Gold Derivatives: Gold Derivatives: - World Gold Council

WORLD GOLD COUNCIL
Gold
Derivatives:
The market impact
London
Business
School
Anthony Neuberger, London Business School
Report prepared for the World Gold Council, May 2001

123456
Gold Derivatives:
The market impact
May 2001
Anthony Neuberger
Associate Professor of Finance
London Business School
Advisers:
Ian Cooper, Professor of Finance, London Business School
Julian Franks, Corp. of London Professor of Finance, London Business School
Stephen Schaefer, Tokai Bank Professor of Finance, London Business School
Gold Derivatives: The market impact

Gold Derivatives: The market impact by Anthony Neuberger, London Business
School, advised by a Steering Group comprising Ian Cooper, Julian Franks and
Stephen Schaefer of London Business School.
The views expressed in this study are those of the author and not necessarily the
views of the World Gold Council or the London Business School. While every
care has been taken, neither the World Gold Council nor the London Business
School nor the author can guarantee the accuracy of any statement or representations
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 6561
E-mail: cpps@wgclon.gold.org Website www.gold.org
Gold Derivatives: The market impact

CONTENTS
Foreword by Haruko Fukuda, Chief Executive, World Gold Council ....................7
About the author ...........................................................................................8
The steering group .........................................................................................8
Executive summary .....................................................................................9
Chapter 1 The physical gold market ...........................................................15
1.1 Production ...............................................................................15
1.2 Consumption ...........................................................................21
1.3 Investment ...............................................................................23
1.4 Data Issues ..............................................................................28
Chapter 2 The paper market ......................................................................29
2.1 What makes gold special? .........................................................30
2.2 Gold derivative contracts ..........................................................32
2.3 The market ..............................................................................37
2.4 Downstream hedging ...............................................................40
2.5 Speculative traders ....................................................................41
2.6 The banking sector ...................................................................43
2.7 Producer hedging .....................................................................46
Chapter 3 The debate ................................................................................53
3.1 The debate outlined .................................................................54
3.2 The impact of derivatives generally ............................................56
3.3 What is special about gold ........................................................57
3.4 The simple consumption model ................................................58
3.5 Other effects of derivative markets .............................................60
Chapter 4 The empirical evidence ..............................................................63
4.1 The impact of short-selling on the price of gold .........................63
4.2 The impact of hedging policy announcements ...........................68
Chapter 5 The gold lending market and its stability ...................................73
5.1 Scenario 1: A cutback in lending ..............................................74
5.2 Scenario 2: A cutback in demand for borrowing ........................80
5.3 The empirical evidenc from lease rates .......................................82
Gold Derivatives: The market impact 3

4
Gold Derivatives: The market impact

Appendices
Appendix 1
Overview ..............................................................................................87
1 The economic role of forward markets ..............................................88
2 Derivatives and market quality: theoretical considerations ..................95
3 Derivatives and market quality: 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
Gold Derivatives: The market impact 5

6
Gold Derivatives: The market impact

FOREWORD
There has been much debate about the impact of the derivatives market on the
spot market for gold. Some people attribute the decline in the dollar price of gold
over the last decade to the rapid growth of the gold derivatives market. Others
claim that the impact of derivatives has been largely beneficial for the gold market,
improving liquidity and helping efficient risk management.
Despite the extent and often ferocity of this debate, there have been few systematic
studies of this important subject. To rectify this, the World Gold Council
asked Professor Anthony Neuberger, a leading expert on derivatives markets, and
his team from the London Business School, to analyse the arguments, present the
evidence and reach conclusions on these issues.
This study forms the second part of a major research project on derivatives markets
sponsored by the World Gold Council. The first part, ‘Gold Derivatives: The
market view’, by Jessica Cross was published in September 2000 and was widely
seen 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, in
particular her estimate of the size of the lending market.
The World Gold Council is grateful to the London Business School for the considerable
care and effort that has gone into ‘Gold Derivatives: The market impact’.
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 Neuberger
and 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 in
the future.
Haruko Fukuda
Chief Executive
Gold Derivatives: The market impact 7

About the author
Anthony Neuberger is Associate Professor of Finance at London Business School
where he is also Associate Dean of the Masters in Finance programme (full-time).
His published academic research includes work on hedging long-term commodity
exposures using short-dated futures contracts, and the impact of trade disclosure
requirements on market liquidity. Before joining the faculty at LBS in 1985
he worked in the UK Civil Service, first in the Cabinet Office and latterly as a
Principal in the Department of Energy.
The steering group
Ian Cooper is Professor of Finance at London Business School. He has published
many papers in the field of international finance, default risk in financial contracts,
and corporate finance. He has held visiting appointments at the Universities
of Chicago and the Australian Graduate School of Management, and has
served on the editorial boards of a number of academic and practitioner journals.
Julian Franks is Corporation of London Professor of Finance at London Business
School where he has served as Director of the Institute of Finance and Accounting,
and Director of the MBA programme. He has held visiting appointments at
the Universities of North Carolina, Berkeley and UCLA. He has published widely
in the field of bankruptcy, corporate restructuring and corporate control, and has
served 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 and
as Research Dean. He has held visiting appointments at the Universities of Bergamo,
Chicago, Berkeley, British Columbia, Cape Town and Venezia, and has served on
the editorial board of numerous academic journals. He has published widely on
the term structure of interest rates, the pricing of derivatives, financial regulation
and risk management.
8
Gold Derivatives: The market impact

EXECUTIVE SUMMARY
The growth of the derivatives market and its benefits
The gold derivatives market has grown rapidly over the last decade. There are
several ways of measuring the size of a derivatives market. A key measure in the
gold market is the amount of liquidity provided to the market by official sector
and other lending. Official sector lending has quintupled over the last decade,
growing from 900 tonnes in 1990 to 4,710 tonnes by the end of 1999; when the
non-official sector is included, total lending at end-1999 was 5,230 tonnes. This
compares with an average level of new mined gold production of 2,300 tonnes/
year over the same period.
Gold has a very active derivatives market compared with other commodities, but
it is not large compared with the market in financial derivatives. Gold accounts
for 45% of the world’s commercial banks’ commodity derivatives portfolio, but
for just 0.3% of their total derivatives portfolio.
There is little doubt that the growth of the derivatives market has been of considerable
benefit to users individually. Central banks have been able to get a current
income on gold holdings. Gold fabricators have been able to insulate themselves
from the impact of fluctuations in the price of gold on their inventory holdings.
Hedging has enabled producers to develop new mines using project finance. Speculators
too have benefited by being enabled to take long or short positions in the
gold market efficiently.
The impact of the derivatives market on spot supply
There is a concern that whatever benefits derivatives have brought to the individual
user, they have come at a heavy collective price. In insulating themselves
from future price falls or in speculating that the price would decline, users of
derivatives have encouraged the very thing against which they seek protection.
Whether this is correct, and we discuss the issue at length, it is clear that the
derivatives market has had an impact on the physical supply of gold.
Transactions in the derivatives market, whether they are motivated by the need to
hedge future production, or to hedge the risk of holding gold in inventory, or
simply by speculation, tend to be seller initiated. The other party to the transaction
– typically a commercial bank or some other intermediary – will seek to
hedge its exposure to the gold price by selling in the spot market (normally borrowed
gold). The sale of gold in the forward market therefore generally leads to a
sale in the spot market.
Gold Derivatives: The market impact 9

When the derivative contract matures, the spot market hedge is removed, and the
bank buys back the gold. Thus the effect of hedging by producers and fabricators
is to bring forward or accelerate sales in the spot market. The volume of sales
brought 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 contracts
being offset by the maturing of old contracts, the effect on the spot market is
neutral. But over the decade of the 1990s the amount of hedging increased rapidly,
with much of the increase occurring in the second half of the period. The net
short 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 derivative
markets, holders of gold increased their lending of gold to the market by
some 4,000 tonnes. The presence of this gold increased physical supply. The
volume is significant, being equal to around 12% of non-investment demand for
gold over the same period.
The impact of accelerated supply on price
The derivatives market does give rise to accelerated supply. The key issue is what
impact this accelerated supply has on the spot price. Physical demand and supply
must match each period. New mined supply is inelastic in the short term. The
impact of accelerated supply depends entirely on how demand responds to price.
One view is that demand each period responds to the price level in the way it does
with most consumable commodities. The incremental supply depresses the spot
price sufficiently so as to create the additional demand which will absorb it. The
price impact can be computed using a price elasticity of demand in the conventional
way.
Analysis on these lines suggests that the spot price of gold may have been depressed
on average by something of the order of 10-15% below the level which it
would otherwise have attained over the decade. This model goes on to predict
that 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 the
gold market also suggests that central bank net selling, which added about 3,000
tonnes 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 significant
role alongside the 4,000 tonnes from the derivatives market.
However, there are reasons, both theoretical and empirical, for believing that this
model greatly overstates the impact of the accelerated supply. It ignores the fact
that gold is held as a store of value and an investment as well as bought as a
10
Gold Derivatives: The market impact

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 perspective,
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 newly
mined gold. Net investment demand for gold, like that for any other investment
good, will be sensitive, not so much to the level of the gold price, but to small
variations in the expected rate of return from holding it.
If accelerated supply does depress the spot price, and if the depression is temporary
because the size of paper short positions is not expected to increase indefinitely,
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 investors
should see the temporary depression in the gold price as a buying opportunity.
This increased investment demand would offset at least in part the accelerated
supply from the paper market.
The theory suggests the impact of accelerated supply on the price should be
limited. The empirical evidence broadly supports this position. We find no
correlation between quarterly changes in the paper short position (as measured
by the aggregate short position of gold producers) and changes in the spot
price of gold. We looked to see whether the gold price rises when a gold
producer announces a reduction in hedging and falls when an increase is announced.
While such an effect is visible in the data, it is only marginally
significant statistically.
While the evidence both theoretical and empirical is not conclusive, it does suggest
that the accelerated supply due to increased forward selling in the last
decade probably did depress the gold price, but the magnitude of the effect is
much too small to explain all the real decline in the gold price seen over the last
decade. The lack of transparency in the gold market may have led to an exaggerated
sense of the role played by derivatives in the decline. Market participants
may have interpreted transactions generated by hedging demands as one component
of a very much larger speculative order flow, and this may have had an
impact 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 impact
on the spot market apart from through accelerated supply. The existence of the
derivatives market is likely to affect the behaviour of those who use it, and therefore
indirectly affect the spot market. These indirect effects of derivative markets
tend to increase both demand and supply for gold. Their impact on the spot price
is ambiguous.
Gold Derivatives: The market impact 11

Owners of gold can use the derivatives market to get extra income from their
holdings. Derivatives greatly widen the range of strategies available, particularly
to large holders, for managing their gold holdings. By increasing flexibility and
return, 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 involved
in downstream activities (refiners, fabricators and distributors). By reducing the
costs and risks associated with holding of large stocks, it allows the widespread
distribution and availability of gold and thus facilitates the marketing of gold to
customers.
Derivatives also reduce the cost of capital for producers, and so tend to encourage
production. Project finance for new mines is often conditional on output being
sold forward. There is evidence that producers who have sold their production
forward 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 physical
possession of their gold is important but for others the convenience yield on
holding 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 stable
relative to other commodities. Without that, there would be no long-term forward
market. Forward prices and spot prices would decouple. Producers would
be 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 than
a few months ahead. The amount of hedging would fall. The derivatives market in
gold would resemble much more closely that in other commodities.
The future stability of the derivatives market depends on the continuing readiness
of the official sector to lend its gold. Most lenders lend their gold for relatively
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 the
supply 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 lenders
are close to their current lending limits.
For example, if a number of central banks decided to withdraw their gold from
the market, it would cause a serious squeeze. Lease rates and spot prices would
rise sharply as borrowers tried to repay their loans. A large and sustained rise in
lease rates would cause substantial losses to producers who have sold gold forward
and retained the lease rate risk, to fabricators and distributors, and to commercial
12
Gold Derivatives: The market impact

anks who are active in the market. The rise in lease rates and spot prices would
attract 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 was
caused 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 the
market has perceived little risk of a crisis in the lending market. Had the perceived
risk been substantial, this should have manifested itself through a spread
or security premium between short- and long-term lending rates. The evidence
suggests that term premia in the gold lending market have been no higher than
they are in the (US dollar) money market.
It is indeed hard to visualise circumstances under which several lenders decide to
withdraw their gold from the market simultaneously. Credit risk is not a major
concern since most of the borrowers are major commercial banks for whom gold is
only a small part of their portfolio. It is unlikely that many holders of gold will
decide to sell their gold at the same time, and seek to recover their lent gold for
that reason. They also have an interest in acting in a way which maintains an
orderly market.
Concerns have also been expressed about the consequences for the derivatives
market of a sudden reduction in the size of producer hedging books. However,
there seems little reason for a concerted withdrawal from hedging, and indeed it
would be very costly for individual producers to cut back their hedge book at the
same time as others are doing it. So while it is possible that a sharp rise in the gold
price could lead to the sudden liquidation of short positions, it is unlikely to be
on 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 gold
derivatives market is likely to slacken or indeed reverse. The Cross report estimates
that, given current policies, the scope for additional official sector lending
is 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 in
new mining developments. There is no reason why hedging demand downstream
should grow other than broadly in line with any increase in demand. The main
contingent factors which will determine the size of hedging demand in future
will therefore be the level and volatility of lease rates, and expectations about
future returns on holding gold.
Gold Derivatives: The market impact 13

The level and volatility of lease rates is likely to have a significant impact in demand
for hedging. Higher lease rates increase the cost of holding inventory, and
therefore tend to depress downstream demand for hedging. Greater volatility in
lease rates reduces the effectiveness of long-term hedges by making them more
risky, 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 in
giving holders of gold the possibility of earning income on their gold holdings
and managing them more flexibly;
2) the rapid growth of the derivatives market over the last decade has accelerated
the physical supply of gold, and probably led to the gold price being somewhat
lower than it would otherwise have been, but the magnitude of the effect
is much too small to explain all the real decline in the gold price seen over the
last decade;
3) the supply of liquidity from increased central bank lending has been indispensable
to the growth of the derivatives market. The constraints on lending under
the Washington Agreement, together with weakness in demand for borrowing
gold, 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 derivatives
will not provide accelerated supply to the spot market in the future, and whatever
impact this has had on the gold price in the past should be reversed.
14
Gold Derivatives: The market impact

CHAPTER 1 THE PHYSICAL GOLD
MARKET
This chapter describes the various elements of the physical market and their characteristics.
The main points made are:
· most of the gold which has ever been mined has been accumulated rather than consumed;
much of it could return to the market again. The level of production, though
it has increased substantially over the last century, at 2,500 tonnes/year, is small
compared with the stock of gold already produced (estimated at 140,000 tonnes).
Production 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 production. 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 expectations about future returns from
holding gold as well as on the current level of the price. Income, cultural and social
and other factors are also important determinants (1.2).
· private investment holdings of gold are substantial (around 25,000 tonnes). Investment
demand is sensitive to economic conditions in the Middle and Far East where it
is most widely held, and to confidence in the financial system. Net investment demand
is likely to be much more sensitive to expectations 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 possibility of future sales have been a
major influence on the market in the second half of the 1990s (1.3).
1.1 Production
Gold has been mined since time immemorial, but levels of production have increased
rapidly since the mid-1800s. At the beginning of the twentieth century,
total production amounted to 450 tonnes per year 1 . By the end of it, production
exceeded 2,500 tonnes/year 2 . With this growth in production, more than a third
of all the gold that has ever been mined has been extracted in the last thirty
years 3 .
The comparison of production levels with the total quantity ever produced is
relevant to gold in a way that is quite unlike other commodities. Most 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 historical 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.
Gold Derivatives: The market impact 15

0
Tonnes
2500
Gold Production Annual Average 1900-1999
2000
1500
1000
500
0
1900-04
1905-09
1910-14
1915-19
1920-24
1925-29
1930-34
1935-39
1940-44
1945-49
1950-54
1955-59
1960-64
1965-69
1970-74
1975-79
1980-84
1985-89
1990-94
1995-99
Source: Central Bank Gold Reserves, Timothy Green; Gold Fields Mineral Services
basis of its gold content, and is as much a potential source of supply of gold to the
market as newly mined gold.
Over the long term the rise in gold output can not be attributed to a rise in the
real price of gold since the real price has shown no clear trend over time. New
discoveries, the effective opening up of new areas and countries to prospecting
and production, and innovations in technology have been the long-term factors
underpinning the increase. Nevertheless fluctuations in the real price of gold have
affected, after a time-lag, output in the medium term.
600
Gold Price 1900-2000
500
400
Us$/oz
300
200
100
0
1900
1905
1910
1915
1920
1925
1930
1935
1940
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
Source: Bannock Consulting, World Gold Council
The fall in production during the First World War and after reflected the disruption
due to the war and its aftermath together with the fall in the real price as
many countries attempted to return to the gold standard afterwards at pre-war
gold prices despite intervening inflation.
16
Gold Derivatives: The market impact

60.00
The Real Price of Gold 1900-2000
in 1900 $
50.00
40.00
30.00
20.00
10.00
0.00
1900
1907
1914
1921
1928
1935
1942
1949
1956
1963
1970
1977
1984
1991
1998
Source: Bannock Consulting, World Gold Council
The rise in the gold price to $35 per oz in 1934 caused a surge in production
until the disruption of the Second World War. Production grew slowly during the
1950s and 1960s but with the price fixed at $35 per oz growth was restrained
once again by a decline in the real price. The consequent lack of exploration
meant that output fell during the 1970s, despite the price explosion, as existing
mines were exhausted; while exploration was resumed the time lag between exploration
and production meant that it was not until the 1980s that this was
reflected in a rise in output. During the 1980s and 1990s output was on a largely
uninterrupted 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 substantial
improvements in exploration, drilling and mining techniques with the
most important innovation being heap leaching. This permitted economic extraction
of gold from low grades of ore which would previously have been considered
as waste. In addition a more welcoming attitude of many developing countries
to foreign direct investment, coupled with improved economic management,
meant that they started to offer a viable operating environment for international
mining companies enabling their gold and other mineral reserves to be exploited.
Together the innovations in technology and the improved operating environments
in many countries meant that over recent decades the number of gold producing
countries has expanded significantly. In 1970 South African output reached its
peak 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 still the largest producer but relatively high costs
and the mining out of earlier discoveries had reduced output to 450 tonnes, 17%
of (much increased) world production. In contrast the next larger producers saw
substantial increases in production between 1981 and 1999: US output up 677%;
Australian up 1545% Canadian up 198% and Chinese up 195%. There has also
been rising output from developing countries as the business environment in
many of these improved.
Gold Derivatives: The market impact 17

Breakdown of Production in 1968
Latin America 2% 6% Rest of World
Asia 3%
USA 3%
Cananda 6%
Total Production =
1,450 Tonnes
USSR
13%
67%
South Africa
Source: Gold Fields Mineral Services
Breakdown of Production in 1999
Total Production =
2,571 Tonnes
Rest of World
20%
17%
South Africa
Other Latin America
10%
13% USA
Peru
5%
Russia
5%
12%
Australia
6%
Indonesia
6%
China
6%
Canada
Source: Gold Fields Mineral Services
The rise in output in the 1980s and 1990s has, however, halted with output in
2000 expected to be close to, or even slightly below, that in 1999. In part this is
due to the increase in output generated from the exploration of the 1970s and the
technological improvements coming to a natural end. But the more serious factor
is the effect of the fall in the real price of gold in the 1990s, a fall which was
accelerated (at least in dollar terms) from the second half of 1996 when the nominal
price plunged as well. This has restricted output and resulted in a sharp
decline in exploration.
18
Gold Derivatives: The market impact

Gold Exploration Expenditure 1997-1999
$billion % Change
1997 2.62
1998 1.56 -40.6
1999 1.09 -30.3
Source: Calculated from Metal Economic Group as reported in the
Financial Times, 6 January 2000
The unfavourable price trends of the second half of the 1990s did not result in an
immediate fall in output although the growth in output was less buoyant than it
would 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 gold
falls below marginal production costs, and the situation appears to be permanent,
the mine can be closed. But closure brings forward termination and reclamation
costs which may be large. It is therefore most attractive for mines which are anyway
reaching the end of their reserves.
But there is much that can be done short of closure. Production can concentrate
on the highest quality, most accessible reserves. Economic pressures may make it
easier to cut costs. According to Gold Fields Mineral Services Ltd (GFMS) 4 , average
cash costs of mining in the Western world have fallen by some 22% in dollar
terms over the last two years although some of this is due to the fall in the currencies
of key producer countries relative to the dollar. And the increasing ability to
hedge future output has also improved the financial conditions of mining companies
and hence helped to cushion marginal production. Use of such methods by
mining companies meant that output only ceased growing in 2000.
Gold Price, Total Costs and Cash Costs *
450
400
Gold Price
350
300
Total Costs
250
200
Cash Costs
150
100
1991 1992 1993 1994 1995 1996 1997 1998 1999
* weighted average of mining cash and total costs.
Source: Gold Fields Mineral Services
4 Gold Survey 2000, GFMS, London, 2000.
Gold Derivatives: The market impact 19

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 last
four years of the decade, are only now starting to cause a fall in output. In the
other direction, when exploration has been sharply cut it takes at least 7-8 years
for a rise in price to generate not just exploration but the subsequent exploitation
of the results, let alone sufficient new output to compensate in addition for the
exhaustion of existing mines.
Gold is found in a variety of geological formations and, to varying degrees, in all
continents. 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 economically
exploitable at current prices and with current technology – are to a large degree,
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 and
the cutback in exploration.
Throughout this section – and necessarily through most of this report – the
analysis has concentrated on the dollar price. While it is convenient to describe
the price of gold in nominal or real US dollars, this is not necessarily the appropriate
measure for producers and consumers outside the US. With the very substantial
changes in real exchange rates that have been experienced over the last few
years, the real price of gold as seen by a South African miner, or an Indian buyer
of 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 national
currency gold price. However the real price of gold has fallen since 1990 in
all 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 a
fairly stable level since. In Australia the real price fell at the beginning of the
decade, recovered in 1993, then fell until September 1999 after which there
has been a very limited 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.
20
Gold Derivatives: The market impact

Real Price of Gold in USD, CAD, Rand, and AUD
140
130
120
110
100
90
80
70
60
50
Rand
USD
AUD
CAD
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Source: World Gold Council
1.2 Consumption
It is common to distinguish between consumption and investment demand for
gold, but it is important to understand that the distinction is blurred. In conformity
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 following
section, while all jewellery uses are treated as consumption and discussed in
this section.
Consumption of gold also differs according to type. Some of the gold used in
industrial and dental applications will not be salvaged and thus be truly consumed.
In 1999, these uses accounted for around 400 tonnes per year 5 . Electronics
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 which
are often highly price competitive have meant that the use of gold has not kept
pace with the growth in the output of electronics products despite gold’s effectiveness
and reliability as an conductor of electricity. In 1999 dentistry demand
was 65 tonnes, up marginally from 62 tonnes in 1990. Other industrial and
decorative applications were estimated to be responsible for 102 tonnes, up from
73 tonnes in 1990.
5
Gold Survey 2000, Gold Fields Mineral Services, London, 2000.
6
Gold Survey 2000, Gold Fields Mineral Services, London, 2000.
Gold Derivatives: The market impact 21

Of the approximately 140,000 tonnes of gold which has been produced it is
estimated that around 67,000 tonnes is in the form of jewellery 6 . However, the
term jewellery covers a wide range of products with different characteristics varying
from market to market. In Asia and the Middle East much gold jewellery is
high carat with a low mark-up. Such jewellery can readily be converted back into
gold. In western developed markets gold jewellery is normally lower carat with a
much higher mark-up to cover the cost of design and distribution. Such items are
less readily convertible back into pure gold.
Distribution of Global Above-Ground Gold (Tonnes)
Other
Fabrication
(15,700)
Unaccounted
(1,300)
Above-ground Stocks,
end-1999 = 140,000
Private
Investment
(25,200)
Jewellery
(67,300)
* Excluding lent gold
Official Holdings*
(30,500)
Source: Gold Fields Mineral Services
While jewellery in western developed countries is primarily bought purely as
adornment, the high carat jewellery of Asia and the Middle East frequently has a
dual 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 particularly
important for the poorer and rural populations, who often do not have access to,
or trust in, bank accounts and more sophisticated financial instruments; or who
may wish to save in a medium other than their national currency. It is also particularly
important to women in a number of cultures. Gold jewellery is considered
the woman’s personal property and therefore is her safeguard against divorce
or other misfortunes. Gold giving is often therefore associated with weddings.
Demand for such gold is affected in the short term by price movements but less
in the long term; indeed the savings characteristic of gold means that a long-term
rising trend in the price against the national currency will not deter purchase. As
well as price and social and cultural factors gold demand is normally elastic with
respect to incomes, rising as incomes increase (indeed studies suggest gold is
more income than price elastic). As in the case of production, movements in the
real price of gold have varied substantially between consuming countries. China
and a number of key consuming countries in the Middle East have exchange rates
fixed in effect to the dollar, with occasional devaluations.
22
Gold Derivatives: The market impact

Real Price of Gold in Selected Key Gold
Consuming Countries
150
1995=100
130
Turkey
110
90
USA
70
Italy
50
Source: World Gold Council
280
230
Real Price of Gold in Selected Key Gold Consuming
Countries
1995=100
Indonesia
180
Japan
130
80
India
China
30
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Source: World Gold Council
Although scrap is normally treated as a source of supply, it is more natural to
cover 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 to
be used in another piece of jewellery. Other things being equal a rise in the national
price of gold normally increases scrap supply. One result of the Asian crisis
in 1997/98 was a substantial temporary rise in the amount of scrap from affected
countries, partly as distress sales and partly as a result of a sharp rise in the national
Gold Derivatives: The market impact 23

price of gold following substantial currency depreciation. The most spectacular
increase was due to the national gold collection campaign in South Korea
where citizens were encouraged to turn in their gold in exchange for national
currency bonds.
1.3 Investment
Investment demand can be split broadly into two, private and public-sector
holdings.
Private sector holdings come in the form of bars and coins. Unlike jewellery, which
is 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 incorporated
into jewellery. According to GFMS, private investment holdings amount to just
under 25,000 tonnes, a figure that has been growing slowly over time. More
interestingly 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 Western
investors, the overwhelming majority is now thought to be held in other parts
of the world.
Reasons for holding physical gold vary widely. In markets with poorly developed
financial systems, inaccessible or insecure banks, or where trust in the government
is low, gold is attractive as a store of value which is portable, anonymous and
readily marketable anywhere. In countries with a stable political and financial
system, the prime attraction of gold is as an investment which has very low, or
negative, 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 primarily as an investment asset, it does not need to be held in
physical form. The investor could hold gold-linked paper assets or could lend out
the physical gold on the market. While proper discussion of the gold lending
market 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 holding
physical gold. In addition he will save on the storage costs.
Investors who hold their gold with a bank in unallocated form (where they have a
claim on the bank for a fixed quantity of gold, but they have no claim to specific
bars) allow the bank to lend out ‘their’ gold. The bank normally retains any
interest on lending the gold, but passes on some of the benefit to its customers by
remitting storage charges.
24
Gold Derivatives: The market impact

Around 35,000 tonnes of gold is held by the official sector, the bulk of it being
with central banks or national treasuries, but with substantial amounts also held
by international agencies. The reasons normally given for holding gold as a reserve
asset are varied – it is not a claim on another state and is therefore not affected by
the actions of any other state; it increases public confidence in the currency in the
way that foreign currency reserves may not; in extremis it may retain its value
better than foreign currencies; as returns are little correlated with other reserves
holding a certain quantity may improve the risk/return trade-off of the reserve
portfolio as a whole. On the other hand, it is an asset which pays little or no
interest, and whose price has not performed particularly well in recent years.
40000
Total Official Sector Gold Holdings, 1970-1999
(Tonnes)
Developing
countries
Other developed
countries
35000
30000
25000
North America
20000
15000
10000
Western Europe
5000
0
Institutions
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
Note: From 1978 to 1998 EU member countries deposited 20% of their gold with the European
Monetary Institute in exchange for ecus. In January 1999, eurozone members transferred a total 747
tonnes 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 absolute
quantity and as a proportion of their total external reserves. Gold holdings
twenty years ago are a good predictor of a central bank’s holding today 7 . The
stability has been particularly marked among the larger holders - including the
United States, Germany, the International Monetary Fund and France. There
have been substantial sales, most notably by Argentina, Australia, Belgium, Canada,
the Netherlands, Switzerland and the UK. There have also been confirmed buyers,
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 to
be many gold sales and purchases by central banks that are never publicised, and are not included in the
data.
Gold Derivatives: The market impact 25

y the way in which reserves are viewed nationally, and the way in which decisions
on reserve policy are taken, and also by the very large size of reserves relative
to the underlying flow of production and consumption.
1998 tonnes
10,000
1,000
Central Bank Gold Holdings, 1978 and 1998
(Logarithmic Scale)
Dots above the line
represent countries whose
reserves rose between 1978
and 1998
100
Dots below the line
represent countries whose
reserves fell between 1978
and 1998
10
1
1978 tonnes
1 10 100 1,000 10,000
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 substantial
official sector sales are thought to be one of the main factors behind the
fall in the gold price since late 1996 – fears given credence by a small number
of 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 major
factors behind the extreme weakness of the gold price, which fell to $252/oz in
August 1999.
26
Gold Derivatives: The market impact

Largest Official Gold Holdings (end 2000)
Tonnes Gold as a % of foreign exchange
holdings
1 United States 8,137 57%
2 Germany 3,469 35%
3 IMF 3,217 n/a
4 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%
Source: IMF, World Gold Council
The price subsequently recovered in September 1999 after the announcement
of a pact between fifteen central banks 8 to limit sales and lending, widely
known as the ‘Washington Agreement on Gold’ (See Appendix 2). The signatories
held between them about half of all official gold, and other large holders,
such as the United States, IMF and Japan, unofficially associated themselves
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.
Gold Derivatives: The market impact 27

1.4 Data issues
Published statistics on certain areas of physical supply and demand are well developed
but there remain gaps such as inventories, the extent of private institutional
gold holdings, and the extent of below-ground reserves. Analytical problems
arise from informal or illegal activity. Some mining is still carried out by
individuals, notably in Latin America and Africa, and their activity is difficult to
track. Gold is easy to smuggle since small quantities have high value. Smuggling
is generally declining as the gradual liberalisation and reduction in taxes underway
in many countries make it less worthwhile but where taxes are high or the market
heavily 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 as
inventory. Gold which is produced at the minehead does not immediately turn
into jewellery around the neck of a customer. Quite substantial amounts of gold
are held as inventory at various stages of the process and data on quantities do not
exist. The existence of this stockpile is important because of its sensitivity to gold
lease rates. So long as lease rates are very low, it is neither expensive nor risky to
hold substantial quantities of gold in inventory because the gold can be borrowed
cheaply. If lease rates were to rise sharply (and we consider this possibility in more
detail later in the report), the immediate sources of additional supply of physical
gold would be from these inventories.
28
Gold Derivatives: The market impact

CHAPTER 2 THE PAPER MARKET
The chapter describes the nature and operation of the derivatives 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. In part this is because of the very
qualities which made it so widely used as money – its high value per unit weight, its
indestructibility, the ease with which its quality can be standardised and verified. But
more important than this has been the existence of large stocks of gold, and the
readiness of its owners – largely in the official sector – to lend it. The availability of
abundant stocks for borrowing at low and generally stable rates, has made it possible
to design derivative products which meet the requirements of producers, fabricators,
speculators and other market participants (2.1).
· the most important derivative product is the forward contract. A forward sale is
equivalent to borrowing gold, selling it on the spot market, and depositing the sale
proceeds in a bank account. The forward dollar price of gold is 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 derivatives traded. Modern option pricing
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 price (2.2.2).
· the exchange traded market COMEX provides a good indication of sentiment. But
most derivatives trading takes place over-the-counter (OTC). The notional value of
banks’ derivative position in gold, though large relative to their other commodity
exposures, does not look large relative to derivative positions in other financial markets.
The evidence is consistent with 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, refiners and wholesalers)
the benefits of being able to borrow gold are straightforward. Their profit margins
are low relative to the value of gold inventory they hold, and can easily be wiped
out by adverse price movements. Borrowing gold, or financing their inventory through
gold linked 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 risks facing a short seller of commodities is a squeeze in the cash market
which raises borrowing rates for the commodity steeply, and thus forces premature
and costly liquidation of a potentially profitable position. In the case of gold, the
existence of substantial stocks available for lending makes borrowing costs fairly predictable
and a squeeze unlikely (2.5).
· commercial banks perform the standard economic functions of a financial intermediary
in any market. They manage the mismatch between lenders and borrowers –
Gold Derivatives: The market impact 29

mismatch of maturity, of lending rates and of credit. They also design and create
complex structures which they hedge into the market. While they do take risk, they are
not well set up to take market risk (e.g. on the level of the gold price) and are likely
to hedge much market risk back into the market (2.6).
· the derivative markets provide producers with a rich array of risk management instruments.
Risk management has a number of different objectives – hedging value,
hedging earnings 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 heavily by
management’s view of the likely profitability of the transaction (2.7.1).
· accounting rules affect the size and composition of hedge books. While the newly
introduced US Accounting Standard (FAS133) will probably not affect the amount
of hedging, it may well influence the instruments used. Cash flow and financing
considerations will limit the size of hedge books for more highly leveraged producers
(2.7.2-3).
· the complexity of individual producer hedge books and their long maturities may give
a misleading idea of the economic impact of producer hedging as a whole. Much of
the optionality nets out; over-simplifying somewhat, the options bought by one producer
are effectively written by another producer, albeit with slightly different terms.
The long maturities of producer hedge books are more of a reflection of an accounting
decision to defer recognition of the profits 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 fairly well reflected by the
effective short position 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 producers
routinely sell their output five years ahead or more. According to the Bank
for International Settlements, gold derivatives account for 45% of the commodity
derivatives exposure of banks in the G10 countries. What features make
gold so special?
Gold has certain qualities which have made it synonymous with money for many
generations, and these go some way to explaining the flourishing derivatives market.
Gold is valuable – 50,000 times as valuable tonne for tonne as oil for example
– and does not deteriorate over time. Quality is easy to verify, and it is cheap to
transform one traded form into another. Costs of storage and transport are small
when expressed as a percentage of value. This means that the gold market is a
single integrated market, with price differentials for location or quality being far
less 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
30
Gold Derivatives: The market impact

proportionate effect on the value of the inventory of a Far Eastern jeweller. Shocks
in 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 contract;
liquidity is pooled.
But at least as important has been a second distinguishing feature of gold: the
extent of above ground stocks, and the reasons for which they are held. In other
commodities stocks are held either because they are necessary work in progress, or
as a safeguard against a future shortage. The holders of these stocks place substantial
value on having physical possession of the commodity. As the likelihood of a
shortage 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 most
commodities is extremely volatile.
Gold is different. For many holders of gold, physical possession of the metal is not
important. The difference between possession of the gold and a warrant giving
entitlement 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 holding
physical gold – is low or even slightly negative once storage costs are taken into
account.
For other holders of gold, both in the official sector and the private sector, physical
possession is central to the reason for holding gold. They want to hold gold
precisely because it is an asset which is no one else’s liability, and this advantage
would be lost by lending the gold.
The behaviour of the gold lending market over the course of the 1990s suggests
that 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 insensitive
to the level of lease rates. But it does take time for a new policy to be put in
place, or for an existing policy to be revised. Whether it is reasonable to expect
gold interest rates to remain as low and stable in the future as they have been in
the past is a matter we turn to later (in Chapter 5). But, as we will argue in the
next section, it is the stability and predictability of gold interest rates that has
underpinned the development of the paper market and the growth in particular
of very long-dated contracts.
Gold Derivatives: The market impact 31

2.2 Gold derivative contracts
The variety and complexity of derivative products and hedge books is considerable.
They are designed to achieve a variety of objectives – economic, financial,
accounting, regulatory. In this section we focus particularly on the economic analysis
of these products. We look at the types of risk which are transferred from the
buyers of derivatives to the sellers. We show that, however complex the structure,
the main gold specific risks which are transferred can be decomposed into spot
gold price risk, gold interest rate risk and gold price volatility risk. In addition
gold derivatives often transfer currency interest rate and exchange rate risks, but
these risks are of less relevance to this study.
The simplest derivative contract is the fixed price forward contract. After showing
how it can be decomposed into a spot transaction and gold and cash borrowing
and lending, we consider the nature and magnitude of the risks transferred between
the buyer and the seller. Then we extend the analysis to more complex
products such as options, and examine the link between complex derivatives and
trading 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 quantity
of the commodity at some fixed price and date to a second party. The party who
is 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 spot
market and investing the cash proceeds.
So for example a producer who wants to sell 1 million ounces of gold forward one
year, when the spot price is currently $300/oz, could instead search for an investor
who has gold and is prepared to lend 1 million ounces for one year at a cash
interest rate of 2%. The producer borrows the gold and sells it on the spot market.
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 the
investor 1 million ounces of gold and $6m interest to repay the loan. The net
effect is that the gold producer hands over 1 million ounces of gold in one year’s
time, and receives cash of $321 - 6 = $315 million. The producer has created a
synthetic forward contract at $315/oz. The forward price is the spot price plus
the dollar interest rate, less the gold interest rate.
The equivalence of the two transactions is important because it ties the forward
market to the gold lending market. With a deep and liquid gold lending market
32
Gold Derivatives: The market impact

there is a deep and liquid forward market, going out at least as far as the gold
lending 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. The
existence of a long-term gold forward market in the absence of a long-term gold
lending market depends on the expectation that gold interest rates will remain
low and stable.
To see this, suppose the producer wants to sell gold five years forward, and
the gold lending market only extends one year. He decides to create a synthetic
forward contract by borrowing the gold for one year at a time, using
the new gold loan to pay back the old. The final price he gets for the gold will
equal the initial 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 unpredictable,
the price is very uncertain. But the uncertainty about the average level
of the one year gold interest rate over the next five years is probably of the
order 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 using
the short term lending market, and thereby get rid of the great bulk of the
price 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 who
wants to buy the gold forward five years, the bank will hedge its risk by short
term gold borrowing. The bank then takes on the risk that gold interest rates will
rise. A producer who wants to sell production forward therefore faces a choice: he
can pass the gold lease rate risk on to the bank and get a fixed price forward
contract, or he can accept a forward contract where the price is adjusted in line
with lease rates, and he bears the lease rate risk. The fixed price deal will probably
prove more expensive since long-term lease rates are on average higher than shortterm
lease rates.
Whether the bank writes a contract with a fixed lease rate, taking on the lease rate
risk, 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 gold
interest rates are so stable, that it makes sense to do the transaction at all in the
absence of a long-term forward buyer of gold. Were gold interest rates as volatile
as oil interest rates, the final price on a long-term floating lease rate forward sale
contract would be so uncertain that it would be quite ineffective in hedging future
revenues. The premium a bank would charge to offer a fixed rate deal would
tend to be so large as to make hedging unattractive. It follows that if the gold
lending market were expected to become much more volatile, the long maturity
derivatives market would shrink.
Gold Derivatives: The market impact 33

The value of a forward contract
A forward contract written at market prices has zero financial value initially. Someone
who has sold production forward can negate the contract either by cancellation
or by buying gold forward on the same terms. But as time passes, and the
gold spot price and gold and dollar interest rates move, the forward price of gold
changes 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 this
change in value may not seem significant. Any change in value of the forward
contract 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 forward
contract is important. First, it represents the effect of hedging as opposed to not
hedging. Second, it may create financing problems. Suppose the forward price
has risen since the inception of the contract, so the hedge is loss-making from the
producer’s perspective. From the bank’s perspective, the contract with the producer
is now an asset, while the hedging transaction it has entered into to offset
the risk is an equal and opposite liability. If the producer were to get into financial
difficulties and be unable to honour the forward sale, the value of the contract is
the amount which the bank stands to lose. To protect itself, the bank may demand
margin (a financial payment on account), or collateral (the posting of some
asset 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. It
is far easier and cheaper to buy gold forward and then sell it than it is to buy a
gold mine and then sell it. It is the low level of transactions costs which allows
producers to modify their hedges rapidly. The value of a forward sale contract can
be 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 market
conditions, consider the case of a producer who has sold gold forward five years at
a fixed price when the spot price is $300/oz, and gold and dollar interest rates are
2% and 7% respectively. The fair forward price is $381/oz. If the spot gold price
rises by $30/oz (a typical annual move) then the fair forward price in five years
rises 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. To
cancel 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 price
had fallen $30/oz, the hedge contract would have a positive value of $27/oz to
the producer.
But it is not only the gold price that can affect the value of the contract. If dollar
interest 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
34
Gold Derivatives: The market impact

goes to +$12/oz. The mark-to-market value of a long-dated fixed dollar rate forward
has a sensitivity to interest rates which is not much less than its sensitivity to
the gold price. If the dollar rate is floating, the sensitivity of value to interest rates
becomes virtually zero, in exactly the same way as the sensitivity of value of a
bond to interest rates is large for long-dated fixed rate bonds, but small for floating
rate bonds.
An increase in the long-term gold interest rate would have an effect similar in
magnitude but opposite in sign to an increase in interest rates. The mark-tomarket
value of a forward contract with a floating gold interest rate would have
virtually 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, the
floating 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 products
which are used by participants in the market. We have argued that long-dated
forward contracts would not exist if they could not be hedged or synthesised
reasonably accurately using the spot and short-term gold lending market. The
same holds true of more complex products.
Hedging options
Consider the case of a producer who wants to buy a put option, giving the right
to sell gold in five years’ time at $300/oz. The bank writing the option will only
be able to offer a good price if it can either find some other party who is prepared
to sell the bank a similar option, or if the bank can hedge itself. Writing the
option and taking the risk on its own books makes no economic sense; the bank
has no advantages and some disadvantages relative to a gold producer in taking
this risk on itself.
To hedge the risk, the bank will follow what is called a delta hedging strategy. The
value 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 $1
change in the gold price causes a $1 change in the value of the put. As the gold
price rises, the chance of the option being exercised falls, so the sensitivity to the
gold price (or delta) is smaller. When the gold price is very high, the put option
is nearly worthless and its price barely changes with the gold price; its delta goes
to zero.
If the bank sells gold forward, and varies the amount with the delta, then it can
ensure that profits or losses on its option position occasioned by movements in
the underlying gold price are offset by profits or losses on its gold forward
Gold Derivatives: The market impact 35

position. In an ideal world, if the hedge is executed properly, the bank should be
perfectly hedged. All the risk that the producer is transferring to the bank is transferred
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 wants
to create a floor on sale proceeds while remaining exposed to the upside could buy
a put option from a bank. Alternatively he could follow a suitable trading strategy
in the forward market. He should sell some of his production forward; as the gold
price rises, he should buy forward, and as it falls he should sell forward. If the
gold price falls sufficiently, he should sell all his production forward, thus locking
in 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 exposed
to 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 buying
a real put option from a bank which will then create a synthetic put to hedge
itself. It is possible to see the producer, through the put option contract, in effect
delegating the operation of the dynamic trading strategy to the bank. Whether it
buys the put options or synthesises it, the net effect on the forward market is the
same. When the position is put on, the producer is directly or indirectly selling a
quantity of gold forward equal to the product of the amount optioned and the
delta. As the gold price rises or falls, the forward sale position declines or increases
with the delta.
Hedge error
In theory, given certain assumptions 1 , the delta hedging strategy works perfectly.
But in practice the assumptions do not hold perfectly, and there can be substantial
hedge error. In particular, the efficacy of the strategy depends on the volatility
in 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, will
be very expensive. A bank which writes a put option and hedges itself prices in a
certain assumption about volatility. It makes a profit or loss on the hedge depending
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 the
buyer 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 short
gold. But both put and call option buyers are buying volatility, for in both cases
the 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 the
currency and the commodity, markets always open, no constraints on borrowing either cash or the
commodity, and the spot price of the commodity following a diffusion process with constant volatility.
36
Gold Derivatives: The market impact

Volatility is not the only factor which gives rise to hedge error. The error is also
affected by the detailed way the forward gold price behaves. Large jumps in the
price for example can throw out the hedge. But volatility is the main determinant
of how well the hedge works.
Although we have looked at the particular example of a simple put strategy, the
same is true of any option, whether a vanilla option like a put or call, or a more
exotic structure such as one where the pay-out is conditioned by the price of gold
hitting some critical level. To every option there corresponds a delta hedging
strategy which replicates the option. The existence of the strategy makes it possible
for the bank to offer the complex option, and also determines the price it must
charge to cover its costs. If the bank is fully hedged into the spot gold market at
all times then the existence of the option gives rise to a corresponding position on
the 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 organised
exchanges. The majority of exchange traded volume is on the New York Mercantile
Exchange (NYMEX) in its COMEX division. Both futures and options are
traded with maturities going out as far as five years for the futures and two years
for the options. Actual delivery consists of the transfer of a COMEX warehouse
receipt. The next largest exchange for gold derivatives is the Tokyo Commodity
Exchange which has about one third the volume of COMEX.
As is typical of futures markets the great majority of contracts are closed out
before delivery. Virtually all trading takes place in the near-dated contracts –
those with up to six months to maturity. Average daily futures volume on COMEX
is some 35,000 contracts, corresponding to 100 tonnes per day or 25,000 tonnes
per 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 over
2,000 tonnes, very high volumes as a result of incessant short-term trading are a
feature of all derivatives markets. A somewhat better indicator of the economic
significance of the market is given by the open interest – the number of contracts
in existence at any one point in time. This averages around 150,000 contracts in
the futures market, or 450 tonnes. It should not be assumed that this means that
there are longs who are collectively long 450 tonnes of gold and shorts who are
collectively short 450 tonnes. Some traders will hold both long and short positions
Gold Derivatives: The market impact 37

(in different maturities) to exploit movements in calendar spreads. Others will
have 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 options
market 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 as
the futures.
A widely followed indicator is the net position of non-commercial traders in the
options and futures market. This is often interpreted as being the aggregate position
of 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 interpretation
is taken at face value then the change in the net non-commercial position represents
a source of supply or demand for gold. Since annual swings in the net position
rarely 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.
Speculative Positions and Gold Price
Net positions on COMEX
Contracts '000s
70
Long
50
30
10
-10
-30
-50
Contracts
Gold Price
US$/oz
410
390
370
350
330
310
290
-70
Gold price
Short
-90
Jan-97 Jan-98 Jan-99 Jan-00
270
250
Source:CFTC/World Gold Council
It is noteworthy that the volume of gold futures trading on COMEX, measured
in contracts, has not changed significantly over the last decade. It has not been
affected 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-thecounter
market. The Bank for International Settlements produces a report on the
38
Gold Derivatives: The market impact

aggregate derivatives position of the major banks in the G10 group of countries at
the end of each half year. Gold derivatives are separately identified.
The report shows that the notional value of outstanding contracts in gold at end
June 2000 was $262 billion. This corresponds to about 27,000 tonnes of gold.
The notional value of outstanding contracts is a similar concept to the open interest
in an exchange traded market. It gives no indication of the net long- or shortposition
of the banking sector. But it does highlight the important role of the
OTC market relative to the exchange traded market.
It is not possible to compare this notional value figure of 27,000 tonnes directly
with the estimate in the Cross Report that 5,230 tonnes of gold were lent at the
end of 1999. But the two figures do not appear inconsistent. Most of the derivatives
market is intermediated by G10 banks. A forward sale of one tonne would
count once; a strategy of buying a put option on one tonne and writing a call on
one tonne would count twice. But then the bank writing the contract has to
manage the position. This might well involve a forward contract with another
bank, or a lease rate swap to manage the lease rate risk. Each of these would add to
the notional value figure even though all that is happening is that risk is being
transferred within the banking sector. The bank writing the original contract may
well need to trade subsequently just to manage its changing risk over time. Thus
a derivative contract between a bank and a customer may generate trades in the
inter-bank market with a notional value which is several times the value of the
original contract. Thus a ratio of 5:1 between gold lending and the notional value
of banks’ derivative exposure is not at all implausible.
Further insight into the magnitude can be obtained by comparing banks’ derivative
exposure in gold and in other markets:
Global Over-the-Counter Derivatives Markets end-June 2000
Notional amount
(US$ 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%
Total 2 81,875 100%
Source: BIS, November 2000
2
This excludes the BIS ‘other’ category which is their estimate of the position in all markets of nonreporting
institutions. This amounted to $12,163 billion. There is no reason to believe that gold figures
more importantly in the positions of non-reporting institutions than in those which report to BIS.
Gold Derivatives: The market impact 39

Looking at gold as a commodity, it supports an unusually large and active derivatives
market. Gold derivatives comprise 45% of banks’ commodity derivatives
books. The reasons for this were discussed above. Gold in many ways resembles a
financial asset rather than a commodity. Comparing gold with currencies, the size
of positions does not look unusually large.
The BIS data explicitly break out the exposure to the US dollar, euro, yen, Swiss
franc, UK pound, Canadian dollar and Swedish krona. The krona is the smallest
of them, yet the notional value of banks’ derivative position in foreign exchange
contracts involving the Swedish Krona at the end of June 2000 was 70% higher
than in gold 3 . To get some, very rough, insight into the size of the derivative
market relative to the level of real activity underlying it, it is interesting to note
that the notional value of banks’ krona derivatives book is equivalent to seven
years of Swedish imports. The notional value of their gold derivatives book is
equivalent to twelve years of gold production.
Another important source of information about the OTC derivatives market is
the Office for the Comptroller of the Currency which monitors the derivatives
exposure of US commercial banks. The OCC shows that in the second quarter of
2000, the notional amount of US Commercial Banks’ exposure in gold derivatives
was $92 billion, or 35% of the BIS figure, suggesting that the balance was due to
non-US banks and to US investment banks. The OCC figures also show how
concentrated the market is: over 80% of the notional value on the books of the
commercial banks is due to just three (Chase, Morgan Guaranty and Citibank).
In London, which is one of the main centres for these trades, the London Bullion
Market Association has just eleven market-making members who include two
of the three big US commercial banks, as well as a number of major international
banks.
2.4 Downstream hedging
Much of the gold which is produced is transformed into high carat jewellery
which is sold at a price closely related to its gold value. All the activities between
mining of the gold and sale of the jewellery – shipment, refining, processing,
manufacture, retailing – are low mark-up activities. If those involved in the chain
had to bear inventory price risk, they would need to have substantial additional
capital and would also seek to minimise their exposure by reducing their stocks to
a minimum.
3
Arguably this overstates the relative size of the gold market since some of the contracts will be lease rate
swaps and similar derivatives which in the case of currencies would be counted as interest rate rather
than FX products. The notional value of Swedish krona interest rate derivatives was more than three
times the value of krona exchange rate derivatives.
40
Gold Derivatives: The market impact

However the presence of a liquid lending market with low costs of borrowing gold
means that holding large inventories is relatively cheap and low risk. The Cross
Report estimates the amount of gold borrowed by the downstream sector in June
and 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 first
quarters 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. If lease rates rise from say 1%
to 4%, the cost of holding inventory quadruples, and demand for inventory should
fall back sharply. This is certainly what seems to have happened in the immediate
aftermath of the Washington Agreement. To a lesser extent, one would expect
inventories to be sensitive to the volatility of lease rates. A processor who has
substantial gold inventories can insulate himself from the volatility of the gold
price 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 or
short position in gold with a view to making money from the change in the gold
price. Thus we distinguish speculators from producers or users of gold who are
hedging to reduce risk, from banks who act as intermediaries, offering derivative
products to customers and hedging the gold price risk, and from end users who
buy 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 speculators
are convinced that the price of a particular commodity is too high, and
decide to sell it short. They borrow the commodity and sell it, waiting for the
price to go down. If the price remains high, they roll their commodity loans, and
maintain 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 commodity
borrowing risk. If the amount of the commodity available for borrowing is cut
back, borrowing rates will rise until many of the speculators are forced to close
out 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 not
have to worry too much about commodity borrowing risk. Indeed the existence of a
liquid short-term gold lending market means that banks and other intermediaries
can offer long-term as well as short-term forward contracts at prices which allow
speculators to lock in expectations about future wholesale gold lending rates.
Gold Derivatives: The market impact 41

Gold futures and forward contracts provide a cheap and efficient means to speculate
on the price of gold. Transaction costs are low, and the basis risk (divergence
in returns between the future and the spot price) is small. Short selling is as easy
as going long. The pricing of derivatives already implicitly reflects the wholesale
market gold and dollar interest rates.
Some commentators talk about a distinct type of speculator who indulges in ‘the
carry trade’. Carry traders observe that the cost of borrowing gold is much lower
than 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 speculators
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 short
gold because they believe that its price in future will be below the current forward
price. The full cost of finance in the carry transaction is not just the gold interest
rate but the gold interest rate plus any appreciation in the spot price of gold. It is
cheaper than borrowing in dollars if and only if the rise in the dollar gold price is
less than the difference between the interest rate on dollars and the interest
rate on gold. But this is exactly the same condition under which short selling
gold is profitable.
It could be argued that borrowing gold is particularly attractive to a highly leveraged
speculator 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 bank
by borrowing in gold rather than in dollars.
It is the combination of low lease rates with a declining gold price which has
made shorting gold, or financing by borrowing gold rather than dollars, attractive
to speculators, in exactly the same way that hedging has been profitable to producers
and fabricators. One additional feature of the gold market has made it
particularly attractive to speculators, and that is gold’s low volatility. Historically,
in the five years up until September 1999, gold based financing has not only
been on average profitable, but it has appeared to be relatively low risk.
A speculator funding himself each month from August 1994 to August 1999 by
borrowing gold would on average have saved 1% per month compared with dollar
borrowing 4 . In only 17 of the 60 months was gold borrowing more expensive
than dollar borrowing, and even in the worst month the additional cost was limited
to 7%.
4
A speculator could create a synthetic gold loan by borrowing dollars and shorting gold futures; the
saving is the return on the gold futures contract. The numbers given in the text assume that the
speculator shorts the nearest maturity COMEX futures at the beginning of each month, and holds the
position for one month. Transaction costs are ignored.
42
Gold Derivatives: The market impact

The risk of such a strategy became apparent in September 1999 when, following
the Washington Agreement, the gold price jumped by over 20%. For a speculator
with short-term horizons and limited risk capital, such a large loss coupled with
the prospects of far increased future risks may well have prompted a rapid cutback
in short positions.
Over the week of the announcement the net long position of non-commercial
traders on COMEX rose by under 100 tonnes. Market participants did not detect
very large purchases by speculators covering their short positions on the cash
market either. This is consistent with the view expressed in the Cross Report that
these 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 the
market requires the services of a variety of financial intermediaries who act as
brokers, dealers, advisers, market-makers, analysts, underwriters and so on. Many
of these functions are straightforward and well understood. In this section we
focus on the risk-bearing functions of financial intermediaries – on the difference
between 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. They
do of course take risk, but they tend to take those risks which they are particularly
well placed to quantify, assess or manage. They will normally try to get rid of or
hedge any risks which they have no comparative advantage in bearing. To illustrate
the role they play, it is useful to consider the way in which a bank brings
together a producer’s desire to hedge with a central bank’s 5 desire to earn a return
on its gold. To fix and simplify the example, suppose the producer wants to hedge
the output from a mine which is expected to produce just one ton of gold in five
years’ 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 producer
could sell the gold on the spot market and invest the proceeds. The producer
could then repay the central bank out of its own production. In this way
the producer in effect sells his production forward at today’s spot price plus the
interest on the deposit less any interest paid to the central bank.
5
The term central bank is used to mean the holder of the official reserves, whether they are formally the
central bank or not. The term commercial bank covers any bank active in the wholesale trading of gold
or gold related derivatives for commercial ends, whether it is an investment bank, a specialised bullion
bank or a commercial bank in the narrow sense of the Glass-Steagall Act.
Gold Derivatives: The market impact 43

In practice, the transaction is most unlikely to be structured in this way. There
are a number of distinct reasons why the central bank and the producer would
not want to deal with each other direct. It is worth enumerating them so as to
elucidate the different roles played by the intermediary.
One reason is the maturity of the deal. Many central banks are not prepared to
lend beyond three months. Yet the producer needs a five-year deal. A bank is
needed to deal with the maturity mismatch. Maturity intermediation is a standard
function of the banking system; banks typically support their long term loans
using short term deposits. In this case, the commercial bank borrows gold for
three months from a central bank and concludes a five year deal with the producer.
The commercial bank expects to roll over the deal with the central bank
every three months, or else to find an alternative lender if the first is unwilling to
roll forward its loan. It is taking on a risk here; if the gold lending market dries up
or if the bank is not able to access it (perhaps because its own credit lines are
exhausted), it could potentially face a serious problem.
A second reason for intermediation is to deal with rate mismatch. If the central
bank is only committed for three months at a time, the gold lending rate will
move with the market every three months. Even if the central bank were prepared
to commit itself to a five-year loan, it may be unwilling to agree to a fixed lending
rate. It may demand that it get paid during the life of the loan an interest rate set
according to the market rate at the time. The producer ideally wants a rate fixed
for the life of the transaction. Again, managing rate mismatch is a standard function
of the banking system.
There are a number of ways of dealing with rate mismatch. The intermediating
bank can take the risk itself, charging the producer a sufficiently high fixed rate to
compensate itself for the risk that the rate it will have to pay for borrowing the
gold will rise. It can pass the risk on to the producer: instead of offering a fixed
price for future production, the price paid to the producer can be varied as the
gold interest rate varies. A third way is to find some third party who is prepared to
take the rate risk. This could be done through a lease rate swap. This third party
pays 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 gold
interest rate risk. This will make sense because a bank is likely to charge a heavy
premium for bearing the risk, whereas the producer may achieve little risk reduction
by passing it on to the bank. To see this, go back to the example of a five year
deal. The uncertainty about the gold price in five years time is about 30% 6 . A
fixed lease rate deal would get rid of all this uncertainty. If the standard deviation
6
More formally, suppose that the annual volatility of gold is 12%. Then the actual gold price in five
years’ time will be distributed around its expected level with a standard deviation of 30%.
44
Gold Derivatives: The market impact

of the average lease rate over the next five years is ½%, then the producer taking
on a floating lease rate deal would face an uncertainty in the price it receives in
five years of 2½%. The producer may be hedging half its production. It does not
make a great deal of sense for it to pay a heavy premium to get rid of a 2½% risk
on half its production when it is content to take a 30% risk on the other half.
However, lease rate swaps are increasing in popularity. They may for example be
attractive to central banks who do not wish to lend their gold for more than three
months but would like to benefit from the generally higher rates for longer
maturities. By lending the gold for three months, and entering into a pay three
months/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 get
physical gold in three months without having to trade on the market.
But the most important drawback of the direct transaction between the central
bank and the mining house is not maturity or rate risk but credit risk. Central
banks are generally very reluctant to bear credit risk. If the central bank lends
gold 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 are
a number of ways of dealing with it. Instead of the central bank dealing directly
with the producer, a commercial bank with a high credit rating could act as
counterparty to both sides.
There is no reason to stop at one layer of intermediation. Central banks may
choose 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 mining
clients, and who have particularly close relationships with and knowledge of
particular producers. Bank A could buy the gold forward from the producer, and
sell the gold forward to Bank B, where Bank B receives gold deposits from the
central 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 A
would be exposed to the producer’s credit. The credit risks between Banks A and
B would be dealt with in the normal way, involving monitoring of credit exposures,
netting agreements, imposition of credit limits, and posting of margin.
Finally, banks play a crucial role in putting together complex structures. We have
seen how complex derivative structures can be created by dynamic trading strategies.
The intermediary who sells such a structure and hedges by carrying out the
appropriate trading strategy is thus doing two things: trading on behalf of his
client, and bearing the risk that the hedge will not match the structure exactly.
Gold Derivatives: The market impact 45

2.7: Producer hedging
We have seen why the gold market supports a deep and active long-term forward
market. Commercial banks have become very skilled at designing risk management
products and strategies to meet the requirements of their clients. Mining
companies use the derivatives market to hedge their production, often many years
into the future.
The principal motive is risk reduction or risk control. But risk reduction has
many dimensions including: increasing predictability of earnings, reducing the
volatility of earnings, increasing the predictability of cash flow, ensuring the profitability
of existing developments, reducing the sensitivity of the share price to
the price of gold. These different concepts of risk have very different implications
for the size, composition and management of the hedge book.
The design of the hedge book will therefore reflect some balance between these
different concerns. These judgements will vary between companies and over time 7 .
It is likely that these judgements will reflect not only risk management priorities
but also perceptions about the expected profitability of different hedging strategies.
If a producer believes that the gold price at the time the gold is mined is
likely 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 future
price he will be more inclined to sell forward. Thus the same sentiments that
cause large speculative flows into or out of the gold market are also likely to cause
very substantial shifts in producer hedging.
Indeed one might well expect these shifts in producer hedging driven by perceptions
of the future gold price to dominate speculative flows. In many ways, producers
are better placed than speculators such as hedge funds to speculate on gold
prices; they are better capitalised, their short positions are written against a large
natural long position, they know the gold market well and they follow its developments
closely.
In this section we will explore the impact of hedging on company value, earnings
and cash flow and show how these different dimensions affect the volume and
design of the hedge book.
7
The view that risk management practices reflect the judgements and priorities of management as much
as the economics of the mining operation receives powerful support from Peter Tufano’s paper ‘Who
Manages Risk? An Empirical Examination of Risk Management Practices in the Gold Mining Industry’
Journal of Finance (September 1996).
46
Gold Derivatives: The market impact

2.7.1 Value
At first sight, the objective of hedging appears to be to get rid of all gold price
risk. But this would lead to a strategy which is far removed from what companies
actually do. The value of a gold producer can be seen as the value of its gold
reserves, less the future costs of extraction, plus the value of the hedge book. To
remove gold price risk entirely, the company should sell forward its entire economically
recoverable reserves.
But in practice few companies sell more than a fraction of their reserves forward 8 .
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 equity
market to the gold market only makes sense if there is reason to believe that
shareholders charge more for bearing it than do gold bullion investors. That may
be the case in some particular instances where the shareholders are undiversified,
but is less relevant where the shares are widely held. For many shareholders, gold
price exposure is an important attraction of gold mining shares. If investors want
to invest in gold mining companies but do not want to face gold price risk, they
do not need the company to hedge on their behalf. They can themselves hedge
using 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 its
non-hedging competitors. A strategy of forward selling which looks like prudent
risk management over a period in which the gold price has fallen would look very
foolish in a period in which the gold price has risen sharply, and the fully hedged
producer derives no benefit from the improvement in the price of its main product.
A very large risk management programme which reduces value volatility can
also 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 be
predicted into the future. The amount of hedging which takes place and the kind
of instruments used are strongly related to the accounting rules which determine
when the profits or losses from the hedge book are recognised in the company’s
accounts.
8
One measure of this is the sensitivity of the aggregate market capitalisation of gold companies to the
gold price. Regressing monthly changes in the one against the other over the last five years suggests that
the market capitalisation of the fourteen largest quoted US, Canadian, Australian and South African
companies rises by about $240m for every $1/oz rise in the spot price of gold. This suggests that they
would need to sell at least a further 7,000 tonnes of gold if they wished to remove gold price risk from
their shares.
Gold Derivatives: The market impact 47

Accounting for hedges has long been a subject of controversy. Gold in the ground
is not recognised as an asset on the balance sheet. Revenue from production is
only recognised when the production is sold. The matching principle suggests
that the profit or loss from a forward sale of that production too should only be
recognised at the time the production is actually sold. This treatment of a hedge
is called hedge accounting, and it has been universally practised.
A hedge book is a collection of financial contracts which can have considerable
value, either positive or negative. For a company which sells its production forward
three years, the value of the book can readily exceed 50% of the company’s
annual production revenue 9 . With hedge accounting, this asset or liability does
not appear on the balance sheet. Losses and gains on the hedge book feed into the
profit and loss account as the hedged production occurs.
Accounting conventions do not affect the total amount of profit the company
makes, but they do affect the time they are recognised. In the absence of hedge
accounting, all changes in the value of the hedge book would have to be recognised
immediately. The hedge book, far from stabilising earnings, would make
them vastly more volatile. Consider a producer who sells production forward three
years. If the gold price rises 10%, there is a gain in the value of future production
offset by a loss on the hedge book. With hedge accounting the two would offset
each other and earnings would be unaffected. In the absence of hedge accounting
the company would face a reduction in earnings in the current year equal to 20%
of revenues, and an increase in subsequent years. It seems unlikely that companies
would be prepared to hedge on a large scale under such circumstances.
To gain the benefits of hedge accounting the company has to tie its hedge contracts
to individual years of production. This influences the design of derivative
products. A spot deferred contract, which is widely used by producers, is virtually
identical to a series of short maturity forward contracts. But the advantage of the
spot deferred contract is that it is tied to a specified maturity date, and the gains
or losses can be deferred until the year of production.
Accounting standards vary over time and across countries, but there has been
slow convergence towards common internationally accepted accounting standards.
Discussions are continuing on formulating an international accounting standard
for recognising and measuring financial instruments. The US accounting standard
FAS 133 Accounting for Derivative and Hedging Activities which was issued in
1998, and amended by FAS 138, is now coming into effect.
9
A hedge book equal to three year’s production will on average have been built up 1½ years earlier.
With a volatility of say 12% in the gold price, the return over this period has a standard deviation of
about 15%, so 3 years sales revenue times 15% is approximately half of one year’s revenue. A more
precise calculation which accurately reflects the build up of the hedge book would give a similar answer.
48
Gold Derivatives: The market impact

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. FAS
133 has made a decisive break with previous practice in demanding that the
hedge book be recognised on the balance sheet at fair value. Changes in the fair
value of the hedge book each year will appear in the income statement. To avoid
the volatility this would cause to reported earnings, these gains and losses will
appear not in the earnings stream, but rather as ‘other comprehensive income’. As
the hedged production is sold, the hedge gains or losses are taken out of the
balance 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 to
qualify for hedge accounting, but their fair value does not need to be recognised
in the balance sheet.
The changes in accounting standards in the US and elsewhere are likely to affect
producer hedging in a variety of ways. While they are unlikely to have a major
impact on the total amount of hedging which takes place, they will tend to favour
strategies which give rise to least volatility in the balance sheet and in reported
earnings. In particular they will encourage forward sales with physical delivery
over cash settled forward contracts, because the former will not impact on the
balance sheet until they mature. And they will tend to favour simpler derivative
strategies over more complex ones which fail to qualify for hedge accounting under
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 the
hedge book. This may in turn lead shareholders to see the hedge book as a source
of risk rather than as part of a risk reduction strategy. It may also encourage
producers to design hedge books whose change in value is easily explicable (forwards
with floating dollar and gold interest rates) rather than those which are
harder to explain (fixed rate, long maturity contracts; options and exotics). On
the assumption that similar rules are eventually included in international standards,
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. Consider
a company which has sold forward its production several years ahead. Suppose
that the spot price of gold then rises sharply. In one sense the company is
indifferent: it has a substantial loss on its hedge book, but the value of its gold
reserves has risen.
Gold Derivatives: The market impact 49

But the bank which has sold the hedge contract may be less relaxed. It is now
facing substantial credit risk. If the producer fails, the bank stands to make substantial
losses even if the value of the gold in the ground is increased. To protect
itself, the bank may require collateral, or impose covenants on what the company
can or cannot do, or require the company to pay margin. The gold in the ground
may not provide good security for a further loan. The impact of margin requirements
can create a liquidity crisis; if the company is not in a strong financial
position it can bring on a solvency crisis.
Even if the banks do not demand margin, they may insist on provisions which protect
and limit their credit exposure, such as retaining the right to terminate the hedge if
the company’s credit deteriorates. Such restrictions on the hedge are potentially very
damaging. They mean that a company still faces a serious financing problem if it
wants to maintain the hedge after the gold price has risen. The alternative of taking off
the hedge when it has lost money risks serious problems if the gold price then falls.
For the company will then have lost money on the hedge with a rising gold price and
then failed to recover the loss when the gold price falls back to its original level.
The overall financial strength of a company therefore may constrain its ability to
hedge its production. Even for a company with considerable financial strength,
the management of the financing of the cash flows is likely to have a considerable
influence on the size of the hedge and the detailed structuring of it.
2.7.4 Composition of the producer hedge book
Producer hedge books, as reported in company accounts, reveal an impressive
array of exotic risk management products. As with the use of derivatives in other
markets, much of the complexity is driven by detailed accounting, legislative, tax
and regulatory concerns. This report is concerned with the interaction of the
derivative market and the spot market, and from that perspective the detail matters
only insofar as it manifests itself at the aggregate level of the producers’ collective
hedge book.
One question of importance is whether producers are net long or net short options.
If they are net long options, the effect will be that they become increasingly
short gold as the price goes down and less short of gold as the price goes up. The
banks hedging the producers’ books will behave like momentum traders, buying
gold as the price rises and selling it as the price falls. Conversely, if producers are
net writers of options, the banks will trade to stabilise the market, buying as the
gold price falls and selling as it rises.
Some producers will generally be buyers of options allowing them to protect
themselves from the downside without giving up the upside, and thus reduce
50
Gold Derivatives: The market impact

their risk. Of course this protection comes at a price – the premium paid for
buying the option. Others will argue that they should be sellers of options because
their own gold reserves constitute an option on gold; in return for paying
the costs of extraction, the producer receives the gold.
Whatever the merits of each argument, there are good reasons for believing that
producers collectively are unlikely to be either large buyers or large sellers at least
of long maturity options. To every option buyer there must be an option seller. It
seems 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 exposed
to 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 to
market and provide capital in accordance with the risk of their trading book.
While they may have strong views about whether the market price of volatility is
excessively high or low, they would need to make a substantial return to induce
them to bear long-dated volatility risk. In these circumstances, it is not clear why
producers 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 option
exposure are holders of gold. They might write long-dated calls against their holdings.
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 within
the sector. While standards of disclosure make it very hard know in detail what
each company’s book looks like – there is too much aggregation and not enough
detail 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 sold
broken down by producer region, with the top figure representing options (both
puts and calls) bought, and the lower figure showing options sold.
Long and Short Positions of Producers in Options, Measured in Mn Oz
Underlying Gold, Broken Down by Maturity.
Maturity 2000 2001 2002 2003 2004 + Total
Australia 2.72 2.87 2.57 2.81 11.82 22.78
0.80 0.87 0.72 0.96 3.78 7.13
N. America 6.60 4.70 0.68 0.75 1.15 13.89
2.24 1.34 1.20 0.80 7.88 13.45
Africa 3.85 0.91 1.06 2.67 3.20 11.69
3.50 2.22 2.40 1.52 2.28 11.92
Total 13.17 8.48 4.32 6.23 16.17 48.36
6.54 4.43 4.32 3.27 13.93 32.50
Source: figures in the table are drawn from Gold and Silver Hedging Outlook, Fourth Quarter 1999 (Scotia
Capital)
Gold Derivatives: The market impact 51

The gross numbers are impressive – the total nominal volume of options bought
and sold by producers is 80 million ounces (some 2,400 tonnes) – but the net
volume is far smaller at 16 million ounces. In part this is because producers often
buy protective puts and finance them by writing calls. While this strategy makes
heavy use of options, it is not very different in its impact on the market from an
ordinary forward sale, particularly when the exercise prices of the bought and
written puts are reasonably close to each other.
But the table strongly suggests the importance of a second factor – some producers
are net buyers of options and others are net sellers of options. If one looks at
the 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 options,
while North American producers are large net sellers, and the net position
is close to zero.
The analysis is quite crude. It aggregates options without much regard to strike or
maturity. It aggregates producers by continent. Appendix 3 contains a far more
detailed analysis which bears out the conclusion that options bought by one
producer tend to be sold by another producer. The banking sector and other
players bear very little of the gross volatility exposure.
It would be interesting to know whether the same is true of lease rate risk. Most
of the gold lending by central banks is of short maturity. Fixing a forward price
means fixing a lease rate for the maturity of the contract. If most of the forward
contracts sold by producers were fixed rate, some other sector – presumably the
banking sector – would have to bear substantial lease rate risk. Unfortunately,
company accounts reveal little about lease rate risk. But it seems reasonable to
assume that, as with volatility risk, and for much the same reason, much of the
lease rate risk is borne by producers rather than by banks.
This analysis suggests that the appearance and the reality of the producer hedge
book in aggregate may be very different. The book contains many puts, calls and
much more complex instruments; the hedging instruments have very long
maturities. 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 accounting
decision to defer recognition of the profits or losses from particular transactions
some 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 fairly
well reflected by the effective short position or delta of the book.
52
Gold Derivatives: The market impact

CHAPTER 3: THE DEBATE
It 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 derivatives market. In this chapter, we review
the arguments and the theoretical evidence. The empirical evidence is reviewed in the
following chapter.
The principal conclusions are:
· The fall in the price of gold over the last decade has coincided with the growth of the
paper market. Short selling by producers and others has added substantially to the
supply of gold from new production. But it does not necessarily follow that the fall in
the gold price was caused by the paper market or that the acceleration of supply has
had a substantial impact on price (3.1).
· The debate about the impact of paper markets on cash markets is neither new nor
confined to gold. Many studies have been carried out in both financial and commodity
markets. The empirical evidence suggests that derivative markets fulfil a valuable
role in promoting the efficient sharing of risk; that while they could in theory destabilise
the price of the underlying assets, it 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 investment aspect. The elasticity of
demand for financial assets is generally extremely high; small changes in price and
expected returns cause large shifts in portfolio composition. But investment demand
for gold may be rather less elastic since the gold has particular attributes (such as
resilience to financial and economic shocks) which make it hard to substitute (3.3).
· Assuming that supply of gold is inelastic and that demand is consumption rather
than investment demand and assuming demand has a unit price elasticity, the
accelerated supply of gold from the derivatives market may have depressed the price 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 attractions 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. In expanding both supply and demand,
the impact on the gold price is ambiguous (3.5).
Gold Derivatives: The market impact 53

3.1 The debate outlined
The argument that derivatives have had a damaging effect on the gold price can
be illustrated by the chart below. It shows the way in which the protracted weakness
in the gold price over the 1990s has been accompanied by a dramatic increase
in the size of the derivatives market. The line is the real price of gold over
the decade (average annual price, deflated by the US consumer price index, and
0
-500
-1000
-1500
-2000
-2500
-3000
-3500
-4000
Producer Short Positions and Real Gold Price
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
580
540
500
460
420
380
340
300
260
Producer Short Position (rhs)
Real Gold Price (rhs)
Source: Own calculations based on Gold Fields Mineral Services Ltd
reported in constant 1999 US dollars). The columns show the aggregate short
position of producers – the more negative, the larger the short position 1 .
The apparent close connection between the increasing volume of derivatives activity
and a falling real gold price suggests or implies a causal link between the
two. The existence of a causal link is supported by an analysis of the supply and
demand for physical gold. GFMS figures show that fabrication demand, which
averaged 3,287 tonnes/year over the decade, comfortably exceeded new mine supply
at 2,332 tonnes/year. It also grew faster (3.7% against 2.1% per annum). As the
table below shows, sales of borrowed gold to hedge producer forward sales have
played 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 for
the former. Since the producer position accounts currently for over half the total, it should give a
reasonably accurate picture of trends in the market as a whole.
54
Gold Derivatives: The market impact

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 309
2,657 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 market
has made to the supply side since it takes no account of short selling by
anyone other than producers. The total volume of gold lending by the official
sector increased by 3,800 tonnes over the decade. In addition private sector lending
at the end of the decade amounted to 500 tonnes, though it is not clear
whether this represented any net increase over the decade given the probable fall
in institutional private sector gold holdings over the period. Taking 4,300 tonnes
as a generous estimate of the increase in gold lending, that is equivalent to 430
tonnes per year of additional supply. Not all of this would come to the spot
market. The availability of cheap gold loans has reduced the cost and increased
the volume of inventories held downstream. No less than 1,465 tonnes of the
gold which was lent as at end 1999 was to downstream users. Much of this must
have been reflected in higher gold inventory levels than were held in 1990, and so
does not represent increased supply. The true impact of the derivatives market to
the spot market may have averaged 300-400 tonnes/year over the period.
Others would see this argument as simplistic – the fact that short selling has
increased at a time that the gold price has been falling could be no more than a
coincidence. There are many other possible explanations for what was happening,
including worries about substantial central bank sales, and shifts in the market
for gold towards the less developed countries. Few people would expect to convincingly
explain large movements in say the value of the euro or the level of the
US stock market by a single supply or demand factor. The fact that net short
selling has increased the supply of physical gold does not prove that it has significantly
depressed the price. The short selling may have been a response to expectations
about the price, rather than caused by it.
It is not obvious for an investment good like gold, that flows rather than stocks are
the relevant measure. The increase in gold lending over the decade amounted to
Gold Derivatives: The market impact 55

some 4,000 tonnes. This is a small volume of gold to expect people to hold relative
to total above ground stocks of gold of some 140,000 tonnes. Given the
depth of international capital markets, it seems plausible that this gold (worth
$40 billion at current prices, spread over a decade or more) could have been
absorbed without much price impact.
It is worth seeing what can be learnt from other markets, and then considering
what 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 confined
to gold. The issue has been raised frequently and over many years both in commodity
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 which
pushes down prices; that derivatives facilitate speculative trading which increases
volatility; that the leverage available from derivatives markets creates cycles of
boom and bust as momentum traders follow a trend and then are forced to unwind
their positions rapidly; that derivatives markets fragment order flow diverting
liquidity away from the cash market; and that derivative markets encourage
market manipulation.
Defenders of derivative markets argue that they improve liquidity, transparency
and increase possibilities for risk-sharing. It is possible to construct internally
consistent models of trading in which derivatives markets are beneficial, and also
models in which they are harmful. Ultimately, the question of whether derivative
markets are broadly beneficial or harmful to efficient price formation is an empirical
one. There is a considerable body of empirical literature covering both commodity
markets and, in rather more depth, financial markets.
We review the arguments and the empirical evidence at length in the paper at
Appendix 1. We conclude that the weight of evidence suggests that:
· derivative markets in general fulfil a valuable role in promoting the efficient
sharing of risk, and in aggregating information;
· while there are ways in which derivatives could in theory destabilise the price
of the underlying assets, there is little evidence that this has been a problem in
other markets;
· there is strong evidence that derivatives help make the underlying market more
56
Gold Derivatives: The market impact

liquid, and also increase the speed with which new information is incorporated
into prices.
The view of derivatives markets as essentially beneficial appears to be shared by
the many governments which have acted to remove impediments to the smooth
functioning of a derivatives market in their own debt. For example many governments
have deliberately taken steps to make it easier to strip bonds and to repo 2
them. This greatly facilitates selling bonds short. Since governments have a strong
interest in a market which places the highest value on their bonds, it is likely that
they recognise that the benefits of increased liquidity more than outweigh any
possible negative effects.
Rather than pursue the idea that it is derivatives per se which cause problems, it
makes sense to concentrate on those features of gold which distinguish it from
other financial assets and commodities, and identify the special reasons (if any)
why derivatives markets may have a special impact in the case of gold.
3.3 What is special about gold?
Gold is in many ways more like a financial asset than a commodity. Unlike most
other commodities, but like financial assets, gold is bought to be stored or kept
rather than to be consumed. Most of the gold that has ever been produced is still
available and could come back to the market under appropriate conditions. The
lending market for gold is also far more developed than for a typical commodity.
The existence of an active lending market with rather stable and low interest rates
is quite typical of financial assets. In many markets equities can be borrowed at a
rate which is only a small margin above the dividend yield. Liquid bonds can be
borrowed at a rate only a small premium to their running yield. From this perspective
it is not surprising that gold, which pays no dividends or coupons, can be
borrowed at a rate close to zero.
If gold were like any other financial asset the evidence in the preceding section
suggests little reason to believe that the derivative market is likely to distort the
cash market. In classic portfolio theory, demand depends not on the price of the
asset but on its expected return. Investors buy an asset if its risk adjusted return is
higher than the market. Demand for individual financial assets tends to be highly
elastic. There are very many different financial assets, most of which are very close
substitutes for each other. Demand for financial assets tends to be measured as a
2
In a repo transaction, the holder of the bond sells it, agreeing to repurchase it at a fixed price
subsequently. It is similar to lending the security, and facilitates short selling and derivative transactions
in much the same way that gold lending by central banks has encouraged the growth of gold derivatives
market.
Gold Derivatives: The market impact 57

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 in
their entirety if the expected return is too low.
All these features of financial assets help ensure that the growth of a derivatives
market is unlikely to have a destabilising effect on prices. Even if the derivatives
market causes investors to rebalance their portfolios, and buy or sell the underlying
asset, large changes in holdings can be accommodated with very little
shift in prices.
If gold behaves like a typical financial asset one would expect it too to have a very
elastic price schedule. If a derivatives market does make it easier for producers and
speculators to sell gold short, then a small price reduction would suffice to attract
new 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 so
high, or that a moderate reduction in expected returns on gold would cause most
holders to liquidate their portfolios. The pattern of investors who hold gold is not
like that for other financial assets. Most private and institutional investors hold
little or no gold. Investors who hold gold do so at least in part because gold has
certain properties which make it peculiarly attractive in the event of acute political
or financial instability. For these investors, gold is not readily substitutable by
other 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 will
have a cash demand for gold which may be largely independent of either the price
of gold or of the expected rate of return on holding gold. This means that the
price elasticity of demand is close to unity, since a 10% increase in the gold price
will reduce the volume of gold bought by 10%.
Gold is also unlike a financial asset in that there is substantial consumption
demand for gold. While it is hard to separate consumption and investment
motives for purchasing jewellery, it is likely that both the price level of gold (for
consumption) and the expected return on gold (for investment) play a part in
determining demand.
3.4 The simple consumption model
There are good reasons for believing that the growth of the gold derivatives market
could have depressed gold prices. The reasons have to do with features of gold
which are specific to gold, and which differentiate it from other commodities and
financial assets. The negative impact will have come from the build-up in short
58
Gold Derivatives: The market impact

positions in the forward market over the decade. A corollary of this is that as and when
the 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 small
fall in price, and the corresponding increase in expected returns leads investors to
buy the asset and mop up the extra supply. In the gold market, there is reason to
believe that the readiness of investors to absorb additional supply might be limited.
Much of the adjustment would have to come from consumption demand; a
substantially 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 in
cents per ounce or hundreds of dollars per ounce. We need to get a feel for the
potential magnitudes.
By starting from a very simple model of the gold market, one can at least put
bounds on the likely magnitudes. Model the gold price as reflecting the interplay
between a supply of gold which is independent of price and a demand for gold
which depends on the price level. Ignore the impact of prices on gold production.
Ignore any adjustments that producers make in their hedging policies, that downstream
users of gold make in their inventory holdings, that speculators make in
their portfolios. Assume that the entire burden of adjustment to any increase in
supply falls on consumers. We will call this model the ‘Simple Consumption
Model’ of the gold market and use it as a benchmark.
In the simple consumption model, the price response is determined by the price
elasticity of demand for gold. It is hard to estimate demand elasticities with any
precision. Murenbeeld 3 estimates an average price elasticity for jewellery demand
of about 1. Veneroso 4 suggests that a figure for the gold market overall in the
range 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 supply
over the decade at a time when net fabrication demand for gold averaged
2,892 tonnes/year. With an elasticity of 1, this suggests an impact of 10-15% on
the gold price.
But the simple consumption model is seriously deficient in at least two important
respects. First, it takes no account of the way in which mine output responds
to price changes. Although, as we have seen in section 1, production is not responsive
to price in the short term, it is responsive to price in the longer term. So
while output levels continued to rise over the whole of the last decade, produc-
3
‘Gold Jewellery Demand Models’, a report prepared for the World Gold Council, M. Murenbeeld
& Associates, April 1999.
4
The 1998 Gold Book Annual, Frank Veneroso, Jefferson Financial, 1998.
Gold Derivatives: The market impact 59

tion is now forecast to have peaked, and exploration expenditure has been cut
sharply. Supply will therefore fall below what it would otherwise have been, and
the effect of this should be reflected in future prices. The existence of a derivatives
market should then help boost the gold price as speculators and producers respond
by cutting back their short positions.
More fundamentally, the argument takes the growth of short selling as an exogenous
fact, and does not seek to explain why it occurred. If we understand why it
occurred, we would be in a better position to say what would have happened in
the absence of a derivatives market. We have argued that the short selling by
speculators, and to some extent by producers, reflects their belief that short selling
would be profitable – that the future spot price of gold would be below the
current forward price. Over the 1990s this belief has been correct. We have also
argued that the decline in the price cannot be attributed primarily to accelerated
supply resulting from the derivatives market. One plausible candidate is fear of
large liquidation of official sector holdings. If players in the derivatives market are
acting rationally, this suggests that the derivatives market may have brought forward
a decline in the gold price which would have occurred anyway, rather than
created a decline.
This then raises the question of what would have happened to demand if there
had been no derivatives market, and gold prices had been kept higher for longer.
Note that this would have meant that the expected return on holding gold
would have been lower. It seems unlikely that the many people holding gold in
different physical forms – bullion, coins, high carat, low valued-added jewellery
- would have been totally indifferent to the returns on holding gold. While
it is hard to quantify the effect, it seems plausible that had there been no derivative
market based selling of gold, more gold holdings would have been liquidated
over the period.
These considerations taken together suggest that the impact of derivatives on the
spot price is likely to have been well below the 10-15% estimate suggested by a
simple consumption model of the gold market.
3.5 Other effects of derivative markets
Much of the debate about the impact of derivatives in the gold market turns on
the way that it causes physical gold, which would otherwise be sitting in private
or official sector vaults, to be mobilised and sold on the spot market. But this is to
ignore the other substantial effects of derivatives which also have an impact on the
gold demand and therefore on the price of gold.
60
Gold Derivatives: The market impact

The existence of the lending market allows owners of gold to get extra income
from 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; through
writing 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, derivatives
make gold a more attractive asset to hold.
The ability to borrow gold easily and at low rates is of benefit to all those involved
in downstream activities such as refiners, fabricators and distributors. It reduces
the costs of manufacturing and selling gold products. By reducing the costs and
risks associated with holding stocks, it allows very large inventories of gold and
low value-added jewellery to be held in the supply chain. This encourages the
widespread distribution and availability of gold and thus facilitates the marketing
of gold to customers.
Derivatives also reduce the cost of capital for producers, and so tend to encourage
production. A producer may be unwilling to develop a mine which is only marginally
economic for fear that the gold price will fall and make the mine unprofitable.
Using derivatives, the producer can lock in a price, or put a floor on the
price so as to insulate the mine from price falls. Project finance for new mines is
often conditional on output being sold forward.
Derivatives may also affect decisions about existing capacity. The Cross Report
has evidence that producers who have sold their production forward may be slower
to cut production as spot prices fall.
This suggests that while the direct impact of accelerated supply from short selling
are likely to have depressed the price somewhat, the indirect effects of the derivatives
market through expanding both the demand and the supply side of the
market have had an ambiguous effect on the price.
Gold Derivatives: The market impact 61

62
Gold Derivatives: The market impact

CHAPTER 4 THE EMPIRICAL EVIDENCE
We have looked at the theoretical arguments about the impact of the paper market on
the physical market. We have seen that sales of gold in the forward market by producers
and speculators induce sales in the physical market, and these sales may themselves
depress the gold price. We now review the evidence that this is indeed the case.
· the only reasonably good quality data we have on forward positions over time is from
the producers. We investigate the relationship between the change in the size of the
producer hedge each quarter, and the change in the gold price. The simple consumption
model predicts this to be substantial and negative. It is in fact weakly positive or
non-existent. Correcting for outliers, timing issues and the impact of price on hedging
does nothing to change this result. The empirical evidence is thus inconsistent with the
view that accelerated supply impacts on price in the way and to the degree suggested
by the simple consumption model (4.1).
· if the gold market is efficient, and investors smooth imbalances between supply and
consumption flows, one would not expect the price to respond to actual flows but
rather to news about future flows. In particular, the impact of a short selling programme
should be visible at the time the programme becomes known rather than at
the time the sales occur. We conduct an event study looking at producer hedging
announcements. The sample set is very small (17 announcements in total) but nevertheless
does show some evidence of increased hedging causing the gold price to fall
and, to a lesser extent, reduction in hedging causing the gold price to rise (4.2).
4.1 The impact of short-selling on the price of
gold
At the heart of the debate about the impact of derivative markets is the question
whether short selling depresses prices. One way of investigating the issue empirically
is to examine the relationship between changes in the net short position and
changes in the gold price. For this to have statistical validity, it is necessary to have
data of high accuracy and at high frequencies.
There are no reliable data for the market as a whole. The best available data are
published by GFMS, and give their estimates of the aggregate delta of producer
hedge books. It is based on data provided by companies in their accounts, supplemented
by GFMS’s own analysis. The data are available quarterly, going back to
the beginning of 1994.
Gold Derivatives: The market impact 63

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 chart
below.
Impact of Producer Hedging on the Gold Price
60
1999Q3
40
20
0
-20
-40
-60
-300 -200 -100 0 100 200 300 400
∆ Producer Hedge Book (qtly, tes)
Source: Own calculations based on Gold Fields Mineral Services Ltd
The results are given by the following equation (the figures in parentheses are
standard errors):
∆Price = - 8.55 + 4.70 ∆Delta + error
(4.38) (2.70)
2
R = 9.31%
This can be interpreted as meaning that on average, if the size of the hedge book
increases by 100 tonnes in a quarter, the price of gold goes up by $4.70/oz. Since
the hypothesis we are testing is that short selling reduces the gold price, the result
is unexpected. However, the slope coefficient of 4.70 is not precise; the number
in 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
64
Gold Derivatives: The market impact

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 conclude
from this that there is no evidence that forward selling by producers
depresses prices.
4.1.1 Outliers
If one plots the observations, it becomes clear that there is one particular observation
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 throw
away 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 were
increasing their hedges rapidly, and the European central banks decided to act in
concert and issued the Washington Agreement. There is little doubt that the
steep rise in the gold price in the quarter came as a result of the Agreement. It was
not caused by the large increase in the volume of hedging (except in the perverse
sense that the hedging may well have been a factor in driving the price down, and
this in turn encouraged the central banks to act).
It does therefore seem sensible to run the regression without the distortions caused
by this one observation. We then get the following result:
∆Price = - 7.77 + 0.9 ∆Delta + error
(3.67) (2.6)
2
R = -5.15%
By omitting this observation, we have turned a possibly significant positive association
between delta and price into a statistically quite insignificant but still
positive 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 depresses
the gold price, is reinforced.
The simplest explanation for this result is that short selling does not depress the
gold price. But it is possible that short selling does depress the gold price, but we
are 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 an
upper bound on the impact of the derivative market on the spot market. Suppose
that model were correct, would we expect it to show up clearly in the data we have?
Gold Derivatives: The market impact 65

To apply the model to our regression, consider the impact of an increase in delta
hedging of 100 tonnes. It adds to supply, and has to be accommodated by an
increase in demand engendered by a fall in the price. If the supply is absorbed in
one 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 a
price elasticity of 1. The slope coefficient in the regression would be –50. In fact
it was +0.9 with a standard error of 2.6; we can be 90% confident that the true
value of the slope coefficient lies between –4.6 and +6.4, and reject with complete
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 on
average the extra supply is absorbed over a year the model still gives a predicted
slope coefficient of –12.5. It is clear that the observed impact of delta hedging is
very different from what the model predicts.
Before coming to a firm conclusion, it is worth exploring two other possible
explanations which might reconcile the Simple Consumption Model with the
empirical evidence. One is that the impact of an increase in short selling has
been missed because we assumed the impact was visible only in the same quarter.
Another is that there are more complicated links between the two variables
we 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 in
the same quarter. Derivative contracts take some time to negotiate and put in
place. Banks may set their hedge in place before the contract is finalised. The
market may learn of the derivative contract before it is finalised. But timing issues
could 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 on
changes in the delta of the hedge book which occurred both in the same quarter
and the two neighbouring quarters. The result of the regression is:
∆Price t = - 2.80 - 3.6 ∆Delta t-1 + 0.7 ∆Delta t - 1.2 ∆Delta t+1 + error
(5.10) (3.0) (3.1) (2.7)
2
R = -5.15%
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Gold Derivatives: The market impact

2
The model as a whole has no explanatory power (the R remains negative) and none
of the coefficients individually differs significantly from zero. We do however finally
have a negative coefficient on the change in the hedge position. Adding the coefficients
together the model suggests that a 100 tonne increase in hedging will reduce
prices in time by $4.1/oz. The implication that most of the negative impact occurs
the quarter after the hedging change has occurred does not seem very plausible. The
standard 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; they
affect 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 hedge
books. First, if producers hold options in their hedge books the delta will change
with 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 same
holds if producers buy call options. The only way that options could be used to
explain the positive coefficients is if producers collectively have written options.
But we have seen that in aggregate producers are net buyers of options, and hence
this exacerbates the puzzle rather than solves it.
It is also difficult to develop a convincing argument that while hedging does lower the
gold price, the effect is masked by changes in hedging policy induced by changes in
the gold price. One might expect that a fall in the gold price, all other things being
equal, is likely to cause an increase in hedging. Thus GFMS in its review of 1999
explains 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 desperately
tried to establish some price floor and lock in some margin.’ This could
explain a negative correlation between changes in the gold price and changes in the
producer 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 position
affect the gold price. We have considered the possibility that the effect is masked
Gold Derivatives: The market impact 67

y changes in hedging caused by changes in gold prices, but this if anything
seems to worsen the puzzle, rather than solve it. It is possible that the data set is
so 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 magnitude
predicted by the simple consumption model, it should have shown up.
We have only looked at flows caused by producer hedging. We have not looked
at the impact of flows from other users of the market, notably hedge funds and
other speculators, simply because we do not have the data. But unless speculative
trading is very large compared with producer hedging, or unless it is negatively
correlated with producer hedging, and neither appears to be likely, it is
probable that an analysis which incorporates speculators' positions would come
to similar conclusions.
One major criticism of the simple consumption model is that it completely ignores
the role of investment and speculative demand. Investors, it is reasonable to
assume, may be prepared to accommodate short term changes in flows. On this
analysis, producer hedging may indeed have an impact on the price of gold, but
that impact is not felt when the short sale actually occurs. Rather the market
responds 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 or
changed, 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 when
the news of the event hits the market. If producer hedging does affect the gold
price, one would expect to see evidence of it in the form of a price reaction to news
about changes in hedging policy.
The standard statistical technique for doing this type of analysis is the event
study. It is widely used in finance, for example for investigating mergers, changes
in 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 a
period. The price of the financial asset is then computed in ‘event time’, that is
relative to the moment the event is announced. The price is corrected for market
wide movements, and the abnormal return on each day before and after the event
is measured. The returns are then averaged across all events to provide a typical
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Gold Derivatives: The market impact

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 the
study is examining is unlikely to be the only event which hits the market that
day. So the return over the event day may owe much to extraneous factors. But
by taking a sufficiently large number of events, the assumption is that this noise
will cancel out. The set of events may be of very different magnitudes. With
hedging announcements for example, one is averaging across totally unexpected
changes in hedging policy by large producers with relatively insignificant changes
by much smaller producers. So by averaging one gets an impact from an ‘average’
hedging announcement.
But perhaps the key assumption in carrying out an event study is that one can
identify with some precision when the event - that is the news about the change
in hedging policy - actually hits the market. To the extent that the announcement
merely ratifies what is already well known, the price impact will not be observed
in 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 the Financial 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 positions
11/02/00: Homestake Mining announces it has not made changes to its gold
hedging policy
07/02/00: AngloGold announces that it had been reducing its hedge commitments
for the past few months and said it would continue to do so
07/02/00: Barrick announces that it remains committed to its hedge programme
04/02/00: Placer Dome announces suspension of gold hedging activities in belief
that price is likely to rise
31/01/00: Agnico Eagle Mines Ltd. Confirms its policy of not selling any of its
future gold production forward
12/11/99: Coeur d'Alene announces that it continues to engage in gold hedging
transactions
29/10/99: Cambior Inc. reports that its gold hedging programme has been
reduced
21/05/99: Newmont Mining announces that it is not about to start hedging its
gold production
Gold Derivatives: The market impact 69

16/04/99: Gold Fields announces that it has made no new forward sales of gold
whatsoever in 1999
06/10/98: Zimbabwe government minister says that it may allow gold producers
to hedge more of their output
05/08/98: Homestake Mining announces that it has changed a long standing
policy against hedging and will allow up to 30% of future gold production
to be hedged in forward market
11/06/98: Ross Mining NL announces that it has hedged an additional 253,000
ounces of gold
21/07/97: Gengold announces that it does not plan to hedge any more gold in
the near future
06/08/96: Newcrest Mining announces that it had liquidated the bulk of its
gold-hedging position for a pre-tax profit of A$ 270m
12/02/96: Barrick announces that it remains committed to hedging but has
reduced its position
18/01/96: JCI Ltd. announces that it has entered into a 7.3 million ounce gold
hedging programme
18/08/95: Beatrix Mines announces it has hedged 2.9 million ounces
22/07/93: Anglo American announces that it has achieved its hedging targets
and is no longer heavily involved in the market
11/10/92: 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 increased
hedging. Two of the events, of opposite type, occurred on the same day (7
February 2000) and were eliminated from the test. An event window of five preevent
days and two post-event days is used and the cumulative abnormal return
for gold is computed for each of the two event categories. The hedging announcements
generally do not coincide with other announcements, and the results are
therefore not contaminated in this respect.
Given the very short window, the method of computation of abnormal returns is
not critical; we have taken the normal return to be zero. The results are shown
graphically 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).
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Gold Derivatives: The market impact

Cumulative abnormal return
1.5%
1.0%
Impact of Hedging on Gold Price
More Hedging
Less Hedging
0.5%
0.0%
-0.5%
-6 -5 -4 -3 -2 -1 0 1 2
-1.0%
Days relative to announcement
-1.5%
Source: Own calculations based on Gold and Silver Hedging Outlook, Scotia Capital.
The figures for the abnormal return on the gold price on the day of the announcement,
and over the three trading days centred on the announcement, are as follows
(figures in parentheses are standard errors 1 ):
Abnormal
Return
Increased
Hedging
Decreased
Hedging
Day T -0.66%
(0.30%)
Day T-1 to T+1 -1.05%
(0.55%)
+0.51%
(0.42%)
+1.21%
(0.55%)
The abnormal returns are the sign one would expect if hedging depresses the gold
price – increased hedging is bad for the gold price, while decreased hedging causes
it 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 announcement
took place on day T relative to the gold price fixing.
The estimates for the impact of both an increase and a reduction in hedging are
similar in magnitude, and they verge on the statistically significant at conventional
1
Standard errors are calculated from the average observed volatility of returns in the gold market in the
period leading up to each announcement. We calculate one day and three day exponentially weighted
squared returns, with a decay factor of 0.9/day. We followed this procedure to take account of the fact
that hedging announcements seem to occur at times of high market volatility, and also to allow for the
possibility of auto-correlation in returns.
Gold Derivatives: The market impact 71

(5%) significance levels. Closer inspection of the individual data points raises
some questions, particularly about the decreased hedging results. Out of the nine
cases of decreased hedging only five show a positive return while four show a
negative return. The overall average in these nine cases is dominated by just one
event – Placer Dome’s announcement of a cessation of hedging on 4 February
2000, when the three day return was 10%. The results for increased hedging
appear more robust; eight out of the nine cases show negative three day returns
and 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 will
add noise, not bias to our results. But the results are statistically significant, so
noise is not the key issue. If the reporting of a hedging announcement is itself
influenced by what is happening in the market, the results could be quite misleading.
For example if a hedging announcement is reported because it explains a
gold price movement (‘the gold price moved down today following the announcement
of increased hedging ...’) when it would not have been reported had the
gold price moved in the opposite direction, we would pick up a spurious correlation
between the two.
With all these qualifications, the evidence does suggest that the market believes
that increased producer hedging is bad for the gold price while reductions in
hedging are good. The immediate impact of an announcement on the market
may of course be subsequently corrected. But assuming a degree of market efficiency
it seems implausible that the market will consistently over-react or underreact.
If the market consistently over-reacted for example, it would be possible to
make money by selling after good news had hit the market and the market overshoots,
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 impact
occurs at the time when the market learns about the strategies or policies, and
this may happen well before the actual flows hit the market.
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Gold Derivatives: The market impact

CHAPTER 5 THE GOLD LENDING
MARKET AND ITS STABILITY
The existence of an extensive derivatives market in gold depends on there being a deep
lending market. In this chapter we explore whether shocks in the lending market, caused
either by demand shocks or by supply shocks, could disrupt the derivatives market and
have serious repercussions for the gold market as a whole.
Specifically, we consider two types of scenario, one involving a withdrawal of gold from
the lending market by the official sector, the other involving a sharp reduction in hedging
demand by producers and speculators. While there are other possible causes of disruption,
these two scenarios represent opposite shocks (one leading to a sharp rise in lease
rates, the other leading to a sharp fall) 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 relative pricing of short- and longer-dated leases, implicitly
ascribes a high probability to a crisis occurring.
The analysis is necessarily rather tentative. 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; it is hard to predict how and when panics will develop. It should also
be emphasised that the analysis is positive and not normative; we make no assessment of
whether the parties active 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:
· it would take a sudden withdrawal of the order of several hundred tonnes to seriously
disrupt the market. A withdrawal of this magnitude is unlikely. The most plausible
reason for such a withdrawal is public concern in several lending countries about the
security of gold reserves which are lent out (5.1.1-2).
· the effect of a large withdrawal would depend heavily on the position at the time of
the signatories to the Washington Agreement. If they were close to their self-imposed
lending limit, they would not be able to stabilise 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 speculative shorts). If
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 scaling 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 possibility of a sharp rise in the gold price bringing 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
Gold Derivatives: The market impact 73

followed the Washington Agreement (5.2).
· evidence from the term structure of lease rates suggests that the market has not attached
much probability 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 borrowing (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 the
gold lending which supports and hedges it has a maturity measured in months. If
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 few
months to repay the gold they had borrowed. In the absence of a very large holder
of gold stepping in to replace the lending, the pressures on the gold market would
be enormous. Indeed it could well be physically impossible to repay all the borrowed
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 banks
could 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 conclude
that it would take a sudden withdrawal of the order of several hundred
tonnes to seriously disrupt the market, that such a withdrawal is unlikely, and
that the most plausible reason for such a withdrawal is widespread public concern
about the security of gold reserves which are lent to a third party. The consequences
of a withdrawal would depend heavily on the position at the time of the
signatories 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 gold
price and lease rates might then rise very sharply, to levels which would cause
serious losses to both bullion banks and hedgers (producers, users of gold, and
speculative shorts). If the signatories were free to lend to the market, they would
be 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
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Gold Derivatives: The market impact

withdrawal turns into a major disruption. The impact of a shock depends on the
conditions 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. But
to provide some focus to the discussion it is useful to have an order of magnitude
in 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 shortselling
and producer hedging changes, and as central banks on occasion withdraw
lent gold from the market in order to sell it. To get some indication of the magnitude
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 135
tonnes; the largest change in demand being nearly 400 tonnes over the third
quarter of 1999.
1999 is quite instructive about the elasticity of the gold lending market. According
to GFMS, the volume of gold borrowing required to hedge producer forward
selling rose by no less than 715 tonnes in the first three quarters of 1999. Lease
rates did rise to historic peaks – by the end of the third quarter the three month
lease rate was at 5.8%, but that was in the immediate aftermath of the Washington
Agreement. Even before the Agreement, the lease rate was close to 4%, which
was very high by historical standards 2 .
Another measure of the elasticity of the lending market comes from shocks on the
supply side. The sharp rise in lease rates towards the end of 1992 was associated
with the withdrawal of gold by the Dutch government prior to a sale of 400
tonnes. This is some time ago, and the lending market has grown substantially
since then.
Putting this evidence together suggests that, with a lending market of around
5,000 tonnes, it would take a withdrawal of well over 10% of this amount to
cause serious liquidity problems, unless there were other special factors prevailing
at 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 country,
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 in
borrowing demand and the level of lease rates by regressing quarterly data proves fruitless. The regression
is only statistically significant if 1999 Q3 is included.
Gold Derivatives: The market impact 75

and total withdrawal by just one of these would probably be insufficient to provoke
a major crisis.
But in any case the likelihood of sudden and total withdrawal appears rather low.
The obvious reason for a sudden withdrawal of gold by an individual country is
that it wants to sell the gold, perhaps because of a foreign exchange crisis. Yet gold
in most cases comprises a small proportion of a country’s total reserves, and tends
to be much less liquid than other reserve assets. It is likely to be easier in a crisis
either to sell other assets or to borrow against the gold, than to liquidate it. The
sudden withdrawal of a single large lender from the market is only likely to be
disruptive if it occurs at a time when other lenders are close to their own lending
limits.
A more worrying scenario is one in which a number of lenders decide to withdraw
from the lending market at the same time. In a bank run, such a concerted withdrawal
would be triggered by fears of the ability of the borrower to repay; the run
occurs because every lender wants to be at the front of the queue. A run on a
single bank would probably not cause major problems to the system as a whole.
As with Drexel’s failure in 1990, it might lead to a period of hesitation as lending
institutions reconsider their credit exposure and their strategy for managing credit
risk. It might also lead to the use of credit enhancement mechanisms, such as the
use of margin or collateral. But there seems no reason why it should greatly affect
the volume of gold lending to the banking sector as a whole.
A run on bullion banks collectively fuelled by worries about their solvency seems
rather implausible. If bullion banking were confined to specialised bullion bankers,
shocks specific to the gold market could damage confidence in all bullion
banks and lead to some kind of run. But virtually all the leading players in the
market are large integrated financial houses. Short of a major crisis of confidence
in the entire financial system, it is hard to see a mass withdrawal from lending
caused by solvency concerns. Furthermore, the fact that the main lenders of gold
are themselves central banks with a strong interest in the stability of the financial
sector, means that they are unlikely to aggravate a systemic problem by withdrawing
deposits, whether of gold or other assets, just at the moment of crisis.
Solvency concerns then are not likely to be the cause of a mass withdrawal from
lending, but broader political concerns might be. If one considers the reasons
normally given for holding gold as a reserve asset, many of them (portfolio diversification,
lack of correlation with other assets) apply equally whether the gold is
held in physical form or whether it is lent. However, other advantages of gold,
such as the fact that it is an asset which is no one’s liability, that it gives public
confidence in the currency, that if appropriately held it is free from the danger of
another authority freezing the asset, are weakened if the gold is lent. As a result
some countries, most notably the US, do not lend their gold.
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Gold Derivatives: The market impact

In the face of a worsening international financial crisis, it is possible that opposition
to lending of national gold reserves fuelled by fears about security and repayment
might suddenly become powerful. Such opposition could well be international,
leading several countries to cut back their lending simultaneously. Thus a
large sudden withdrawal of gold from the lending market does not seem to be an
imminent or likely prospect. But nor does it appear to be so unlikely that it is not
worth 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 deposited
with another, this may create problems for the individual bank facing a loss
of 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 to
lend it to the market, there may be short-term liquidity problems, but it is unlikely
to cause a major crisis. Problems arise if the lent gold is withdrawn and not
lent out again, or if the gold is sold to a body which does not lend gold, as could
be 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 sector
suddenly 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 other
lenders. If the signatories to the Washington Agreement are close to their collective
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 the
desire or ability to fill the gap at short notice is small. Cross estimates that, excluding
these sources, there is currently no more than 1,000 tonnes of gold in the
official sector which could in principle be available for lending.
The short-term elasticity of supply is likely to be small. Lease rates would need to
be high for a prolonged period to get holders in the official sector to start lending
or 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 may
be 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 about
banks’ ability to satisfy their depositors, does not provide a strong incentive to
any institution to relax its lending policies rapidly.
There are only a limited number of ways of accommodating a withdrawal on this
scale if other holders of gold are not prepared to lend. One is through a reduction
in commercial banks’ loans to downstream users (jewellery manufacture, refining,
Gold Derivatives: The market impact 77

distribution). Since the interest rate on such loans tends to be floating, any change
in market rates is likely to be passed on very speedily to borrowers, who are likely
to react strongly to an increase in gold interest rates. Indeed, there was much
evidence in September 1999 of this happening with the jump in lease rates following
the Washington Agreement. Cross estimates that these stocks were running
at some 1,100-1,500 tonnes in 1999, so they could likely offset a substantial
proportion of the postulated withdrawal.
So far we have omitted the increased requirements of the commercial banks for
gold for themselves in the event of a crisis. If there is a serious fear of a squeeze in
the 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 their
depositors and customers when there is not a liquid lending market to rely on.
The aftermath of the Washington Agreement illustrates the point. The Agreement
apparently did not lead to any reduction in lending. Indeed there is some
evidence that new lending took place. But lease rates rose sharply, leading to a
substantial flow of consignment gold back to London; this was presumably held
by commercial banks seeking increased liquidity.
A large withdrawal and the absence of new lenders is likely to lead to spot market
purchases of the same order of magnitude as the volume of gold withdrawn, once
account has been taken of the reduction in consignment stocks and the increase
in 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 force
the spot gold price to rise sharply. So the withdrawal would be accommodated by
a combination of spot purchases (accompanied by a higher spot price), and reduced
gold borrowing downstream (encouraged by a rise in lease rates). This
would satisfy the physical supply and demand balance. But it does not necessarily
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 previously 3 . The
banks may be happy with this position if they believe that the spot price of gold
in future is likely to be higher than the current forward price. But if the immediate
crisis leaves the banks’ views about the future gold price unchanged, they will
only 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 five years from a producer. It
hedges 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 buys
gold spot and delivers it to the central bank. The commercial bank now has a naked long position in the
gold market since it is committed to purchasing gold at a fixed price from the producer and has no hedge.
78
Gold Derivatives: The market impact

lower than it was previously. This means that any rise in today’s spot price has to
be more than offset by an increase in lease rates.
It may help to give some illustrative numbers. Suppose prior to the crisis the gold
price is $270/oz and the lease rate is low. Suppose that 500 tonnes of lending is
then unexpectedly withdrawn from the market and not replaced. Suppose that
after allowing for a reduction in consignment stocks, and an increase in gold held
by commercial banks, commercial banks need to buy 500 tonnes of gold on the
spot market to meet depositors’ demands. Suppose that these purchases force the
gold price to rise to $330/oz. Suppose too that it is generally expected that the
market 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 and
expected to decline sharply. Not only will they want to sell gold forward, but so
too will all their customers.
The market will only be able to reach equilibrium if the one-year forward gold
price is around $270/oz – where the spot price is expected to be at that time. But
a spot price of $330/oz and a one year forward price of $270/oz implies a oneyear
gold lease rate of about 20%. Clearly all the numbers are just given as examples,
but they illustrate the fact that any shock withdrawals which cannot be
matched by increased deposits from other holders or reduced lending could force
a surge in the spot price and a very large increase in lease rates.
It could be argued that this informal calculation is excessively alarmist. Gold
interest rates have periodically peaked at around 4% but the peaks have never
lasted long, and rates have then gone down to well under 2% or less. But, following
the Washington Agreement, we are in a different world. With much of the
available supply of lending being constrained, a shock to lending which occurred
when the Washington signatories are close to their limits could cause far greater
volatility 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 jewellers
and other downstream borrowers of gold. To some extent they can mitigate
the 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 low
margin relative to the levels of gold inventory they carry. A rise in gold financing costs
of several percent could threaten the viability of some businesses and do long-term
damage to the whole system which distributes gold to the final consumer.
The major borrowers of gold are commercial banks. However, in many cases they
can pass on any rise in lease rates because of the nature of the forward purchase
Gold Derivatives: The market impact 79

contracts they have with producers. In rolling spot or spot deferred contracts the
price the bank is committed to paying for future production is reduced if lease
rates rise. Furthermore there is considerable use of products such as lease rate swaps
which shifts the risk between banks, and between banks and producers. There is
some evidence also of central banks taking on some of the lease rate risk.
Although producers disclose much more information about their hedge books
than they used to, it is still not possible in most cases to predict how far any
individual producer would be affected by a sudden spike in lease rates, nor indeed
how much of the risk is borne by producers collectively as opposed to commercial
banks. 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 commercial
failures. Second, that these are more likely to occur among producers than
commercial banks because the commercial banks active in the gold market tend
to be far more heavily diversified than are producers. Third, the risk of large
moves in lease rates reduces the attractiveness of hedging since it brings a new risk
which either the hedger or the seller of the hedging product has to bear, which
would 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 focused
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 sudden
reduction 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 maturity,
but not to take out any new hedges. The size of the aggregate producer hedge
book would decline by some 800 tonnes in the first year alone. The banking
sector 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 to
lease 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 not
find 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 whether
the build up in hedging depressed the gold price; a reversal of the build up might
also fail to have a clear impact on the gold price. Against this, it could be argued
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Gold Derivatives: The market impact

that the hedge book built up gradually over a decade; a sharp decline in the hedge
book might have a more noticeable impact.
But there are good reasons to believe that any impact on the price is likely to be
self-limiting. A steep rise in spot prices caused by a scramble for gold to repay
gold loaned from the official sector would be widely seen as temporary. A temporary
peak in the gold price accompanied by abundant supplies of physical gold
available for borrowing at low rates creates the ideal environment for short sellers
to come into the market. The short sellers could be speculators and hedge funds.
They could also include commercial banks, deciding to continue to borrow gold
and maintain a short position even when there is no longer an offsetting purchase
contract 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. Any
sharp increase in the gold price which is seen as temporary would undermine the
incentive for producers to act in concert. A producer with a substantial hedge
book who decides to scale it back will find it very expensive to implement the
policy at a time of temporarily high spot prices and low lease rates. Cutting back
the size of a hedge book means buying gold forward. But buying at a time when
the spot price is boosted by the actions of other producers, and the forward price
is very high relative to expected future spot price levels, is expensive. It makes
more sense to wait until the effect of changes in other producers’ hedge books has
worked its way through the market. A policy of not taking out any new hedges
would have a less obvious cost, but it would be hard to justify to shareholders
changing a policy of hedging just at the time when hedging looks as if it is most
likely to be profitable. It seems unlikely then that a voluntary reduction in producer
hedging would occur on such a scale and such a speed as to force a substantial
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 by
some exogenous factor, could force a substantial involuntary 4 liquidation of short
positions whether these are held by producers or speculators. Although the mechanisms
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 short
position. If the short has limited financial resources, he may be forced to liquidate
the position to avoid potential future losses even though the increase in the spot
price 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 in
the market caused by derivatives, and associated financing and other constraints. Trades provoked by
new 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.
Gold Derivatives: The market impact 81

In the case of a producer whose market short position exists to offset a natural
long position in physical gold, the threat of premature liquidation might seem
small since any loss on the short position should be fully offset by gains on the
physical position. But in practice the counterparties to the short position cannot
readily gain title to the physical resources in the ground, so a large realised loss on
the short position can create severe financing problems. Such problems have been
apparent not only in the gold market (e.g. Ashanti) but also in other commodity
markets (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 the
more 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 are
subject to margin requirements on their hedging; this suggests that such forced
liquidations would only apply to a small part of the overall producer hedge book.
Turning to speculators – hedge funds, commodity trading advisers and commercial
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 position
which is more relevant 5 , there have been few indications of many funds having
been long gold in recent years. The extent to which they would be forced to
liquidate positions depends on their leverage and also how large a part gold forms
in their portfolio. While relatively little is known about the composition of the
speculative short position, the response to the enormous price spike in September
1999 does give some confidence that only a small fraction of this position is likely
to be liquidated for financial reasons.
This analysis suggests that we are unlikely to see a steep spike in the gold price
brought about by a number of producers deciding to cut back their hedging
simultaneously. There is a possibility of a sharp rise in the gold price bringing
about the liquidation of some of the short positions held by both speculators and
producers, but there is no reason to expect in future that it would be on any
greater 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’s
view of the probability of serious disruption to the lending market. If borrowers,
hedging a long-term exposure using short-term loans, perceive a real possibility
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.
82
Gold Derivatives: The market impact

substantial premium for borrowing at longer-term. By extending the maturity
of their loans, they reduce the frequency with which they have to return to the
market. Thus when the perceived risk of disruption is high, longer maturities
should 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 vary
over time, and longer term rates are likely to reflect the market’s assessment at the
time of future changes in borrowing rates. Also, it is common in money markets
for the term structure to be on average upward sloping, possibly reflecting lenders’
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 that
the gold market might become illiquid, one would expect to observe a large premium
in longer-term rates, and one furthermore which varies substantially with
the perceived probability of a crisis. In this section we therefore examine the
behaviour of the term premium in gold lease rates to understand the probability
the 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 months
Mean rate: 1.34% 1.45% 1.55% 1.73%
Differences:
Mean: 0.12% 0.10% 0.18%
Standard
0.28% 0.22% 0.21%
Deviation:
% < 0: 21.0% 22.9% 15.0%
It can be seen that the lease rate curve is normally upwards sloping – the one
month 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 the
context of a level of lease rates which is itself not very high. An owner of gold who
chooses to lend his gold just in the one month maturity earns only 1.34% per
annum on average. Lending for 12 months the return is 1.73%, or 30% more.
Gold Derivatives: The market impact 83

Gold Forward Lease Rates 1993-99
5.0
Rolling monthly averages (%)
4.5
4.0
1 mth
3.5
2-3 mth
4-6 mth
3.0
7-12 mth
2.5
2.0
7-12 mth
1.5
1.0
0.5
1 mth
0.0
93 94 95 96 97 98 99
Source: Own calculations; Reuters
The chart shows the evolution of the term structure over time. It shows the 1
month spot rate, and the implied forward rates for borrowing 2-3 months forward,
4-6 months forward and 7-12 months forward. The upward sloping term
structure was a persistent feature of borrowing rates in the gold market, being
reversed only at times when the level of rates was high. The longer forward the
borrowing, the more expensive it is and the more stable is the rate.
5.3.2 How does the term premium behave?
The term premium – the difference between the cost of borrowing long, and the
expected cost of borrowing over the same period by a series of short-term contracts
– is not directly observable since we do not know the market's expectations
of future rates. But we can estimate the premium by constructing a forecast of
future rates, based on current rates, which would have worked well historically.
We focus on the one and three month rates 6 and compare the change in 1 month
rates over the next two months with the slope and level of the current term structure.
Specifically, we run the following regression for all months t:
84
Gold Derivatives: The market impact

(
t + 1,1) + r(
t + 2,1)
− r(
t,1)
= α + β
+
2
[ f ( t,2
− 3) − r(
t,1)
] β r(
,1)
1 2
t
where r(t,1) is the one-month spot rate at time t and f(t,2-3) is the forward rate
for 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's
forward rate, and the Expectations Hypothesis holds, then a should be zero, b1
should be one and b2 should be zero. If these parameter values are rejected, then
there is evidence of the existence of a term premium.
The results of the regression are shown in line A of the table below:
α β 1 β 2
adj R 2
[A] 1993-99: 0.49% -0.08 -0.37 20.2%
(0.14%) (0.21) (0.08)
[B] 1993-97: 0.06 1.10 -0.15 29.0%
(0.16) (0.34) (0.09)
(Standard errors in parentheses)
Line A clearly rejects the Expectations Hypothesis. Indeed, it suggests that the
shape of the term structure has no relevance in forecasting future lease rates – the
estimated coefficient is small (-0.08) and is statistically insignificantly different
from zero, but far from 1. The significant coefficient on b 2
suggests 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 we
look at the first five years of the data, we get a very different picture, as presented
in line B. The coefficient b 1
is now strongly significant both statistically and
economically. Indeed it is indistinguishable from 1. The coefficient b 2
is now not
significant. Line B supports the Expectations Hypothesis. It implies that the term
premium 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 years
than it does over the whole period.
Looking at the period 1993-97 only, it is reasonable to conclude that forward
rates have been a good predictor of future spot rates, and that the term premium
has been small. The evidence in more recent times is less easy to interpret. The fact
that the forward rate has not been such a good predictor of future spot rates could
be explained in two ways. One explanation is that the Expectations Hypothesis
6
The results for other maturities are consistent. The advantage of using short maturities is that the data
set is quite short, and the tests have greater statistical power with shorter maturity contracts.
Gold Derivatives: The market impact 85

emains valid, that term premia have remained small and stable, but the market
has been highly unpredictable. In particular, the market failed to foresee the
Washington Accord and the associated very steep jump in rates. Forward rates
then rose almost as much as short rates, reflecting the market’s belief that lease
rates 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 an
expectation about future short-term rates, but rather the fear of disruption suddenly
became 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 structure
in gold does tend to be upward sloping. The regression analysis suggests that the
term premium does not vary in a systematic way with the level or slope of the term
structure. It is still an open question whether the term spread which exists on average
does reflect some, albeit small, premium for disruption risk, or whether it can be
explained 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 months
Mean rate: 5.08%
(1.34%)
5.19%
(1.45%)
5.30%
(1.55%)
5.52%
(1.73%)
Differences:
Mean: 0.11%
(0.12%)
0.11%
(0.10%)
0.22%
(0.18%)
Standard
Deviation:
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 strikingly
similar. Since the spread in the dollar market does not reflect significant concerns
about market breakdown, it does suggest that term spread in the gold market is
unlikely to be due primarily to fears of illiquidity or market breakdown.
One can reasonably conclude that in the period prior to the Washington Agreement,
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 might
have been in long-term rates was comparable with term premia in money markets
where fears of disruption were negligible.
Since the Washington Agreement was signed, the relationship between the slope
of the term structure of lease rates and expectations of future lease rates has been
much less easy to explain. Certainly the evidence is consistent with longer-term
rates including a substantial but variable premium, reflecting varying levels of
concern about the availability of gold for borrowing.
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Gold Derivatives: The market impact

APPENDIX 1 THE INTERACTION BETWEEN
DERIVATIVE AND CASH MARKETS
Overview
Derivative markets have long attracted controversy. Some people argue that they have a
powerful distortionary impact on the underlying physical markets, reducing liquidity,
increasing volatility, depressing prices and generally damaging the interests of legitimate
users of the market. Others have argued for the beneficial impact of derivatives, pointing
to the way they facilitate the control of risk, and the efficient allocation of risk between
different agents, and the role that derivative markets play in ensuring that prices respond
to new information speedily and accurately.
The controversy has attracted much academic research, both of a theoretical and of an
empirical nature. In this report, we review the literature across both commodity and
financial markets, and seek to identify the mechanisms by which the existence of derivative
instruments may affect supply, demand and hence the price of the underlying asset.
We summarise and analyse the evidence for such linkages.
Derivatives take many different forms; in gold for example they include futures contracts,
forward contracts of various designs, gold loans, options with more or less exotic
features and gold-denominated bonds. But the most significant impacts of derivative
markets come with the introduction of the simplest instruments, forward contracts 1
.
The first section of the report discusses the economic function and purpose of forward
markets. It starts with contracts on non-storable commodities, extends the analysis to
take account of the effects of storage, and then looks at forward contracts on financial
assets. Commodity forward markets serve two principal functions: price revelation and
risk sharing. By revealing the price at which the commodity can be sold forward the
forward market improves the efficiency of investment in new productive capacity. By
allowing people to buy and sell forward, it improves the efficiency with which stocks are
used. Forward markets not only allow risk to be shared more efficiently between producers
and consumers but also facilitate outside capital entering the market and sharing
risk. In the case of financial assets, the major impact of forward markets is on the
liquidity of the market through the reduction of transaction costs, and the concentration
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 daily
basis.
Gold Derivatives: The market impact 87

The second and third sections of the report examine the impact of derivative markets on
the underlying physical market. Section 2 concentrates on the theoretical arguments and
considerations. It discusses the role of destabilising speculation and the impact of short
selling, the possible impact of fragmentation of order flow between the physical and
derivatives market, and the impact of producer hedging on output.
Section 3 reviews the empirical evidence. This has come mainly from financial rather
than commodity markets. The weight of evidence suggests that the impact of derivatives
markets is beneficial – derivatives improve the mechanisms for risk sharing, they increase
market transparency and they improve the speed with which new information is
incorporated into prices. There is no undisputed evidence which suggests that derivatives
markets destabilise the cash markets, and a substantial number of studies which suggest
that derivative markets may actually decrease the volatility and increase the efficiency of
the cash market.
The main conclusions coming out of this study are:
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 underlying
assets, but there is little evidence that this has been a problem in most other markets;
There is evidence that derivatives help make the underlying market more liquid, and
also increase the speed with which new information is incorporated into prices.
1 The economic role of forward markets
1.1 Commodity forwards
The standard explanation of the economic function of commodity forward contracts
in textbooks today owes much to the work of economists in the 1950s and
1960s including Working (1953, 1962), Johnson (1960) and Stein (1961). They
took issue with the then traditional view that there were two distinct types of
participant in the organised commodity futures markets – producers who used
the market to hedge, or minimise risk, and speculators who sought to make money
by taking a view. They argued that all participants in the market were likely, as
rational economic agents, to be interested in both risk and return. Working in
particular emphasises that producers and processors are likely to be well informed
about future price levels and relationships, and will tend to take a position on the
exchange when prices are out of line with their perception of fair value.
To explain the modern view of the economic function of forward markets it is
helpful to start with the problems of a producer – the owner of a mine, or a farmer
– who has to invest some capital in order to produce the commodity. The
88
Gold Derivatives: The market impact

producer faces price risk because of the time which elapses between making the
production decision and selling the commodity. When the producer decides to
invest in new capacity he incurs known costs, but the revenues are uncertain
because the price he will eventually receive for his output is unknown. In deciding
how much to produce (‘the investment decision’), the producer has to depend
on his own forecast of the future spot price of the commodity and bear the
risk of his forecast being wrong.
Suppose now that a forward market is opened. The producer has two decisions
to 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 to
affect 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 in
the presence of a forward market the investment and hedging decisions are
separable. The investment decision should be taken purely on the basis of the
forward price at the time the investment decision is taken. The producer should
act 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 producer
decides to sell his output forward, and whether or not he believes the
forward price is reasonable.
That is not to say that the producer should sell all his output forward. If for
example the forward price is far below the producer’s expectation of the future
spot price, and if he believes in his own forecast, he should not sell all his output
forward. 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 producer
necessarily acts on the basis of his own forecast of future spot prices and takes
investment decisions which take account of the uncertainty of the price at which
he will actually sell. With a forward market, investment decisions can be taken on
the basis of the current forward price, and uncertainty about the future price is no
longer a factor in investment decisions.
A number of important consequences flow from this separability result. In a world
where producers do not know much about the forecasts and production plans of
other producers, the forward price captures valuable information which makes
the investment process more efficient. The forward market makes it difficult for
the infamous ‘hog cycle’, beloved of economics text books, to materialise. In the
hog cycle, underproduction one year leads to a shortage with consequent high
prices. This attracts new producers into the market, leading to a glut the following
year. The result is a very volatile price. In the presence of a forward market in
hogs, this type of behaviour would not occur. With a forward market, the feedback
loop is instantaneous and production plans which in aggregate will lead to
Gold Derivatives: The market impact 89

over-production will cause forward prices to fall and plans to be revised before
they are put into effect.
In addition to providing information which is socially valuable, forward markets
also lead to more efficient sharing of risk in the economy. In a world without
forward markets, each producer bears price risk on his own output. With forward
markets producers who are risk averse sell their production forward, and thereby
reduce or eliminate the risks they have to bear. The long side of the forward
market is taken by producers who are readier to bear risk or, more plausibly, by
consumers 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 hedging
needs of consumers who are buying forward, the forward price will tend to be
forced below the consensus forecast of the future spot price. Long forward positions
will tend to deliver positive, if risky, returns 1 . Speculators 2 will be attracted
into the market, predominantly on the long side.
If risks are borne by those more prepared to bear them, then the cost of risk borne
by the economy as a whole is reduced. The existence of a forward market, by
improving the efficiency with which risk is borne, reduces the effective cost of
production of the commodity in much the same way as more efficient production
technologies. As with any other cost reduction, the ultimate impact depends on
the degree of competition upstream and downstream. If input and output markets
are competitive, the reduction in costs will lead to higher profits for producers,
which will in turn attract new investment which will then lead to increased
output and lower prices. The technological improvement whether it comes from
improved production technology or improved risk sharing technology, leads to
the creation of value. The division of this value between producers and consumers
depends on the relative elasticity of supply and demand.
On this traditional view, forward markets reduce the volatility of the underlying
spot price by providing a mechanism for concerting investment decisions, and
aggregating information about the future supply/demand balance. Forward markets
will tend to lower commodity prices by reducing the risk which producers
are forced to bear. By improving information flows and risk sharing, forward markets
will tend to improve welfare in the economy, though how that welfare gain is
shared between parties is not clear from the model.
2
The predicted positive expected returning on long forward positions is known as ‘normal backwardation’
and was first discussed by Keynes (1930) in his Treatise on Money. It is quite distinct from the other
use of the term backwardation to signify the situation when the current forward price is trading below
the spot price.
3
The term ‘speculator’ is used in a technical (and morally neutral) sense to signify an agent who has a
purely financial interest in the commodity, intending neither to produce it nor consume it.
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Gold Derivatives: The market impact

1.2 The role of storage
So far we have ignored the role of storage; the model presented applies most
naturally to the production of an agricultural commodity where there are two
periods – a time for investment and a time for consumption. But for commodities
like gold which are extracted rather than grown, and which can be stored if not
consumed, more sophisticated analysis is required.
Note that the existence of a forward market is equivalent to the existence of a
commodity lending market. If the forward market exists, a synthetic commodity
loan can be constructed by a spot sale and forward repurchase. Conversely, if a
lending market exists, a forward sale can be synthesised by a spot sale coupled
with borrowing the commodity. There may be some institutional differences between
the contract and its synthetic equivalent, but these are small relative to the
similarities, and at this stage of the analysis we can ignore them. For the present
then in discussing the impact of a forward market, I include commodity lending
markets as well as standard forward markets.
The equivalence between forwards and commodity lending also means that the
prices in the two markets are tied to each other. Assuming a standardised commodity,
and ignoring taxation, credit and other similar issues, the cost of borrowing
a commodity, expressed as an annually compounded rate b for a time of length
T must be related to the spot price today S 0
, the forward price today for delivery
at T denoted by F 0,T
, and the riskless rate of interest r (also continuously compounded)
by the formula:
F
0, T
= S e
( r−b)T
0
Note that, in this definition, the person borrowing the commodity also bears the
cost of storage, insurance and so on.
If there is a forward or a commodity lending market, and if individual agents are
too small to influence the market, people holding inventory presumably believe
that they are getting some benefit from holding stocks which equals or exceeds
the borrowing cost. Otherwise they would be better off lending the commodity
to someone else. Now the benefits from holding stocks include the savings when
there is breakdown in logistics, a surge in demand or a sudden spike in the price.
It is reasonable to assume that there will be a strong link between the size of these
benefits at the margin and the level of stocks held. If the level of stocks is very low,
a small hiatus in supplies could cause disruption, so the marginal value of inventory
is high. Conversely when stock levels are high, even a large and improbable
shock may have little impact, so the marginal value of inventory will be low, and
commodity borrowing rates will also be low.
Gold Derivatives: The market impact 91

There is a welfare gain from opening a market in commodity borrowing. In the
absence of a market, the only way to borrow the commodity is to buy spot now
and then sell spot in the future. The cost of borrowing is uncertain. An agent’s
assessment of the cost will reflect their own assessment of where the spot price
will be in future and on their attitude to risk. Different agents will assess the cost
differently, and agents who assign a low cost to borrowing will be holding inventories
which could be used far more efficiently by other agents who put a higher
cost on borrowing. With a market in borrowing the commodity, these agents will
be able to trade until they equalise their marginal benefits from holding stock.
The level of borrowing rates affects production decisions as well as storage decisions.
Suppose for example that stocks of the commodity are sufficient to meet
ten years demand, and that storage costs are negligible. Then the cost of borrowing
the commodity for up to ten years should be negligible, and the forward price
should equal the spot price plus the riskless interest rate. An agent who contracts
to sell one ton of the commodity forward to some time T (less than ten years) will
be 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 we
have already argued, in the presence of a forward market the output of the mine
should be valued using today’s forward price whether or not the output is actually
to be sold forward. Assume that the producer wishes to maximise the present
value of future profits. The present value of future revenues is independent of the
time at which the mine is developed. The present value of future costs is likely to
fall the longer production is delayed. This is for two reasons. First, technological
improvements will tend to reduce the costs in real terms. Second, provided that
the appropriate discount rate exceeds the rate of inflation (a very plausible assumption)
delaying any costs adds to project value. This means that the profit
maximising owner will delay developing the mine 4 .
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 defer
production. Conversely, if stocks are low and commodity borrowing rates are
high, forward rates will be low relative to spot rates, and producers will have an
incentive to accelerate production.
4
Indeed there is a further reason for delay. The undeveloped mine has option value. The commodity
price can change for better or worse; if the mine is already under development the owner may have little
alternative but to proceed according to plan. With the mine not yet developed, the owner can respond
by bringing forward or delaying development further.
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Gold Derivatives: The market impact

1.3 Financial forwards
There are substantial differences between commodity and financial forward contracts.
In general financial assets are held for financial reasons, and the only compensation
the owner will require for lending the asset is the cash flow the asset
generates (such as interest coupons or dividends). The cost of borrowing a security
over a period when it generates no cash flow is close to zero. There are exceptions:
bonds may be more expensive to borrow if they are ‘on the run’ and therefore
particularly liquid, or if they are the cheapest to deliver into a futures contract.
Equities may similarly be costly to borrow if there is some corporate event
like 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, at
least 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 forward
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 forward
price. Unlike a commodity forward market, a financial forward market provides
little information not already available from the spot market. Furthermore, transactions
on the forward market can readily be replicated without the forward market.
A long forward position can be synthesised by a spot purchase financed by
borrowing. A short forward position can be synthesised similarly if the underlying
can be sold short.
Financial forwards and futures reveal little new information and barely extend the
range of feasible trading strategies. Their impact comes from the liquidity and
reduction in transaction costs they provide. A long spot position financed by
borrowing 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 easier
and cheaper for traders with poor access to credit markets to get a highly leveraged
position. The standardisation of the terms of the contract means that trading is
concentrated in a single liquid and transparent pool. The ease of netting long
and short positions makes futures markets particularly well suited for holding
positions 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 prohibited
or costly.
1.4 Long-dated forwards, options and other derivatives
Despite the variety of derivative contracts which are actually used, we have concentrated
so far on a single forward market. It is worth considering briefly the
additional economic functions served by having a richer collection of derivative
contracts. One function they serve is to enable traders to delegate the execution of
Gold Derivatives: The market impact 93

a strategy to a specialised intermediary. For example, a producer may want to
hedge, but may dislike the unpredictability of cash flows associated with
the mark-to-market on futures contracts. If the producer buys a forward
contract from an intermediary, and the intermediary then buys futures contracts,
the intermediary bears no significant risk, but effectively acts as an agent
of the producer.
But many derivative contracts allow different risks to be traded. Consider longdated
forward contracts. Forward contracts of different maturities tend to be quite
highly correlated, so a long-dated contract can be replicated reasonably well by
taking 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 a
rolled over short contract comes because in the former the convenience yield is
locked in from the beginning, while in the latter it is determined by the market at
each contract roll.
The existence of long maturity contracts is therefore particularly important in
commodities where the convenience yield (or, equivalently, the cost of borrowing
the commodity) is very volatile. In the case where a producer sells gold forward
long term 1 to an intermediary who hedges by selling short dated futures contracts,
the producer is getting rid of all price risk, the intermediary is taking
convenience yield risk, and the spot price risk is borne by the counterparty in the
futures market.
Many other derivatives are structured with option-like features. The Black and
Scholes approach to option pricing, which underpins all modern theories of derivatives,
shows how an option can be replicated exactly (under certain assumptions)
by dynamically trading the underlying forward contract. Inverting this
argument, one can say that options are not redundant from an economic perspective
precisely to the extent that those assumptions are not valid. The key assumptions
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 purchased
a put option from an intermediary who then hedges in the forward
market. The risk left with the intermediary is that the forward price will be
much more volatile than expected, that the price jumps (particularly when it is
close to the strike price), and that the market becomes illiquid when prices are
moving rapidly.
5
Some forward contracts with a long maturity, such as rolling spot contracts, are actually structured so
as to leave the convenience yield risk with the producer.
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Gold Derivatives: The market impact

The existence of a rich array of derivative contracts beyond a simple forward contract
allows participants to delegate the execution of trading strategies to financial
intermediaries, and to enable them to manage more subtle risks than changes in
the level of the spot price, such as changes in the future commodity lending rate,
and changes in the volatility of prices.
2 Derivatives and market quality: theoretical
considerations
Much of the debate about the impact of derivatives markets on the underlying
has turned on the issue of whether making markets more liquid, reducing barriers
to participation and widening the range of risks which can traded is always beneficial,
or whether it can damage the quality of the underlying market. In general
it seems plausible that the opening of a new market, such as a forward market or
a market in options, can only be beneficial. No one is forced to use the market.
People who do use the market do so because they believe they get some benefit
from using it. Even if the new market attracts irrational speculators who trade on
whim or fashion, and they destabilise prices, they cannot exist forever. In the long
run their irrational behaviour will cause them to lose money and they will be
eliminated from the market.
There are also informational benefits from opening new markets. Unless the new
market is totally redundant, prices on the market will reveal information to the
public. One might reasonably assume that increasing generally available information
is beneficial.
Yet these general considerations are not compelling. As Hart (1975) demonstrates,
it is possible to design theoretical models in which the opening of a new financial
market is damaging. He shows how in a world of rational utility maximising
traders opening a new market can diminish welfare. The argument that irrational
investors will be eliminated from the market in the long run is also not very
powerful. The long run may turn out to be very long indeed. If there is a continuing
supply of irrational investors into the market, there can well be a significant
and persistent population of irrational investors as some die and others are born.
In the rest of this section we explore the main theoretical reasons for believing
that derivatives may affect the cash market: the ease of building a highly leveraged
position, the ease of short-selling, the fragmentation of trading between cash and
derivatives markets, the impact of hedging on physical production, and the ability
of a large trader or cartel to manipulate prices.
Gold Derivatives: The market impact 95

2.1 Derivatives market and leverage
It has often been argued that low transaction costs and, particularly, the availability
of high leverage, encourage speculation and that this speculation damages the
underlying market. While the detailed argument varies somewhat, the general
idea is that there are irrational investors who exhibit their irrationality through
some kind of herding or trend following behaviour. These irrational investors are
credit constrained so the existence of a futures market 6 allows them to enter the
market and build up larger positions than they would otherwise take. Opening a
futures market allows more investors to enter the market, which is a good thing
since it improves the risk-sharing activity of the market. But it also reduces the
average level of rationality, which is damaging.
The real damage done, however, by the irrational investors occurs because their
leveraged position tends to induce stampedes. Suppose that irrational investors
have built up a large long position, forcing prices above their natural equilibrium
level. If the market then starts to move down, their high leverage and limited
access to credit forces them to liquidate part of their position. If these irrational
investors are large in aggregate, the rest of the market will only be able to absorb
the trades by moving prices still further down. The sales snowball, and prices
crash through the equilibrium level.
This argument seeks to relate the existence of derivatives markets to crashes, but
the argument is symmetrical. It can be used equally well to explain steep price
rises if the irrational investors start net short, and are forced to cover their short
positions in a hurry. The conclusion is that easy leverage in general, and futures
markets in particular, cause an increase in the volatility of the underlying.
A number of authors have developed formal models to assess the net welfare impact
of opening a derivative market, but the results depend on the parameters
used. Stein (1987) for example has a model where speculators are not allowed to
trade on the spot market but are active traders on the futures market. This can be
seen as an extreme case of credit constrained speculators, and a spot market with
very high margin requirements. The speculators have noisy information, but are
irrational in the sense that they think their information is better than it really is.
This makes the futures market price a noisy signal of supply disturbances. The
noise is transmitted by arbitrage to the cash market, which reduces the quality of
the cash market. The opening of the futures market therefore both increases the
risk bearing capacity of the market and also adds noise. Stein shows that the
benefit of the first can be more than offset by the damage done by the second,
though this is not the case for what he takes to be realistic parameters.
6
The argument focuses on the way futures markets allow traders to get high leverage. Traders can also get
leverage if they are allowed to buy spot on margin, so the arguments apply equally to margin requirements
in the spot market.
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Gold Derivatives: The market impact

The argument that leverage induces volatility was largely endorsed by the Brady
Commission (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 Securities
and Exchange Commission, the Federal Reserve Board and the Commodities
and Futures Trading Commission. The SEC Chairman concluded that raising
margins 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 selling
easier. In some spot markets short selling is either prohibited or restricted (for
example, on the New York Stock Exchange, stocks can only be sold short on an
up-tick). Even where short selling is unrestricted, the seller needs to borrow the
asset in order to deliver it to the market, and stock borrowing may be difficult or
expensive for tax or regulatory reasons. By contrast, on a forward or futures market
it is as easy to go short as to go long. Arbitrage then ensures that any selling on the
forward 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 which
they can sell, their weight in determining the market clearing price will be diminished.
But the argument is not convincing. It ignores the fact that those who
sell short must ultimately buy back if they are to realise any profits. It also assumes
that the trading behaviour of other parties is not affected by the short
selling constraint. If traders know that those who are more bearish about the price
are unable to participate in the market, they will surely treat the consensus view
of those who are participating as biased upwards.
A further argument against the view that short-selling constraints increase prices
is that the constraints would not have any effect on the income from holding the
asset. A higher price would mean that the total return (running return plus capital
growth) would be lower on constrained assets, and investors would therefore
shun them, leading prices to match those on unconstrained assets. However this
argument is less applicable to gold than to other assets because of the peculiar
nature of the return from holding gold.
There are reasons for believing that short-selling constraints may actually reduce
asset 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 asset
will tend to be lower, and owners of the asset will lose income from lending the
asset. It is striking how in recent years many governments have taken measures to
make it easier to sell their bonds short. They have a strong interest in raising the
Gold Derivatives: The market impact 97

prices of their bonds and reducing their borrowing costs, so in the particular case
of the government bond markets at least it appears that the issuers believe that
allowing short selling raises rather than reduces spot asset prices.
2.3 Derivative markets and fragmentation
When individual stock options were first listed in the US one of the concerns was
that it would fragment the market in the underlying and reduce liquidity. There
was never much evidence that this was a problem in practice. In recent years, as
the New York Stock Exchange has lost its effective monopoly on trading in individual
shares, it has become clear that many competing market places can be
linked electronically without any danger of the ‘pool of liquidity’ being broken
into a number of smaller, shallower pools.
However there are some issues of fragmentation which still merit attention. In
particular, the listing of a stock index future enables investors who want to change
their market exposure to do so in one transaction rather than through a large
number of individual stock trades. With much of the portfolio trading going
through the index futures market, and only the net being transacted on the spot
market, this means that a higher proportion of trading in individual stocks reflects
investors’ views on those specific stocks rather than reflecting views on the
market as a whole. If on average those stock-specific views are correct, then intermediaries
who provide liquidity will need to protect themselves from dealing
with well informed traders by restricting the size in which they deal and widening
the spread. Thus the introduction of a stock index future may lead to a widening
in dealing spreads and a reduction in market depth in the underlying spot
market. Ultimately this could affect the depth and liquidity in the futures market
as well.
The existence of derivatives trading can also affect information flows. One function
which many markets perform is dissemination of trading information – volumes,
prices and so on. To the extent that transfers of economic interest take place
outside the reporting net, this trading information becomes less accurate. It would
not be right to equate derivative trades with unreported trades. Typically, trading
on derivative exchanges is as open and transparent as trading on spot markets.
Off-market spot transactions are no more transparent than off-market forward
transactions. But there is a particular issue relating to options transactions.
If a trader buys an over-the-counter forward contract, the contract itself may not
be known to the market. But the counterparty to the transaction, typically a
financial intermediary, will hedge himself and that hedging trade may become
known to the market. So in effect the intermediary is doing the trade on behalf of
the client, and even if the original trade is not known about immediately it is
concluded, it impacts the market soon after. But now consider what happens if
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Gold Derivatives: The market impact

the trader buys an option contract. The counterparty may well choose to delta
hedge the transaction, putting on a hedge right away and then adjusting it as
prices change, buying as prices rise, selling as they fall. The initial hedge becomes
known to the market soon after the contract is signed, but the subsequent trading
only 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 is
the result of a contract entered into some time earlier, the market may interpret
the selling as being based on current information, and therefore mark prices down
further. Genotte and Leland (1990) have a theoretical model in which relatively
small option positions which are not known to the market give rise to substantial
price instability. It provides some theoretical support for the view that portfolio
insurance played a significant role in the stock market crash of 1987.
Following up on this argument, it is interesting to analyse why formal portfolio
insurance or option based strategies should have such a severe effect. There seems
little difference in principle between an investor who enters now into some option
contract in effect delegating the dynamic trading strategy to an intermediary,
and one who changes his portfolio composition as relative prices change,
doing the dynamic trading himself. Presumably the purchaser of portfolio insurance
would, in the absence of an explicit service provided by an intermediary do
implicit 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 contracts
are drawn up. With precise strike levels and time horizons, the delegated
strategy may be quite abrupt with large price moves necessitating large transactions,
and with particular trading intensity at specific price levels or times. The
investor following a broadly similar strategy may do it less mechanically, adjusting
his trading to market conditions.
So far we have discussed the impact of derivatives on the general volatility of spot
prices. But the hedging of derivative contracts can also have a more local and
short-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 and
barrier levels which are round numbers. Hedging and arbitrage activity is likely
to be particularly intense whenever derivatives are close to expiry and whenever
the price is close to the strike or barrier level. This intense trading activity could
well affect the price of the underlying at least temporarily.
The hedging at expiry issues affects futures and forward contracts as well as option
contracts. While the great majority of exchange traded futures contracts are
closed out prior to maturity, some are held to maturity, and they play a crucial
role in maintaining the integrity of the futures market. Now with contracts which
Gold Derivatives: The market impact 99

equire physical delivery, the maturity of the futures contract can see particular
demand for the deliverable asset and, if several grades are deliverable, on the cheapest
to deliver. There is scope for manipulation here, creating a squeeze for example
by holding a large long position and also buying up available supplies of the
deliverable asset. But even without deliberate manipulation there is scope for the
price of the deliverable asset to be distorted by the existence and terms of the
futures contract.
If the contract requires cash settlement the futures contract can also affect the
spot market at maturity. For arbitrageurs who hold a futures position and an
offsetting cash position need to trade in the cash market at maturity if they want
to close out their position. The simultaneous presence of a large number of traders
who are not interested in absolute price levels – selling at the highest, buying
at the lowest – but rather in relative price levels – their average realised price
relative to the closing price of the futures – can lead to trading behaviour which
destabilises the cash market.
2.4 Derivative markets and production decisions
The existence of derivatives will have a significant impact on the underlying market
if producers use derivatives for hedging, and if their subsequent production
and investment decisions are affected by the hedge. The assumption that producers
behave like risk averse economic agents which provides the basis for much of
the analysis in the first section of this report is hard to motivate in a world where
they and their shareholders have free access to the capital markets. Even if shareholders
are risk averse individuals, corporate hedging may be unnecessary because
the risks are likely to be insignificant in the context of a diversified portfolio. In
cases where the shareholder does wish to hedge, it may well be easier for the
shareholder to do so directly for the portfolio as a whole rather than depend on
the hedging policies of individual managers.
There has been a surge in theoretical papers dealing with this question. Smith
and Stulz (1995) identify three motives for hedging at the corporate level which
apply even if shareholders can hedge risk as cheaply on their own account:
· Taxes: taxes are not fully symmetric. Hedging may add value by reducing the
probability of unrelieved tax losses.
· Bankruptcy: bankruptcy is costly. Hedging may be useful in reducing the variability
of earnings and hence reduce the probability of financial distress.
· Agency: firms are managed by managers who have their own financial objectives.
Depending on their remuneration package and stock ownership, they
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Gold Derivatives: The market impact

may wish to manage risk to optimise their own utility. Insofar as they have
heavy and rather undiversified exposure to the firm, they may well wish to
hedge. This urge to hedge will be offset to some extent if they have an asymmetric
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 for
hedging. 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 their
skills, and are less subject to chance.
Froot, Scharfstein and Stein (1993) point to yet another reason for hedging based
on the costs of external fund raising. Firms get investment opportunities which
are valuable. Because of capital market imperfections, such as information
asymmetries between shareholders and management, it is more costly to raise
funds externally than internally. Then unforeseen fluctuations in cash flow may
lead to good investment projects not being exploited. By stabilising cash flow,
hedging may allow the firm to continue to invest when internally generated cash
flows are low.
All these various motives for hedging also lead to hedging decisions having a real
impact on operating decisions. For example if bankruptcy is costly, then a company
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 the
output forward, the value of the project may not increase, but the reduced probability
of financial distress may allow the project to proceed. Faced with the question
of shutting down a potentially loss making venture, the fact that the sales
price is hedged may similarly reduce the risks and allow the project to continue
longer 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 explicitly
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 if a
number 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 supply
of a commodity over time, it is sometimes possible for them to control a substantial
proportion of the commodity which is actually deliverable at some specific
point 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 the
futures market, and ensure that most of the commodity which is deliverable against
Gold Derivatives: The market impact 101

the contract is actually in their possession. The spot price gets bid up and so does
the future. The coalition can make profits either by closing out the position at a
high price or by selling the physical commodity at a high premium.
Corners distort the spot market, and prevent futures markets from achieving either
price discovery or effective risk sharing. They depend on monopoly power or
on a coalition of some kind for otherwise each agent who is part of the squeeze has
an incentive to take his profit just before everyone else does, and the squeeze never
takes place. They are perennial problems of commodity futures markets and in
practice futures exchanges use a number of ways to identify and then frustrate
such tactics.
3 Derivatives and market quality - empirical
evidence
There are numerous studies which seek to detect the impact of futures trading on
the underlying market. In general they find little or no evidence that derivatives
damage the underlying market, and some studies find beneficial impact. The
large 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. It is
easy enough to compare market quality measures (volatily, auto-correlation, depth,
bid-ask spread) before and after the opening of a futures market. But for each
market there is normally just one observation – the change between before and
after the market opens Showing a significant change over that period is a long way
from showing that the change in market quality was caused by the opening of the
futures market.
It would be easier to ascribe causation if any change due to the futures market is
expected 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 underlying
spot market is likely to be felt gradually as the volume of trading picks up.
The direction of causation is also an issue. If futures markets are needed for risk
management and hedging purposes, they are most likely to be introduced when
the underlying market is volatile. But volatility tends to be mean reverting. So
one would then naturally find that the opening of a futures market is accompanied
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 futures
because each raises rather specific issues. The textbook theory of futures
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markets suggests that they should have greatest impact in smoothing out supply/
demand imbalances and reducing volatility when the underlying commodity is
expensive to store or actually deteriorates in storage. So we turn first to look at the
evidence from commodity markets.
3.1 Evidence from commodity futures
The early research on the impact of commodity futures trading on the spot market
concentrated heavily on potato and onion markets. Working (1960) found
that ‘futures trading in onions substantially reduced the amount of price variation
in spot prices of onions’. Gray (1963) found that futures trading reduced the
range in seasonal onion prices, and the range increased after onion trading was
banned. Johnson (1973) however, surveying the entire period from 1930 to 1968
concluded that ‘there was no significant shift in price performance in the cash
onion market during the entire period’. Emerson and Tomek (1969) found no
evidence that futures trading in potatoes influenced the average annual spot price
level, and Gray (1974) suggests that it has stabilised annual variability through
stabilising production levels.
Cox (1976) looked at six agricultural commodities over the period 1928-71. He
found that serial correlations and variances both declined after the listing of futures
contracts suggesting that the opening of a futures market improved the
quality of the underlying price.
3.2 Evidence from bond futures
As already noted, gold is in many ways more like a financial instrument than a
commodity. Storage costs are low, it does not deteriorate, the value of physical
possession is low and there is an active borrowing market. It is therefore interesting
to look at futures on financial instruments, and we start with the oldest financial
futures contracts, bond futures.
The first traded bond futures contracts were on Government National Mortgage
Association (GNMA) certificates. They started trading in 1975. Froewiss (1978)
looked at the volatility of spot GNMA bond prices before and after the futures
market opened, comparing it with the volatility of Treasury bond prices. He found
the relative volatility unchanged, though the two volatilities were more closely
correlated after the futures opened. The positive auto-correlation in GNMA spot
price returns before the futures opened vanished after the opening of the futures
market. He concluded that futures trading had not destabilised the spot market,
that it could possibly have resulted in more efficient information processing in
Gold Derivatives: The market impact 103

the GNMA market, reduced random fluctuations in GNMA spot prices, and led
to the GNMA market being better integrated with the Treasury bond market.
Simpson and Ireland (1982) also looked at the volatility of GNMA yields before
and after the opening of the futures market, controlling for the volatility of Treasury
and FNMA bond prices, and concluded that ‘trading in GNMA futures did
not affect the volatility of cash prices for GNMA certificates’.
Figlewski (1981) regressed the volatility of GNMA prices on the amount of open
interest 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 activity
led to an increase in spot price volatility. However, the results are sensitive to
the comparison period used. When Moriarty and Tosini (1985) extended the
sample period to 1983, they found no evidence that the opening of the futures
contract affected volatility of the spot market.
The fundamental problem with these studies is their lack of power to identify any
causal link. Showing that market quality measures are on average different in the
periods before and after the market opens is not compelling evidence of a link
between 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 helps
very little since it too is highly correlated with time.
Seeking to avoid these problems Bhattacharya, Ramjee and Ramjee (1986) look
at the time series properties of daily volatility in the cash and futures market and
test whether unexpectedly high volatility in one market is followed by increased
volatility in the other. They find weak evidence of futures volatility leading spot
market 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 destabilizing
effects in the cash market.’ The implications one can legitimately draw from a
test of this sort are quite limited; the fact that high volatility in the futures
market is followed by high volatility in the cash market does not necessarily
mean 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 the
introduction of the Treasury bond futures contract in 1977. After correcting for
macro-economic variables he finds a small reduction in volatility. When using
futures market trading volume and open interest as explanatory variables, he finds
coefficients which are insignificant though negative. He concludes that his results
‘while not powerful, are consistent with the notion that the T-bond futures market
helped reduce the daily volatility in cash bond prices’.
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Hegde (1994) attempts a more severe test of the impact of Treasury bond futures
on the spot market. He argues that if the impact does exist it should be particularly
obvious in circumstances where the degree of interaction between the spot
and futures market changes most abruptly. He therefore looks at the volatility of
the bond which is cheapest to deliver as it becomes cheapest to deliver or as it
ceases to be cheapest to deliver, and also at the volatility of the cheapest to deliver
over the delivery month. For it is the cheapest to deliver bond which is likely to be
the subject of most arbitrage activity, and where the impact of futures induced
volatility is likely to be most marked. Looking at daily data from 1979-88, he
concludes that ‘the tests fail to reject the null hypothesis that changes in the price
level 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 is
not necessarily a bad thing. If fundamentals are volatile one would expect a wellfunctioning
market to reflect the fact. But one would expect a well-functioning
market to process information rapidly and efficiently. Positive auto-correlations in
returns are an indication that prices are slow to adjust to news; negative autocorrelations
are a sign that they overreact. Cohen (1999) tests for auto-correlations
in three major bond markets (US, Japan and Germany) by looking at variance
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 government
bond market) they decline. The declines in variance are statistically
significant. The evidence therefore suggests that these major markets have
become significantly more efficient following the opening of futures markets
and, to a lesser extent, options markets. However, attempts to tie the improvement
specifically to the opening of derivatives markets were unsuccessful.
The changes were too gradual to confirm or reject the hypothesis that
other 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 are
on an index or basket of stocks, and that they are cash settled. One reason that
opening an index futures market may have a real impact is that it gives the opportunity
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 done
at a price known in advance, or if, as is normally the case, the bid-ask spread in
the future is much narrower that is in the individual stocks.
Gold Derivatives: The market impact 105

Cash settlement is also significant. Traders holding futures positions at expiration
who want to maintain their exposure must trade in the cash market at or near to
the point of expiration. This trading activity, and the impact it has on prices, have
been the subject of some attention.
Edwards (1988) compares volatility before and after index futures contracts
were listed, and finds no evidence that the S&P 500 and Value Line futures
contracts in 1982 increased volatility in the cash market. While he finds that
there is increased volatility on those days when S&P 500 futures contracts expire,
the excess volatility is largely confined to the last hour of trading, and
much of the price movement is reversed the following day. He ascribes this
largely to a temporary liquidity problem rather than to some permanent increase
in volatility. These results on expiration confirm and extend earlier work
by Stoll and Whaley (1986).
Jegadeesh and Subrahmanyam (1993) show that the bid-ask spread on S&P 500
stocks increased following the introduction of the S&P 500 futures contract in
1982. This work, based on daily data, also found evidence of an increase in the
adverse selection component of the spread in those stocks, but the results are not
statistically significant.
Their work is supported and extended by Choi and Subrahmanyam (1994) who
use intra-day data to investigate the impact of the opening of the MMI (major
market index – a 20 share index) contract on the cash market in 1984. The choice
of contract is dictated primarily by data availability; no reliable intra-day price
data were available when the S&P 500 contract opened two years earlier. They
examine three samples of stocks before and after the futures started trading:
the 20 stocks in the MMI, 20 S&P 500 stocks not in the MMI, and 20 stocks
not in the S&P 500. They look at the behaviour of the average bid-ask spread
and find that, when corrected for general trends, volatility, prices and volume,
the spread on the MMI and S&P 500 samples widened, but that on the
non-S&P 500 narrowed. The changes are small economically, but significant
statistically. They also find that these changes are mirrored in changes of measures
of information asymmetry, with widening asymmetry being associated
with widening spreads. They find no evidence of increased volatility, but volumes
did increase.
The evidence is consistent with the thesis that futures markets increase trading
volume and information flow to the underlying market. The changes in spread
appear to be due to a change in the proportion of informed trading in the underlying
stocks: with the introduction of a futures contract, traders who have no information
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.
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Cohen (1999) shows that the introduction of index futures into four major equity
markets (US, Japan, Germany and UK) was accompanied by a significant fall
in 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 trading
was accompanied by the underlying market becoming more efficient, but there is
no evidence of causation.
A study by Lee and Tong (1998) looks at the impact of the introduction of futures
trading on individual stocks in Australia. This is interesting because the
introduction 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 individual
stock must be due solely to the opening of a futures market on what was already
a traded underlying. Lee and Tong look at volatility and volume, and control for
other market wide changes in these variables by comparing with a sample of large
stocks on which no futures were traded. They find no evidence of a change in
volatility, but clear evidence of an increase in trading volume in those stocks where
futures are introduced.
3.4 Evidence from stock margins
The debate about the impact of futures markets on the cash market has been
paralleled by a debate about the impact of stock margins. Under the US Securities
Exchange Act of 1934, the Federal Reserve Board (FRB) has determined
the initial margin requirements for stocks. The lower the margin, the more that
an investor can leverage an initial cash outlay. If the level of stock margins does
have a significant impact on the volatility of prices, then it is highly plausible
that stock index futures would also have an impact on volatility, since they
provide 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 negative
correlation between the level of margins and the volatility of returns on the S&P
500. The results have been strongly contested. In particular Hsieh and Miller
(1990) argue that the Hardouvelis results are based on faulty econometric techniques,
and that the data properly interpreted do not support his claims. Other
empirical studies of the issue have also failed to support Hardouvelis’ thesis. Kupiec
(1998), in a review article, concludes that ‘no substantial body of scientific evidence
supports the hypothesis that margin requirements can be systematically
altered to manage the volatility in stock markets’.
Gold Derivatives: The market impact 107

3.5 Evidence from options: price levels
Much of the empirical work on options has been done on individual stocks. It is
convenient to look separately at the impact on price levels, on the riskiness of the
underlying, and on information effects.
If options are redundant securities (because they can be replicated by delta trading)
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 the
underlying more attractive to hold, and thus lead to an increase in the price.
Conversely, if options damage market quality, listing might be accompanied by a
price reduction. So a number of studies have looked at whether option listings are
accompanied by abnormal returns.
Conrad (1989) looked at the impact of the introduction of options on 96 individual
US stocks in the period 1974-80. She finds a positive price impact of the
order of almost 3% which is largely concentrated in the few days before the option
is introduced. The impact appears to be permanent, not being reversed in
the subsequent 30 days. She finds little impact associated with the announcement
of option trading. This is striking: in an efficient market, the impact will
occur at the time the information reaches the market. The decision to list an
option 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 option
being announced. She suggests that one reason for the price impact may be that
option traders buy the underlying stock in advance of listing in the knowledge
that they are likely to be net option writers.
Detemple and Jorion (1990) extended the study to 368 options introduced in
the period 1973-86. They confirm the existence of a listing effect, but show that
it is much weaker in the period after 1980. They also show that the positive
return on the stock is paralleled by a positive return on the industry generally
and, somewhat more weakly, on the market. They also find no significant announcement
effect except in one part of the sample period. They attribute the
positive returns to the benefits of making the market more complete. The spillover
to other stocks in the industry comes because a more complete market in the
risk of that industry is beneficial to all stocks in the industry. The decline in the
effect over time they attribute to a reduction in benefits as the market becomes
more complete.
Sorescu (1999) takes the data sample forward to 1995, and confirms the positive
price effect of option listing in the period to 1980, but finds that thereafter it
becomes significantly negative. Sorescu describes the result as puzzling. While
the lack of positive listing returns after around 1980 could be explained by a
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Gold Derivatives: The market impact

number of factors – Sorescu puts forward the substantial completeness of the
market following the listing of stock index options in 1982, or the tougher regulatory
environment imposed on option traders in 1979 – it is hard to explain the
significant negative impact from options listing. A tentative explanation he gives
is that the introduction of options allows people with negative information about
the 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 no
change in the beta of the stocks, this reflects a reduction in the idiosyncratic risk
of the stocks. While recognising the possibility that this fall in volatility may
reflect the tendency of Exchanges to list options on stocks which have been highly
volatile, she finds no evidence that stocks in the period prior to having listed
options have attracted particular press comment. Detemple and Jorion (1990)
find a 7% reduction in stock price volatility in the 60 days after option listing
compared with before; the reduction is statistically significant. Betas do not change
significantly but both market risk and idiosyncratic risk fall. Damodoran and
Lim (1991) also find a decline in variance in the two years after option listing
compared with before, and show that the reduction in variance is due to a reduction
in the noisy (transitory) component in returns. These results on volatility
were substantially confirmed by a number of other studies including Nabar and
Park (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 after
they have options listed, and the bid-ask spread narrows. But the reverse is true
for the 98 OTC stocks in the sample. The results on OTC stocks were largely
confirmed by Wei, Poon and Zee (1997) for a sample of 173 options which listed
in the period 1985-90, who find that volume and volatility increase, but they do
not find a significant change in bid-ask spreads.
4 Conclusions
Theoretical arguments suggest that commodity forward markets play a valuable
role in both information pooling and risk sharing. They serve to help co-ordinate
investment decisions and storage versus consumption decisions. The empirical
evidence supports the theory, albeit not very strongly, and provides little or no
support for the view that derivatives increase the volatility or instability of spot
prices. The evidence from financial markets suggests that derivatives provide
Gold Derivatives: The market impact 109

additional benefits in terms of increasing liquidity and increasing the efficiency
with which new information is impounded into prices. There is little evidence
that derivatives undermine the spot market or make spot prices more volatile.
There is some evidence from stock index futures which suggests that the opening
of an index futures contract widens the bid-ask spread in the individual components,
but that observation has limited relevance for a commodity like gold which
is 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 underlying
assets, but there is little evidence that this has been a problem in most
other markets;
There is evidence that derivatives help make the underlying market more liquid,
and also increase the speed with which new information is incorporated
into prices.
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References to Appendix 1
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Impact of CBOE Option Initiationo n the Volatility and Trading Volume of the
Underlying Equities, 1973-1876’, Financial Review, 24, 1, 19-29.
Bhattacharya A.K., A.Ramjee and B.Ramjee, 1986, ‘The Causal Relationship
between Futures Price Volatility and the Cash Price Volatility of GNMA Securities’,
Journal of Futures Markets, 6, 1, 29-39.
Bortz, G.A., 1984, ‘Does the Treasury Bond Futures Market Destabilize the Treasury
Bond Cash Market?’, Journal of Futures Markets, 4, 1, 25-38.
Brennan, M.J., 1991, ‘The Price of Convenience and the Value of Commodity
Contingent Claims’, in Stochastic Models and Option Values, ed. D. Lund and B.
Oksendal, North Holland.
Choi H., and A.Subrahmanyam, 1994, ‘Using Intraday Data to Test for Effects of Index
Futures on the Underlying Stock Markets’, Journal of Futures Markets, 14, 3, 293-322.
Cohen B.H., ‘Derivatives, Volatility and Price Discovery’, International Finance,
2, 2, 167-202.
Conrad J., 1989, ‘The Price Effect of Option Introduction’, Journal of Finance,
44, 2, 487-498.
Cox, C.C., 1976, ‘Futures Trading and Market Information’, Journal of Political
Economy, 84, 6, 1215-37.
Damodoran A., and J.Lim, 1991, ‘The Effects of Option Listing on the Underlying
Stocks’ Return Processes’, Journal of banking and Finance, 15, 647-664.
Detemple J., and P.Jorion, 1990, ‘Option Listing and Stock Returns’, Journal of
Banking and Finance, 14, 781-801.
Edwards F.R., 1988, ‘Futures Trading and cash Market Volatility: Stock Index
and Interest Rate Futures’, Journal of Futures Markets, 8, 4, 421-439.
Emerson P.M., and W.G.Tomek, 1969, ‘Did Futures Trading Influence Potato
Prices?’, American Journal of Agricultural Economics, August.
Fedenia M., and T. Grammatikos, 1992, ‘Options Trading and the Bid-ask Spread
of the Underlying Stocks’, Journal of Business, 65, 3, 335-351.
Figlewski S., 1981, ‘Futures Trading and Volatility in the GNMA Market’, Journal
of Finance, May, 445-456.
Fite D., and P. Pfleiderer, 1995, ‘Should Firms use Derivatives to Manage Risk’, Risk
Management: Problems and Solutions, ed W. Beaver and G. Parker, McGraw-Hill.
Froewiss K.C., 1978, ‘GNMA Futures: Stabilizing or Destabilizing?’, Federal
Reserve Bank of San Francisco Economic Review, Spring, 20-29.
Froot K., D.S. Scharfstein, and J.C. Stein, 1993, ‘Risk Management: Coordinating
Corporate Investment and Financing Policies’, Journal of Finance, 48, 5,
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Gennotte G. and H. Leland, 1990, ‘Market Liquidity, Hedging and Crashes’,
American Economic Review, 80, 5, 999-1,021.
Gray R.W., 1963, ‘Onions Revisited’, Journal of Farm Economics, May.
Gold Derivatives: The market impact 111

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’, Federal
Reserve Bank of New York Quarterly Bulletin, Summer.
Hardouvelis G., 1990, ‘Margin Requirements, Volatility, and the Transitory Component
of Stock Market Prices’, American Economic Review, 80, 4, 736-763.
Hart O., 1975, ‘On the optimality of Equilibrium when the Market Structure is
Incomplete’, Journal of Economic Theory, 11, 3, 418-443.
Hegde S., 1994, ‘The Impact of Futures Trading on the Spot Market for Treasury
Bonds’, 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 Introduction
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 Onion
Market’, 1930-68, US Department of Agriculture, ERS Technical Bulletin 1470.
Johnson L.L., 1960, ‘The Theory of Hedging and Speculation in Commodity
Futures’, Review of Economic Studies, 27, 3, 139-151.
Keynes J.M., 1930, Treatise on Money, London.
Kupiec P.H., 1998, ‘Margin Requirements, Volatility and Market Integrity:
What have we learned since the Crash?’, Journal of Financial Services Research,
13, 3, 231-255.
Lee C.I., and H.C.Tong, 1998, ‘Stock Futures: the effects of their Trading on the
Underlying Stocks in Australia’, Journal of Multinational Financial Management, 8,
285-301.
Moriarty E.J., and P.A.Tosini, 1985, ‘Futures Trading and Price Volatility of GNMA
Certificates – Further Evidence’, Journal of Futures Markets, 5, 633-641.
Securities and Exchange Commission, 1988, ‘The October 1987 Stock Market
Break’, 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 the
Price Volatility of GNMA Securities’, Journal of Futures Markets, 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 Quantitative 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 Political Economy, 95, 6, December, 1,123-45.
112
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Stoll H.R., and R.E.Whaley, 1987, ‘Program Trading and Expiration Day Effects’,
Financial Analysts Journal, 43, 2, 22-28.
Stulz R., 1996, ‘Rethinking Risk Management’, Journal of Applied Corporate Finance,
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
Quantitative 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 Studies,
I, 1, 3-31.
Working H., 1962, ‘New Concepts concerning Futures Markets and Prices’,
American Economic Review, 52, 431-459.
Gold Derivatives: The market impact 113

114
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APPENDIX 2 A DETAILED ANALYSIS OF
PRODUCER HEDGE BOOKS
Producers in aggregate have a large short position in gold through their derivatives
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 sellers
of options. The question is important because if they are large net buyers of options,
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 hedging
activity could tend to increase the volatility of the gold price.
The impact on the market is the same whether banks have written put or call
options; for that reason we do not distinguish between puts and calls in this
analysis. It also follows that if producers are large net sellers of options, the effect
of 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 short
options by taking a snapshot at the end of 1999. There is limited information in
the public domain about the composition of individual producer hedge books.
Annual accounts show the nominal size of exposures broken down by broad category
of instrument (put, call, rolling forward etc), by maturity year. The average
strike for derivatives in each bucket is also normally provided. The information
has been brought together and updated quarterly by Scotia Capital in its publication
‘Gold and Silver hedging Outlook’. The analysis in this Appendix and in the
main 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 single
bucket. Contracts may be complex, and involve features (such as barriers, stepups
and so on) which may profoundly affect the risk characteristics of the contract.
These features are revealed, if at all, only in the most general way. We will
ignore these features, and assume in particular that all calls and puts in each time
bucket 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 all
mature mid-year (or in the case of options expiring in 2004 and later, we assume
they expire at the end of 2004). We discuss below how these simplifications may
affect the conclusions.
The analysis in the main body of the report suggests that gold producers in aggregate
bought 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 to
a call with a short forward position). This broad picture of producers being active on
both sides of the market, while borne out by deeper analysis, is rather superficial.
Gold Derivatives: The market impact 115

The simple summation treats all options as equal. But they do not contain similar
amounts of optionality. A six month call option with a strike price $100/oz above
the current spot price is almost certain to expire worthless. It would not be worth
trying to hedge it. If the strike is $100/oz below the spot price, it is very likely to
be exercised, so the hedging strategy is to buy the gold forward, and not to adjust
the hedge unless the gold price rises very sharply, so a deep-in-the-money option
contains little optionality. By contrast, the hedge on an option which is close to
the money has to be rebalanced constantly as the price of gold varies. Thus
optionality is greatest for options closest to the money (where the strike is close to
the spot) and the uncertainty about whether it will be exercised is greatest.
The degree of optionality is normally measured by the gamma of the option. This is
a number which represents the change in hedge ratio per unit change in the gold
price. Thus one step in doing a deeper analysis is to calculate the gammas of the
options so that we can compare option contracts on the basis of their optionality
rather than their nominal size.
A second issue is that many producers make use of both long and short positions
in their portfolios. So for example, a producer may buy protective puts, and finance
the purchase by writing call options. The overall effect may not in fact
differ very much from selling gold forward at a single price. We break down producers
into two categories: those who are net buyers of options and those who are
net sellers. To do this we take the size (measured in ounces of gold optioned) of all
bought option positions in the producer’s hedge book which mature in 2002 and
beyond, and subtract it from the size of written option positions. The reason for
looking only at longer-dated options is that shorter-dated options can be hedged
more 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 $/oz
change in the gold price and in m ozs of at the money options equivalent)
2000 2001 2002 2003 2004+ Total
buyers 45.4 32.0 3.5 14.1 23.9 119.0
(m oz eq) 3.5 4.3 0.6 3.0 6.1
sellers 9.3 -8.2 -7.8 -5.9 -22.1 -34.7
(m oz eq) 0.7 -1.1 -1.4 -1.2 -5.6
all 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 and
interest rate of 1% and 5% at all maturities, and a volatility of 15%. The conclusions are robust to
changes in these parameters.
116
Gold Derivatives: The market impact

The table shows for example that net buyers of options had a long position in
options with a gamma of 119 thousand ounces. This means that if all these options
were written by banks which wanted to hedge themselves, then they would
need to buy 119,000 ounces of gold every time the gold price rose by $1/oz (and
sell the same amount if it fell by $1/oz).
To give a more familiar measure of exposure, the numbers are also expressed as the
equivalent 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 call
options with the same maturity.
The table suggests that producers in aggregate are substantial buyers of shortdated
options. It also shows that while individual producers may have quite large
net long or short positions in longer dated options, the longs and the shorts
cancel 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 at
the shorter maturities in particular need to be treated with caution since aggregation
into crude buckets can well distort the estimates substantially. But there is
no reason to believe that the approximations would increase the apparent degree
of netting across producers, and some reason to believe that it might lead to it
being understated.
Thus the analysis confirms the thesis in the main report that most of the longdated
volatility exposure in producers hedge books nets out between producers,
and little long-dated volatility risk is borne by the banking sector.
Gold Derivatives: The market impact 117

APPENDIX 3
The Washington Agreement on Gold
THE SIGNATORIES
Oesterreichische Nationalbank
Banque Nationale de Belgique
Suomen Pankki
Banca d’Italia
Banque Centrale du Luxembourg
De Nederlandsche Bank
Banque de France
Deutsche Bundesbank
Central Bank of Ireland
Banco do Portugal
Banco de España
Sveriges Riksbank
Schweizerische Nationalbank
Bank of England
European 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 programme
of sales over the next five years. Annual sales will not exceed approximately 400
tonnes 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 leasings
and their use of gold futures and options over this period.
5 This agreement will be reviewed after five years.
118
Gold Derivatives: The market impact

WGC CENTRE FOR PUBLIC POLICY STUDIES
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 by
Robert Pringle, June 1993
ties and Gold: New Market Constraint? by Helen
B. Junz and Terrence F Martell, September 1997
No. 17 An Overview of Regulatory Barriers to The
World Gold Trade by Graham Bannock, Alan
Doran and David Turnbull, November 1997
No. 3 Utilizing Gold Backed Monetary and Financial
Instruments to Assist Economic Reform
in the Former Soviet Union by Richard W
Rahn, July 1993
No. 4 The Changing Relationship Between Gold
and the Money Supply by Michael D Bordo and
Anna J Schwartz, January 1994
No. 18 Utilisation of Borrowed Gold by the Mining
Industry; Development and Future Prospects, by
Ian 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. 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 Market
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 Selected
papers given at two conferences, 1993
No. 10 Central Banking in the 1990s - Asset
Management and the Role of Gold Selected papers
given at a conference on November 1994
No. 11 Gold As a Commitment Mechanism: Past,
Present and Future by Michael D Bordo, January
1996
No. 12 Globalisation and Risk Management
Selected papers from the Fourth City of London
Central Banking Conference, November 1995
No. 13 Trends in Reserve Asset Management
by Diederik Goedhuys and Robert Pringle, September
1996
No. 14 The Gold Borrowing Market: Recent Developments
by Ian Cox, November 1996.
No. 15 Central Banking and The World’s Financial
System, Collected papers from the
Fifth City of London Central Banking Conference,
November 1996
No. 16 Capital Adequacy Rules for Commodi-
No. 21 The Swiss National Bank and Proposed
Gold Sales, October 1998
No. 22 Gold As A Store of Value by Stephen
Harmston, November 1998
No. 23 Central Bank Gold Reserves: An historical
perspective since 1845 by Timothy S Green,
November 1999
No. 24 Digital Money & Its Impact on Gold: Technical,
Legal & Economic Issues by Richard W
Rahn, Bruce R MacQueen and Margaret L Rogers.
No.25 Monetary problems, monetary solutions and
the role of gold by Forrest Capie and Geoffrey
Wood, April 2001
No. 26 The IMF and Gold ( revised) by Dick Ware,
May 2001.
Special Studies:
Switzerland’s Gold, April 1999
A Glittering Future? Gold mining’s importance
to 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 Jessica
Cross, September 2000
The New El Dorado: the importance of gold mining
to Latin America, March 2001
Available from Centre for Public Policy Studies, World Gold Council, 45 Pall Mall, London
SW1Y 5JG, UK. Tel + 44.(0)20.7930.5171, Fax + 44.(0)20.7839.6561. E-mail:
cpps@wgclon.gold.org Website: www.gold.org
Gold Derivatives: The market impact 119

Headquarters: UK
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120
Gold Derivatives: The market impact