Gold Forwards Presentation - CPM Group

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					          Gold Forwards



CPM Group
November 2003
Gold Forwards

Gold forward contracts are the mechanism through
  which producers and fabricators lock in future
  sales and purchases of gold, at prices determined
  at the time the contract is entered into.
Forwards allow producers and consumers to lock in
  a guaranteed price for future delivery.




CPM Group
Gold Forwards – The Misunderstanding

  Gold forwards are grossly misunderstood and
    misrepresented in the gold market.
  • Many market observers believe that when a
    producer sells forward the counter-party bullion
    dealer or bank borrows physical gold and sells it
    in the spot market to hedge against their forward
    purchase commitments.
  • This is not accurate, however. This inaccuracy has
    certain negative consequences for the gold market.


  CPM Group
Clouding the issue
 The misunderstanding stems from a muddling of the
   mechanics of gold swaps, which bullion dealers
   enter into with gold inventory holders such as
   central banks, and gold forwards. These are two
   distinct transactions, executed independently of
   each other.
 Mixing these distinct transactions together, someone
   can construct what appears to be a forward
   hedging program. It looks good on paper, but it is
   unrepresentative of how banks actually trade.

 CPM Group
Gold Forwards – The Misunderstanding
  The gold (and now silver) market is unique in
    believing this.
  • Forward transactions occur constantly in other
    commodities, including energies, base metals,
    agricultural commodities. They also occur in
    currencies, interest-bearing assets, and equities.
  • In none of these markets do people believe that
    banks use spot physical sales to hedge forward
    purchase commitments. Only in gold and silver do
    people believe this, despite an enormous body of
    evidence to the contrary.

  CPM Group
Gold Forwards – The Misunderstanding
  There are many inconsistencies and obvious
    shortcomings in the belief that producer gold
    forwards increase physical spot sales.
  • The theory overlooks real market evidence to the
    contrary.
  • The theory overlooks forward purchases by
    jewelers and others. The theory would suggest
    these need to be hedged by dealers with spot
    physical purchases.


  CPM Group
Gold – The most liquid forward
commodity market
The gold forward market is many times more liquid than
  the forward markets of other commodities.
• Gold represents less than 1% of world physical
  commodities trading, yet gold represents more than
  50% of world commodities derivatives markets.
• Gold is money. It is traded like money. It is lent like
  money. This is the essence of understanding how gold
  forwards, swaps, and other transactions work.
• If any commodity has the forward liquidity necessary
  to cover hedging with paper commitments, it is gold.

   CPM Group
Gold Forwards
 The following schematic, from the World Gold
   Council, illustrates how these two transactions are
   mixed together.
 This schematic combines a gold swap and a forward
   sale.
 Following this schematic is a diagram for a forward
   transaction, and a diagram of a gold swap.




 CPM Group
WGC schematic on gold forward sale
                             6
           Receives contract price for gold                                2
           delivery and interes t on depos it                 Borrows amount of gold in
               les s the leas e rate of gold                    forward sale contract

Producer                                        Bullion                                    Central
                                                Dealer                                      Bank

              Enters forward sale, gold                            Pays leas e rate on
             delivered at date of contract                          borrowed gold 5
                          1


                                                                    4
                      Sells borrowed 3                    Receives proceeds from
                      gold at spot price                  sale, invests to earn interest


                                                Spot
                                                Market


    CPM Group
WGC schematic on gold forward sale
 • The preceding diagram theoretically illustrates
   how a dealer buys gold forward from a producer.
 • This diagram actually mixes schematics for two
   distinct transactions together.
    – One is a gold swap between a bullion dealer
      and a gold inventory holder.
    – One is a gold forward transaction between a
      bullion dealer and a mining company.
 • The preceding schematic makes a compelling
   case, but it inaccurately portrays how the market
   works.
  CPM Group
Gold Forwards
In reality, a gold forward transaction is only one half of this
   operation.
• The producer agrees to sell gold to a bullion dealer at an
   agreed upon price at a future date.
• The bullion dealer goes into the forward dealer market and
   hedges its exposure with a forward sale of its own, or by
   delta hedging this exposure with gold put options.
• (Delta hedging uses options, not physical gold, in contrast
   to another myth in the market.)
• At maturity, the producer delivers its physical gold. The
   dealer sells the gold, and pays the producer for its gold.


 CPM Group
Gold Forward Sales
Forward sale between a mining company and a dealer
                   Dealer agrees to buy gold from producer
           1
                          at a future date and price


               3 Dealer pays for gold at future delivery
                                                             Bullion
Producer                                                     Dealer
                    Producer agrees to sell gold to dealer
               1         at a future date and price

                         Producer delivers the gold
                     3
                         at the future date and price                      2
                                                                       Dealer hedges forward commitment
                                                                       with offsetting forward sale or
                                                                       option strategy, with another bullion
                                                                       trading dealer, or on an exchange.


                                                             Market


    CPM Group
Gold Forwards
 A bullion dealer does not need to enter into a gold
   swap, own gold, or even have access to gold in
   order to agree to a gold forward purchase from a
   mining company. Gold forwards are based on
   credit.
 • A dealer agrees to buy gold from a producer at an
   agreed upon price and future date. It agrees to this
   based on the creditworthiness of the producer.
 • The dealer then hedges its gold price exposure
   with a forward sale or option.
 • A spot sale does not protect against future price
   changes.
 CPM Group
Gold Swaps
Gold swaps are used by bullion dealers to build
  liquidity on their books and add cash liquidity at a
  low cost.
• Gold swaps provide dealers one of their lowest
  priced sources of money in the world.
• Bullion dealers will do as many gold swaps as
  possible, regardless of any forwards or other
  transactions they might undertake.
• The Drexel Burnham Lambert collapse in 1989
  illustrated all of this publicly.

CPM Group
Gold Swap Mechanics
   Gold loan or swap between a bullion dealer and a central bank
   Gold loans represent one of the cheapest sources of money for bullion dealers. Because of this,
   most bullion dealers aggressively seek gold loans and swaps, as a source of funding.

                                                            1
                                               Dealer borrows gold at outset.      Central
                                                                                    Bank
                                  Bullion                                         or other
                                  Dealer                      4                     Gold
                                                   Pays lease rate on gold,      Inventory
                                                   Returns gold at maturity.       Holder
                         2
   Dealer sells borrowed gold
   at spot price. Hedges with
   forward purchase. Receives                  3
   proceeds from sales, invests              Dealer later buys
   in debt instruments to earn               gold back.
   interest. Interest received
   exceeds costs of borrowing
   and the contango.
                                   Gold
                                  Market


 CPM Group
Conclusions
• Gold forwards do not involve selling borrowed physical
  gold on a spot basis, and do not increase physical supplies
  on a spot basis.
• Gold forwards increase the turnover of paper gold in the
  market, but not the flow of physical gold into the market.
• Gold forwards affect gold prices through their effects on
  the forward spread and liquidity in the market.
• Much of the gold market does not understand this.
• These inaccuracies misrepresent how the gold market
  operates.
• These misrepresentations cause problems for the gold
  market, and could cause more problems in the future.


 CPM Group
 30 Broad Street, 37th Floor
   New York, N.Y. 10004
 Telephone: (212) 785-8320
  Telefax: (212) 785-8325
E-mail: info@cpmgroup.com
Website: www.cpmgroup.com

				
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