to participate in the market, they will surely treat the consensus viewof those who are participating as biased upwards.

A further argument against the view that short-selling constraints increase pricesis that the constraints would not have any effect on the income from holding theasset. A higher price would mean that the total return (running return plus capi-tal growth) would be lower on constrained assets, and investors would therefore

shun them, leading prices to match those on unconstrained assets. However thisargument is less applicable to gold than to other assets because of the peculiarnature of the return from holding gold.

There are reasons for believing that short-selling constraints may actually reduceasset prices. They reduce participation in the market and hence reduce liquidity.If the demand for borrowing the asset is reduced, the borrowing rate for the assetwill tend to be lower, and owners of the asset will lose income from lending theasset. I t is striking how in recent years many governments have taken measures tomake it easier to sell their bonds short. They have a strong interest in raising the




the trader buys an option contract. The counterparty may well choose to deltahedge the transaction, putting on a hedge right away and then adjusting it asprices change, buying as prices rise, selling as they fall. The initial hedge becomesknown to the market soon after the contract is signed, but the subsequent tradingonly becomes known over time.

There is then a risk that the market misinterprets the trading of the intermediary.The market falls, and the intermediary sells. Unaware that this selling pressure isthe result of a contract entered into some time earlier, the market may interpretthe selling as being based on current information, and therefore mark prices downfurther. Genotte and Leland (1990) have a theoretical model in which relatively

small option positions which are not known to the market give rise to substantialprice instability. It provides some theoretical support for the view that portfolioinsurance played a significant role in the stock market crash of 1987.

Following up on this argument, it is interesting to analyse why formal portfolioinsurance or option based strategies should have such a severe effect. There seemslittle difference in principle between an investor who enters now into some op-tion contract in effect delegating the dynamic trading strategy to an intermedi-ary, and one who changes his portfolio composition as relative prices change,doing the dynamic trading himself. Presumably the purchaser of portfolio insur-ance would, in the absence of an explicit service provided by an intermediary doimplicit portfolio insurance by selling as asset prices fall, and buying as they rise.

The answer may turn on the way in which option and portfolio insurance con-tracts are drawn up. With precise strike levels and time horizons, the delegatedstrategy may be quite abrupt with large price moves necessitating large transac-tions, and with particular trading intensity at specific price levels or times. Theinvestor following a broadly similar strategy may do it less mechanically, adjust-ing his trading to market conditions.

So far we have discussed the impact of derivatives on the general volatility of spotprices. But the hedging of derivative contracts can also have a more local andshort-term impact on the cash market. Traded options mature at fixed times.

Both over-the-counter and exchange traded options tend to have strike prices andbarrier levels which are round numbers. H edging and arbitrage activity is likelyto be particularly intense whenever derivatives are close to expiry and wheneverthe price is close to the strike or barrier level. This intense trading activity couldwell affect the price of the underlying at least temporarily.

The hedging at expiry issues affects futures and forward contracts as well as op-tion contracts. While the great majority of exchange traded futures contracts areclosed out prior to maturity, some are held to maturity, and they play a crucialrole in maintaining the integrity of the futures market. Now with contracts which




may wish to manage risk to optimise their own utility. Insofar as they haveheavy and rather undiversified exposure to the firm, they may well wish tohedge. This urge to hedge will be offset to some extent if they have an asym-metric reward such as stock options or bonuses which have a limited downside.

Fite and Pfleiderer (1995) echo much of this and point to a further reason forhedging. Firms are managed by managers who want to communicate their skills.By hedging those cash flows which are outside their control (the behaviour of gold prices) they can ensure that their financial results more closely reflect theirskills, and are less subject to chance.

Froot, Scharfstein and Stein (1993) point to yet another reason for hedging basedon the costs of external fund raising. Firms get investment opportunities whichare valuable. Because of capital market imperfections, such as informationasymmetries between shareholders and management, it is more costly to raisefunds externally than internally. Then unforeseen fluctuations in cash flow maylead to good investment projects not being exploited. By stabilising cash flow,hedging may allow the firm to continue to invest when internally generated cashflows are low.

All these various motives for hedging also lead to hedging decisions having a realimpact on operating decisions. For example if bankruptcy is costly, then a com-pany may be unwilling to develop a mine, even if it has positive value, because of the fear that if it fails the whole firm may enter financial distress. By selling theoutput forward, the value of the project may not increase, but the reduced prob-ability of financial distress may allow the project to proceed. Faced with the ques-tion of shutting down a potentially loss making venture, the fact that the salesprice is hedged may similarly reduce the risks and allow the project to continuelonger than it would if the sales price were not hedged.

2.5 Derivative markets and monopoly

At various places in the analysis of the impact of derivative markets we have ex-plicitly assumed that the agent is a price taker – that is to say he is too small to

influence market prices, and accepts them as given. If there is a monopolist or i f anumber of major players collude, then much of the analysis falls away.

The clearest example of the problems which may arise is the corner or squeeze.While it may be implausible for an individual or a coalition to control the supplyof a commodity over time, it is sometimes possible for them to control a substan-tial proportion of the commodity which is actually deliverable at some specificpoint in time. If the coalition can do this at the time a futures contract matures,they can potentially make very large profits. They hold long positions in thefutures market, and ensure that most of the commodity which is deliverable against




the contract is actually in their possession. The spot price gets bid up and so doesthe future. The coalition can make profits either by closing out the position at ahigh price or by selling the physical commodity at a high premium.

Corners distort the spot market, and prevent futures markets from achieving ei-ther price discovery or effective risk sharing. They depend on monopoly power oron a coalition of some kind for otherwise each agent who is part of the squeeze hasan incentive to take his profit just before everyone else does, and the squeeze nevertakes place. They are perennial problems of commodity futures markets and inpractice futures exchanges use a number of ways to identify and then frustratesuch tactics.

3 Derivatives and market quality - empirical

evidence

There are numerous studies which seek to detect the impact of futures trading onthe underlying market. In general they find little or no evidence that derivativesdamage the underlying market, and some studies find beneficial impact. Thelarge number of empirical studies and the absence of a compelling conclusion are

perhaps unsurprising in the light of the limited power of the empirical tests. I t iseasy enough to compare market quality measures (volatily, auto-correlation, depth,bid-ask spread) before and after the opening of a futures market. But for eachmarket there is normally just one observation – the change between before andafter the market opens Showing a significant change over that period is a long wayfrom showing that the change in market quality was caused by the opening of thefutures market.

It would be easier to ascribe causation if any change due to the futures market isexpected to occur precisely on the day the market opens. But that is not plausible.Most futures markets are little used initially. Any impact they have on the underly-

ing spot market is likely to be felt gradually as the volume of trading picks up.

The direction of causation is also an issue. I f futures markets are needed for riskmanagement and hedging purposes, they are most likely to be introduced whenthe underlying market is volatile. But volatility tends to be mean reverting. Soone would then naturally find that the opening of a futures market is accompa-nied by, even if it is not the cause of, a decline in volatility.

In surveying the evidence, we look separately at commodity, bond and stock fu-tures because each raises rather specific issues. The textbook theory of futures




the GNMA market, reduced random fluctuations in GNMA spot prices, and ledto the GNMA market being better integrated with the Treasury bond market.Simpson and Ireland (1982) also looked at the volatility of GNMA yields beforeand after the opening of the futures market, controll ing for the volatility of Treas-ury and FNMA bond prices, and concluded that ‘trading in GNMA futures didnot affect the volatility of cash prices for GNMA certificates’.

Figlewski (1981) regressed the volatility of GNMA prices on the amount of openinterest and the volume of trading in the futures market over the period 1975-79,and found a positive if weak relation, which suggested that futures trading activ-ity led to an increase in spot price volatility. However, the results are sensitive to

the comparison period used. When Moriarty and Tosini (1985) extended thesample period to 1983, they found no evidence that the opening of the futurescontract affected volatility of the spot market.

The fundamental problem with these studies is their lack of power to identify anycausal link. Showing that market quality measures are on average different in theperiods before and after the market opens is not compelling evidence of a linkbetween market quality and the existence of a futures market. Using a measure of futures activity, such as volume or open interest, as an independent variable helpsvery little since it too is highly correlated with time.

Seeking to avoid these problems Bhattacharya, Ramjee and Ramjee (1986) lookat the time series properties of daily volatility in the cash and futures market andtest whether unexpectedly high volatility in one market is followed by increasedvolatility in the other. They find weak evidence of futures volatility leading spotmarket volatility in one of their tests, but the magnitude of the effect is not large,and the effect vanishes in a second, similar test. They conclude that the ‘actions[of speculators in the futures market] do not appear to cause any destabilizingeffects in the cash market.’ The implications one can legit imately draw from atest of this sort are quite limited; the fact that high volatility in the futuresmarket is followed by high volatility in the cash market does not necessarilymean that the volatility in the cash market is caused by the futures market.Rather all it may show is that the futures market reacts more swiftly to news

than does the cash market.

Bortz (1984) examines the volatility of Treasury bond prices before and after theintroduction of the Treasury bond futures contract in 1977. After correcting formacro-economic variables he finds a small reduction in volatility. When usingfutures market trading volume and open interest as explanatory variables, he findscoefficients which are insignificant though negative. He concludes that his results‘while not powerful, are consistent with the notion that the T-bond futures mar-ket helped reduce the daily volatility in cash bond prices’.




Hegde (1994) attempts a more severe test of the impact of Treasury bond futureson the spot market. He argues that if the impact does exist it should be part icu-larly obvious in circumstances where the degree of interaction between the spotand futures market changes most abruptly. He therefore looks at the volati lity of the bond which is cheapest to deliver as it becomes cheapest to deliver or as itceases to be cheapest to deliver, and also at the volatility of the cheapest to deliverover the delivery month. For it is the cheapest to deliver bond which is likely to bethe subject of most arbitrage activity, and where the impact of futures inducedvolatility is likely to be most marked. Looking at daily data from 1979-88, heconcludes that ‘the tests fail to reject the null hypothesis that changes in the pricelevel and volatility of bonds at these three critical time points are no different

from the behavior during the surrounding weeks.’

Most of the studies cited so far have looked at volatility. But volatility by itself isnot necessarily a bad thing. If fundamentals are volatile one would expect a well-functioning market to reflect the fact. But one would expect a well-functioningmarket to process information rapidly and efficiently. Positive auto-correlations inreturns are an indication that prices are slow to adjust to news; negative auto-correlations are a sign that they overreact. Cohen (1999) tests for auto-correla-tions in three major bond markets (US, Japan and Germany) by looking at vari-ance ratios – how volatility on a one–day horizon relates to multi-day volatility.In an efficient market the ratio would be one.

Prior to the trading of futures and options the variance ratios exceed one,often significantly; subsequently (except in the case of the Japanese govern-ment bond market) they decline. The declines in variance are statisticallysignificant. The evidence therefore suggests that these major markets havebecome significantly more efficient following the opening of futures marketsand, to a lesser extent, opt ions markets. H owever, attempts to tie the im-provement specifically to the opening of derivatives markets were unsuccess-ful. The changes were too gradual to confirm or reject the hypothesis thatother factors may have been important.

3.3 Evidence from stock index futures

The evidence from stock index futures is coloured by the fact that the futures areon an index or basket of stocks, and that they are cash settled. One reason thatopening an index futures market may have a real impact is that it gives the oppor-tunity to trade baskets of stocks in a single transaction. This may be significant if executing a large set of orders is expensive or time-consuming or cannot be doneat a price known in advance, or if, as is normally the case, the bid-ask spread inthe future is much narrower that is in the individual stocks.




Cash settlement is also significant. Traders holding futures positions at expirationwho want to maintain their exposure must trade in the cash market at or near tothe point of expiration. This trading activity, and the impact it has on prices, havebeen the subject of some attention.

Edwards (1988) compares volatility before and after index futures contractswere listed, and finds no evidence that the S& P 500 and Value Line futurescontracts in 1982 increased volatility in the cash market. While he finds thatthere is increased volatility on those days when S&P 500 futures contracts ex-pire, the excess volatility is largely confined to the last hour of trading, andmuch of the price movement is reversed the following day. He ascribes this

largely to a temporary liquidity problem rather than to some permanent in-crease in volatility. These results on expiration confirm and extend earlier workby Stoll and Whaley (1986).

Jegadeesh and Subrahmanyam (1993) show that the bid-ask spread on S& P 500stocks increased following the introduction of the S& P 500 futures contract in1982. This work, based on daily data, also found evidence of an increase in theadverse selection component of the spread in those stocks, but the results are notstatistically significant.

Their work is supported and extended by Choi and Subrahmanyam (1994) whouse intra-day data to investigate the impact of the opening of the MMI (majormarket index – a 20 share index) contract on the cash market in 1984. The choiceof contract is dictated primarily by data availability; no reliable intra-day pricedata were available when the S& P 500 contract opened two years earl ier. Theyexamine three samples of stocks before and after the futures started trading:the 20 stocks in the MMI, 20 S& P 500 stocks not i n the MMI, and 20 stocksnot in the S& P 500. They look at the behaviour of the average bid-ask spreadand find that, when corrected for general trends, volatility, prices and vol-ume, the spread on the MMI and S& P 500 samples widened, but that on thenon-S&P 500 narrowed. The changes are small economically, but significantstatistically. They also find that these changes are mirrored in changes of meas-ures of information asymmetry, with widening asymmetry being associated

with widening spreads. They find no evidence of increased volatility, but vol-umes did increase.

The evidence is consistent with the thesis that futures markets increase tradingvolume and information flow to the underlying market. The changes in spreadappear to be due to a change in the proportion of informed trading in the underly-ing stocks: with the introduction of a futures contract, traders who have no informa-tion about individual stocks can trade the future, meaning that the proportion of informed trading in the major stocks rises, and with it the bid-ask spread.




Cohen (1999) shows that the introduction of index futures into four major eq-uity markets (US, Japan, Germany and UK) was accompanied by a significant fallin variance ratios, which were generally above unity prior to the introduction of futures contracts and which subsequently were insignificantly different from one.As in bond markets, one can conclude that the introduction of futures tradingwas accompanied by the underlying market becoming more efficient, but there isno evidence of causation.

A study by Lee and Tong (1998) looks at the impact of the introduction of fu-tures trading on individual stocks in Australia. This is interesting because theintroduction of an index future may have impact either because of the opening of

a futures market as such, or because it facilitates trade in diversified baskets of stocks. By contrast, the impact of the introduction of a future on an individualstock must be due solely to the opening of a futures market on what was alreadya traded underlying. Lee and Tong look at volatility and volume, and control forother market wide changes in these variables by comparing with a sample of largestocks on which no futures were traded. They find no evidence of a change involati lity, but clear evidence of an increase in trading volume in those stocks wherefutures are introduced.

3.4 Evidence from stock margins

The debate about the impact of futures markets on the cash market has beenparalleled by a debate about the impact of stock margins. Under the US Secu-rities Exchange Act of 1934, the Federal Reserve Board (FRB) has determinedthe initial margin requirements for stocks. The lower the margin, the more thatan investor can leverage an initial cash outlay. I f the level of stock margins doeshave a significant impact on the volatility of prices, then it is highly plausiblethat stock index futures would also have an impact on volatility, since theyprovide far greater leverage.

Evidence to support this view is found in Hardouvelis (1988 and 1990) looking

at US stock price data since the 1930s. He finds a statistically significant negativecorrelation between the level of margins and the volatility of returns on the S& P500. The results have been strongly contested. In particular Hsieh and Miller(1990) argue that the Hardouvelis results are based on faulty econometric tech-niques, and that the data properly interpreted do not support his claims. Otherempirical studies of the issue have also failed to support Hardouvelis’ thesis. Kupiec(1998), in a review article, concludes that ‘no substantial body of scientific evi-dence supports the hypothesis that margin requirements can be systematicallyaltered to manage the volatility in stock markets’.




3.5 Evidence from options: price levels

Much of the empirical work on options has been done on individual stocks. I t isconvenient to look separately at the impact on price levels, on the riskiness of theunderlying, and on information effects.

If options are redundant securi ties (because they can be replicated by delta trad-ing) then the opening of an options market should have no effect on the price of the underlying. If options are not redundant, it is plausible that they make theunderlying more attractive to hold, and thus lead to an increase in the price.

Conversely, if options damage market quality, listing might be accompanied by aprice reduction. So a number of studies have looked at whether option listings areaccompanied by abnormal returns.

Conrad (1989) looked at the impact of the introduction of options on 96 indi-vidual US stocks in the period 1974-80. She finds a positive price impact of theorder of almost 3% which is largely concentrated in the few days before the op-tion is introduced. The impact appears to be permanent, not being reversed inthe subsequent 30 days. She finds little impact associated with the announce-ment of option trading. This is striking: in an efficient market, the impact willoccur at the time the information reaches the market. The decision to list anoption on a stock is generally not a complete surprise. So in an efficient market,

the price impact should be spread over the period up to the listing of the optionbeing announced. She suggests that one reason for the price impact may be thatoption traders buy the underlying stock in advance of listing in the knowledgethat they are likely to be net option writers.

Detemple and Jorion (1990) extended the study to 368 options introduced inthe period 1973-86. They confirm the existence of a listing effect, but show thatit is much weaker in the period after 1980. They also show that the positivereturn on the stock is paralleled by a positive return on the industry generallyand, somewhat more weakly, on the market. They also find no significant an-nouncement effect except in one part of the sample period. They attribute the

positive returns to the benefits of making the market more complete. The spilloverto other stocks in the industry comes because a more complete market in therisk of that industry is beneficial to all stocks in the industry. The decline in theeffect over time they attribute to a reduction in benefits as the market becomesmore complete.

Sorescu (1999) takes the data sample forward to 1995, and confirms the positiveprice effect of option listing in the period to 1980, but finds that thereafter itbecomes significantly negative. Sorescu describes the result as puzzling. Whilethe lack of positive listing returns after around 1980 could be explained by a




number of factors – Sorescu puts forward the substantial completeness of themarket following the listing of stock index options in 1982, or the tougher regu-latory environment imposed on option traders in 1979 – it is hard to explain thesignificant negative impact from options listing. A tentative explanation he givesis that the introduction of options allows people with negative information aboutthe stock to take a short position more cheaply.

3.6 Evidence from options: price volatility

Conrad (1989) finds that on average the volatility of underlying stocks is lower in

the 200 days after option listing than it was in the preceding 200 days. With nochange in the beta of the stocks, this reflects a reduction in the idiosyncratic riskof the stocks. While recognising the possibility that this fall in volatility mayreflect the tendency of Exchanges to list options on stocks which have been highlyvolatile, she finds no evidence that stocks in the period prior to having listedoptions have attracted particular press comment. Detemple and Jorion (1990)find a 7% reduction in stock price volatility in the 60 days after option listingcompared with before; the reduction is statistically significant. Betas do not changesignificantly but both market risk and idiosyncratic risk fall. Damodoran andLim (1991) also find a decline in variance in the two years after option listingcompared with before, and show that the reduction in variance is due to a reduc-tion in the noisy (transitory) component in returns. These results on volatility

were substantially confirmed by a number of other studies including Nabar andPark (1988), Bansal, Pruitt and Wei (1989) and Skinner (1989).

Fedenia and Grammatikos (1992) look at both New York Stock Exchange (NYSE)and OTC traded stocks on which options were traded up to 1988. They found,in accordance with other studies, that the volatility of NYSE stocks declines afterthey have options listed, and the bid-ask spread narrows. But the reverse is truefor the 98 OTC stocks in the sample. The results on OTC stocks were largelyconfirmed by Wei, Poon and Zee (1997) for a sample of 173 options which listedin the period 1985-90, who find that volume and volatility increase, but they donot find a significant change in bid-ask spreads.

4 Conclusions

Theoretical arguments suggest that commodity forward markets play a valuablerole in both information pooling and risk sharing. They serve to help co-ordinateinvestment decisions and storage versus consumption decisions. The empiricalevidence supports the theory, albeit not very strongly, and provides little or nosupport for the view that derivatives increase the volatility or instability of spotprices. The evidence from financial markets suggests that derivatives provide




additional benefits in terms of increasing liquidity and increasing the efficiencywith which new information is impounded into prices. There is little evidencethat derivatives undermine the spot market or make spot prices more volatile.There is some evidence from stock index futures which suggests that the openingof an index futures contract widens the bid-ask spread in the individual compo-nents, but that observation has limited relevance for a commodity like gold whichis highly standardised.

One can therefore draw the following conclusions:

Derivative markets in general fulfil a valuable role in promoting the efficient

sharing of risk, and in aggregating information;

There are ways in which derivatives could destabilise the price of the underly-ing assets, but there is little evidence that this has been a problem in mostother markets;

There is evidence that derivatives help make the underlying market more liq-uid, and also increase the speed with which new information is incorporatedinto prices.




Gray R.W., 1964, ‘The Attack on Potato Futures Trading in the United States’,Food Research Institute Studies , IV, 2.Hardouvelis G., 1988, ‘Margin Requirements and Stock Market Volatility’, Fed- eral Reserve Bank of New York Quarterly Bulleti n , Summer.Hardouvelis G., 1990, ‘Margin Requirements, Volatility, and the Transitory Com-ponent of Stock Market Prices’, American Economic Review , 80, 4, 736-763.Hart O., 1975, ‘On the optimali ty of Equil ibrium when the Market Structure isIncomplete’, Journal of Economic Theory , 11, 3, 418-443.Hegde S., 1994, ‘The Impact of Futures Trading on the Spot Market for TreasuryBonds’, Financial Review , 29, 4, 441-471.Hsieh D. and M.Miller, 1990, ‘Margin Regulation and Stock Market Volatility’,

Journal of Finance , 45, 1, 3-30.Jegadeesh N., and A.Subrahmanyam, 1993, ‘Liquidity Effects of the Introduc-tion of the S& P 500 Index Futures Contract on the Underlying Stocks’, Journal of Business, 66, 2, 171-187.Johnson A.C., 1973, ‘Effects of Futures Trading on Price Performance in the Cash On-ion Market’, 1930-68, US Department of Agriculture, ERS Technical Bulletin 1470.Johnson L.L., 1960, ‘The Theory of Hedging and Speculation in CommodityFutures’, Review of Economic Studies , 27, 3, 139-151.Keynes J.M., 1930, Treati se on Money , London.Kupiec P.H., 1998, ‘Margin Requirements, Volatility and Market Integrity:What have we learned since the Crash?’, Journal of Fi nancial Services Research ,13, 3, 231-255.Lee C.I., and H.C.Tong, 1998, ‘Stock Futures: the effects of their Trading on theUnderlying Stocks in Australia’, Journal of Mult inational Financial Management , 8,285-301.Moriarty E.J., and P.A.Tosini, 1985, ‘Futures Trading and Price Volatility of GNMACertificates – Further Evidence’, Journal of Futures Markets , 5, 633-641.Securities and Exchange Commission, 1988, ‘The October 1987 Stock MarketBreak’, Division of Market Regulation, February.Nabar, P.G., and Park, S-Y., 1989, ‘Options Trading and Stock Price Volatility’,New York University Salomon Brothers Center Working Paper , 460, April.Simpson W.G., and T.C. Ireland, 1982, ‘The Effect of Futures Trading on thePrice Volati lity of GNMA Securities’, Journal of Futures Market s, 2, 4, 357-366.

Skinner, D.J., 1989, ‘Options Markets and Stock Return Volatility’, Journal of Financial Economics , 23, 1, June, 61-78.Smith C., and R. Stulz, ‘The Determinants of Firms’ Hedging Policies’, Journal of Financial and Quanti tati ve Analysis , 20, 4, 391-405.Sorescu S.M., 1999, ‘The Effects of Options on Stock Prices: 1973 to 1995’,Journal of Finance , forthcoming.Stein J.L., 1961, ‘The Simultaneous determination of Spot and Futures Prices’,American Economic Review , 51, 5, xxx.Stein J.C., 1987, ‘Informational Externalities and Welfare-Reducing Speculation;,Journal of Politi cal Economy , 95, 6, December, 1,123-45.




Stoll H.R., and R.E.Whaley, 1987, ‘Program Trading and Expiration Day Ef-fects’, Financial Analysts Journal , 43, 2, 22-28.Stulz R., 1996, ‘Rethinking Risk Management’, Journal of Appli ed Corporate Fi- nance , 9, 3, 8-24.Wei P., P.S.Poon and S.Zee, 1997, ‘The Effect of Option Listing on Bid-Ask Spreads,Price Volatility and Trading Activity of the Underlying OTC Stocks’, Review of Quanti tative Finance and Accounting , 9, 165-180.Working H., 1953, ‘Futures Trading and Hedging’, American Economic Review ,43, 314-343.Working H., 1960, ‘Price Effects of Futures Trading’,Food Research Institute Stud- ies , I, 1, 3-31.

Working H., 1962, ‘New Concepts concerning Futures Markets and Prices’,Ameri can Economic Review , 52, 431-459.




APPENDIX 2 A DETAILED ANALYSIS OFPRODUCER HEDGE BOOKSProducers in aggregate have a large short position in gold through their deriva-tives book. They also hold both long and short positions in options on gold.What is not immediately clear is whether producers are large net buyers or sellersof options. The question is important because if they are large net buyers of op-tions, banks are likely to be large net sellers of options. In hedging their exposure,they will tend to buy gold after a price rise and sell after a price fall. This hedgingactivity could tend to increase the volatility of the gold price.

The impact on the market is the same whether banks have written put or calloptions; for that reason we do not distinguish between puts and calls in thisanalysis. I t also follows that if producers are large net sellers of options, the effectof bank hedging is the opposite, and it may help to stabilise the gold price.

In this Appendix we examine whether producers in aggregate are net long or shortoptions by taking a snapshot at the end of 1999. There is limited information inthe public domain about the composition of individual producer hedge books.Annual accounts show the nominal size of exposures broken down by broad cat-egory of instrument (put, call, roll ing forward etc), by maturi ty year. The averagestrike for derivatives in each bucket is also normally provided. The informationhas been brought together and updated quarterly by Scotia Capital in its publica-tion ‘Gold and Silver hedging Outlook’. The analysis in this Appendix and in themain report are based on the publication for the fourth quarter of 1999.

The level of disclosure does not make it possible to analyse precisely the effect of the hedge book. Several different contracts may be amalgamated into a singlebucket. Contracts may be complex, and involve features (such as barriers, step-ups and so on) which may profoundly affect the risk characteristics of the con-tract. These features are revealed, if at all, only in the most general way. We willignore these features, and assume in particular that all calls and puts in each timebucket are ordinary European options (exercisable only at maturity), that the

strike prices of all options in the same bucket are the same, and that they allmature mid-year (or in the case of options expiring in 2004 and later, we assumethey expire at the end of 2004). We discuss below how these simplifications mayaffect the conclusions.

The analysis in the main body of the report suggests that gold producers in aggregatebought options on 48.4 million ounces of gold and sold options on 32.5 million ounces(we do not distinguish here between a put and a call because a put option is identical toa call with a short forward position). This broad picture of producers being active onboth sides of the market, while borne out by deeper analysis, is rather superficial.




The simple summation treats all options as equal. But they do not contain similaramounts of optionality. A six month call option with a strike price $100/oz abovethe current spot price is almost certain to expire worthless. I t would not be worthtrying to hedge it. I f the strike is $100/oz below the spot price, it is very l ikely tobe exercised, so the hedging strategy is to buy the gold forward, and not to adjustthe hedge unless the gold price rises very sharply, so a deep-in-the-money optioncontains little optionality. By contrast, the hedge on an option which is close tothe money has to be rebalanced constantly as the price of gold varies. Thusoptionality is greatest for options closest to the money (where the strike is close tothe spot) and the uncertainty about whether it will be exercised is greatest.

The degree of optionality is normally measured by thegamma of the option. This isa number which represents the change in hedge ratio per unit change in the goldprice. Thus one step in doing a deeper analysis is to calculate the gammas of theoptions so that we can compare option contracts on the basis of their optionalityrather than their nominal size.

A second issue is that many producers make use of both long and short positionsin their portfolios. So for example, a producer may buy protective puts, and fi-nance the purchase by writing call options. The overall effect may not in factdiffer very much from selling gold forward at a single price. We break down pro-ducers into two categories: those who are net buyers of options and those who arenet sellers. To do this we take the size (measured in ounces of gold optioned) of allbought option positions in the producer’s hedge book which mature in 2002 andbeyond, and subtract it from the size of written option positions. The reason forlooking only at longer-dated options is that shorter-dated options can be hedgedmore easily into the traded options market.

The result is as follows:

Gamma of Producer Hedge Books at end 1999 1

broken down by net buyers and sellers of options (measured in th oz per $/ozchange in the gold price and in m ozs of at the money options equivalent)

2000 2001 2002 2003 2004+ Totalbuyers 45.4 32.0 3.5 14.1 23.9 119.0(m oz eq) 3.5 4.3 0.6 3.0 6.1sellers 9.3 -8.2 -7.8 -5.9 -22.1 -34.7

(m oz eq) 0.7 -1.1 -1.4 -1.2 -5.6all 54.8 23.8 -4.3 8.2 1.8 84.3

(m oz eq) 4.2 3.2 -0.8 1.7 0.5

1 Vegas were calculated using Merton’s formula, assuming a spot price of $290/oz, a lease rate andinterest rate of 1% and 5% at all maturities, and a volatility of 15%. The conclusions are robust tochanges in these parameters.




The table shows for example that net buyers of options had a long position inoptions with a gamma of 119 thousand ounces. This means that if all these op-tions were written by banks which wanted to hedge themselves, then they wouldneed to buy 119,000 ounces of gold every time the gold price rose by $1/oz (andsell the same amount if it fell by $1/oz).

To give a more familiar measure of exposure, the numbers are also expressed as theequivalent volume of at-the-money options. Thus the table shows that producers’aggregate gamma in options which mature in 2004 or later is 1.8 thousand ounces.This corresponds to a net long position of 0.5 million ounces of at-the-money calloptions with the same maturity.

The table suggests that producers in aggregate are substantial buyers of short-dated options. It also shows that while individual producers may have quite largenet long or short positions in longer dated options, the longs and the shortscancel each other out, leaving a very small net position.

The analysis must be treated with some caution, given the limitations of the data,and the fact that it is a snapshot taken at one moment. The estimates of gamma atthe shorter maturities in particular need to be treated with caution since aggrega-tion into crude buckets can well distort the estimates substantially. But there isno reason to believe that the approximations would increase the apparent degreeof netting across producers, and some reason to believe that it might lead to itbeing understated.

Thus the analysis confirms the thesis in the main report that most of the long-dated volatility exposure in producers hedge books nets out between producers,and little long-dated volatility risk is borne by the banking sector.




APPENDIX 3

THE SIGNATORIES

Oesterreichische NationalbankBanque Nationale de BelgiqueSuomen PankkiBanca d’I taliaBanque Centrale du LuxembourgDe Nederlandsche BankBanque de FranceDeutsche BundesbankCentral Bank of IrelandBanco do PortugalBanco de EspañaSveriges RiksbankSchweizerische NationalbankBank of EnglandEuropean Central Bank

THE PRESS RELEASE

Press Communiqué - 26 September 1999

Statement on Gold

In the interest of clarifying their intentions with respect to their gold holdings,the above institutions make the following statement:

1 Gold will remain an important element of global monetary reserves.

2 The above institutions will not enter the market as sellers, with the exception

of already decided sales.

3 The gold sales already decided will be achieved through a concerted programmeof sales over the next five years. Annual sales will not exceed approximately 400tonnes and total sales over this period will not exceed 2,000 tonnes.

4 The signatories to this agreement have agreed not to expand their gold leasingsand their use of gold futures and options over this period.

5 This agreement will be reviewed after five years.

The Washington Agreement on Gold




No. 1 Derivative Markets and the Demand for Gold by Terence F Martell and Adam F Gehr, Jr, April 1993

No. 2 The Changing Monetary Role of Gold byRobert Pringle, June 1993

No. 3 Utilizing Gold Backed Monetary and Fi-nancial Instruments to Assist Economic Re-form in the Former Soviet Union by Richard WRahn, July 1993

No. 4 The Changing Relationship Between Gold and the Money Supply by Michael D Bordo and Anna J Schwartz, January 1994

No. 5 The Gold Borrowing Market - A Decade of Growth by Ian Cox, March 1994

No. 6 Advantages of Liberalizing a Nation’s Gold Market by Professor Jeffrey A Frankel, May 1994

No.7 The Liberalization of Turkey’s Gold Mar-ket by Professor Ozer Ertuna, June 1994

No. 8 Prospects for the International Monetary System by Robert Mundell, October 1994

No. 9 The Management of Reserve Assets Se-lected papers given at two conferences, 1993

No. 10 Central Banking in the 1990s - Asset Management and the Role of Gold Selected pa-pers given at a conference on November 1994

No. 11 Gold As a Commitment Mechanism: Past,Present and Future by Michael D Bordo, Janu-ary 1996

No. 12 Globalisation and Risk Management Selected papers from the Fourth City of LondonCentral Banking Conference, November 1995

No. 13 Trends in Reserve Asset Management by Diederik Goedhuys and Robert Pringle, Sep-tember 1996

No. 14 The Gold Borrowing Market: Recent De-velopments by Ian Cox, November 1996.

No. 15 Central Banking and The World’s Fi -nancial System, Collected papers from theFifth City of London Central Banking Con-ference , November 1996

No. 16 Capital Adequacy Rules for Commodi-

WGC CENTRE FOR PUBLIC POLICY STUDIES

ties and Gold: New Market Constraint? by HelenB. Junz and Terrence F Martell, September 1997

No. 17 An Overview of Regulatory Barriers to TheWorld Gold Trade by Graham Bannock, AlanDoran and David Turnbull, November 1997

No. 18 Utilisation of Borrowed Gold by the Mining Industry; Development and Future Prospects,byIan Cox and Ian Emsley, May 1998

No. 19 Trends in Gold Banking by Alan Doran,June 1998

No. 20 The IMF and Gold by Dick Ware, July 1998

No. 21 The Swiss National Bank and Proposed Gold Sales, October 1998

No. 22 Gold As A Store of Value by StephenHarmston, November 1998

No. 23 Central Bank Gold Reserves: An histori-cal perspective since 1845 by Timothy S Green,November 1999

No. 24 Digital Money & Its Impact on Gold: Tech-nical, Legal & Economic Issues by Richard WRahn, Bruce R MacQueen and Margaret L Rogers.

No.25 Monetary problems, monetary solutions and the role of gold by Forrest Capie and GeoffreyWood, April 2001

No. 26 The IMF and Gold ( revised) by Dick Ware,May 2001.

Special Studies:

Switzerland’s Gold , April 1999

A Gli ttering Future? Gold mining’s importanceto sub-Saharan Africa and Heavily Indebted Poor Countries, June 1999

Proceedings of the Paris Conference “Gold and

the International Monetary System in a New Era” ,May 2000

20 Questions About Switzerland’s Gold, June 2000

Gold Derivatives: The Market View by JessicaCross, September 2000

The New El Dorado: the importance of gold min-ing to Latin America, March 2001

Available from Centre for Public Policy Studies, World Gold Council, 45 Pall Mal l, LondonSW1Y 5JG, UK. Tel + 44.(0)20.7930.5171, Fax + 44.(0)20.7839.6561. E-mail:[email protected] Website: www.gold.org

gold derivatives the market impact

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