* The producer has future gold production to deliver... enters into a contract to sell gold in the future at a fixed price.
* Why? Price protection; take advantage of $45/oz higher forward premiums to spot (E.g. $300 + ($80 - $35) = $345, where $80 is the interest rate earned & $35 is the lease rate payment)
* What is the interest rate earned? The producer must earn interest on the spot value of the gold sold in the future. Otherwise the producer would simply sell the gold now, and earn interest on the cash received now.
* What is the lease rate? The producer is paying for not delivering the gold now, because there is
* The MAJOR risks a producer has to hedging...
+ How low cost are their mines? (cost of production)
+ How well diversified & certain is their production? (certainty of having gold)
+ How good is their credit? (defining terms of contracts -- including margining on termination rights); (must avoid margin calls, early terminations rights (& thus possibly forced early delivery))
* Other risks include...
+ Counterparty risk... E.g. bullion bank declares bankruptcy, trustee defaults on gold purchase from the producer b/c spot is lower than the contract and the contract is thus a liability)
+ Opportunity cost
* Quality assets & strong credit mean...
+ Multi-year terms (up to 10-15 yrs) (= flexibility for producer)
+ No margin, & no early termination rights
+ Better pricing on long-term contracts
+ Higher forward prices based on l.t. vs. s.t. interest rates
Bullion Bank
* Plays an intermediary role in creating the gold lending & gold hedging markets. They take on the borrowing of gold, the spot positions, the deposit risk etc.
* Makes the 'vig' and does not have market exposure.
* But takes on producer's credit risk (i.e. the producer must deliver gold to bullion bank in the future). If the gold is not delivered, they may have to pay more than the amount set in the futures contract with the producer to purchase the gold they owe the Central Bank from the market.
* Sells the borrowed gold to the spot market & deposits cash received with its own funding desk, thus there is no credit risk between the two counterparties (as they are the same entity)
Central Bank
* Lends gold & receives interest payments for lending to the Bullion Bank.
* Takes on Bullion Bank credit risk (i.e. must receive gold back from Bullion Bank). That is why Central Banks deal with "AA" rated Bullion Banks and not with Producers directly.
* From 1989 thru 2002, the 3-month lease rate (the rate earned for lending the gold) was under 2%, 86% of the time
An Example Of The Whole Picture...
The producer sells its future production of gold to the bullion bank for $345. (This represents the spot rate of $300 plus interest received of $80, less lease payment of $35)
The bullion bank makes a spot sale of gold for $300. But it has no gold in its inventory until it receives future delivery from the producer.
So the bullion bank borrows gold from the central bank, makes a lease payment (of $31, less than the $35 paid by the producer) to the central bank for borrowing the gold, & delivers the borrowed gold to the spot buyer in exchange for $300 cash.
The bullion bank in return deposits the $300 cash to earn interest (of $83, more than the $80 paid t the producer) until the future contract w/the producer expires, at which point it pays the producer $345 for the gold, which is delivered to the central bank... all open positions collapse.
MTM
* Mark-to-market is the replacement value of the hedge positions at a particular point in time.
* Gold price moves up => Impact on MTM is negative; Same hedge/future sale to the bullion bank would now lock in a higher price
* US rates move down => Impact on MTM is positive; Hedge would return lower price
* Lease rates move up => Impact on MTM is positive; Hedge would return lower price
* MTM creates credit exposure to counterparties. MTM thresholds can be used to mitigate credit exposure through margining, or early termination
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spot-deferred contract - A forward contract that gives the seller the option to roll the contract forward rather than make delivery on a specific date. Often used by gold producers to hedge gold price exposures. Also called Undated Forward
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The forward price is based on i) the then spot price ii) the interest rate differential between borrowing gold & the USD deposit
