John Paul Koning Deriving the gold lease rate Financial Graph & Art www.financialgraphart.com January 2012 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 1,800 The gold forward offered rate (GOFO) is the rate at which the nine market making 1. Gold Price members of the London Bullion Market Association are willing to borrow cash in London, submitting gold as collateral. A gold 1,000 forward transaction functions much like a Gold in $US swap, one bank exchanges cash for gold with another bank for some period of time before 800 the transaction is reversed. Rates are quoted for terms of 1, 2, 3, 6, and 12 months. Gold in Euros 400 There is almost no correlation between the gold price in the top chart and GOFO in the second chart. The gold forward rate has almost always been above zero.This means 200 that those who agree to temporarily accept gold in exchange for cash expect to be compensated for the inconvenience of bear- ing this transaction.This inconvenience relates 2. Gold Forward Offered Rate (GOFO) to the higher cost of storing gold relative to 8% cash and gold’s inferior liquidity. On those rare occasions when GOFO has gone nega- tive - for instance October 1999 - banks 6% have temporarily treated gold’s conveniences as superior to cash and, as a result, have been willing to pay a premium to own it. 4% The London Interbank Offered Rate (LIBOR) is the rate at which sixteen major banks can borrow cash in London on an 2% unsecured basis. 3 month 6 month 12 month As chart 3 shows, LIBOR and GOFO gener- 0% ally move together, although LIBOR has typically been quoted higher than GOFO.This is because a lender prefers to make loans on a secured basis than on an unsecured basis -2% since the former is much safer. A gold forward transaction - essentially a cash loan secured by gold - is less risky for a lending -4% bank to conduct than an unsecured loan. Thus, banks lending on gold collateral will usually be willing to set GOFO below LIBOR. 3. London Interbank Offered Rate (LIBOR) and GOFO The gold lease rate is the rate at which gold is lent out on an unsecured basis.While 8% LIBOR and GOFO are generally available, The di erence between lease rates are usually not publically quoted. LIBOR and GOFO equals the Nevertheless, a hypothetical lease rate can derived lease rate 6% be derived from LIBOR and GOFO. Say a major bank borrows gold and pays the lease rate, then swaps this gold for cash for 4% six months with another major bank, paying GOFO. It invests this cash at LIBOR. The cost of this transaction - the sum of the lease rate and GOFO - cannot be less than the LIBOR 6 month GOFO return. For if it were less, banks would simply 2% borrow the gold and sell it forward for cash, 6-month investing the proceeds at LIBOR thereby LIBOR earning themselves risk-free profits. In a 0% competitive market, this risk-free opportunity will be arbitraged away so that the following conditions always holds: lease rate + GOFO = LIBOR.Thus, knowing GOFO and LIBOR, -2% the lease rate can be calculated. As chart four shows, the derived gold lease 10% rate has typically been positive. Banks who lend gold expect to receive a return on the 4. Derived Lease Rate loan, and borrowing banks have been willing to provide that return. However, since 2009 8% derived lease rates have frequently fallen into negative territory, especially the three-month rate. Somewhat counter-intuitively, those 6% borrowing gold for short periods now expect to receive a fee, and those lending are willing to pay this fee. One reason that lending banks might be willing to incur a negative 4% lease rate is that storage costs have risen. By 6-month 3 month paying other banks to take on the burden of LIBOR 6 month storing their gold, gold owners avoid these 12 month 2% costs while continuing to enjoy the benefit of exposure to the gold price. Gold lease rates are almost always at a 0% discount to LIBOR. It is more convenient to hold cash than gold due to gold’s high stor- age costs and inferior liquidity.Therefore, -2% lenders require a higher interest rate to compensate them for foregoing the superior 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 conveniences of cash. October 1999 was a rare exception, with lease rates rising above John Paul Koning, 2012 Gold price data from the World Gold Council. LIBOR and GOFO from the London Bullion Market Association LIBOR.
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