The gold lease rate by andinovajah


									                                                                                                                                                                                                       John Paul Koning

         Deriving the gold lease rate
                                                                                                                                                                                                     Financial Graph & Art
                                                                                                                                                                                                              January 2012

        1993   1994    1995   1996   1997      1998       1999        2000   2001   2002    2003     2004     2005     2006      2007      2008    2009    2010     2011

                                                                                                                                                                             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.
                                                                                                                                                                             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
                                                                                                                                                                             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
                                                                                                                                                                             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
                                                                                                                                                                             borrow the gold and sell it forward for cash,
                                                                                                                                                                             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
                                                                                                                                                                             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
                                                                                                                                                                             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
                                                                                                                                                                             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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