Gold Derivatives The Market Impact

WO R LD G O L D CO U NCI L
Gold Derivatives:
The market impact
London
Business School
Anthony Neuberger, London Business School

Report prepared for the World Gold Council, May 2001
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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 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
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
Appendices Appendix 1 Overview ..............................................................................................87 1 2 3 4 The economic role of forward markets ..............................................88 Derivatives and market quality: theoretical considerations ..................95 Derivatives and market quality: empirical evidence ..........................102 Conclusions ..................................................................................109
References ........................................................................................111 Appendix 2 A detailed analysis of producer hedge books ....................................115 Appendix 3 The Washington Agreement on Gold .............................................118
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 Neubergers analysis draws heavily on Dr Crosss 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
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.
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 worlds 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.
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 i m p a c to fa c c e l e r a t e ds u p p l yd e p e n d se n t i r e l yo nh o wd e m and 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
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.
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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
banks 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.
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.
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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 year1 . By the end of it, production exceeded 2,500 tonnes/year2 . 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 years3 . The com p a r i s o no fp r o d u c t i o nl e v e l sw i t ht h et o t a lq u a n t i t ye v e rp r o d u c e di s r e l e v a n tt og o l di naw a yt h a ti sq u i t eu n l i k eo t h e rc o mmo d i t i e s .M o s to ft h eg o l d whichhasbeenproducedhasnotbeenperm a n e n t l yc o n s u me d ;much ofi tc o u l d a ts o m et i mec o m eb a c kt ot h em a r k e t .M u c ho fi tw i l lb et r a d e dl a r g e l yo nt h e
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.
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0
Tonnes 2500 2000 1500 1000 500 0 1900-04
Gold Production Annual Average 1900-1999
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
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.
Gold Price 1900-2000
600 500 400 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 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.
1995-99
60.00 50.00 40.00 30.00 20.00 10.00 0.00
The Real Price of Gold 1900-2000 in 1900 $
1900
1907
1914
1921
1928
1935
1942
1949
1956
1963
1970
1977
1984
1991
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.
1998
Breakdown of Production in 1968

Latin America Asia 3% USA 3% Cananda 6% 2% 6% Rest of World Total Production = 1,450 Tonnes
13% USSR 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% 12% Australia 6% China 6% Canada
Russia 5% 6% Indonesia
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.
Gold Exploration Expenditure 1997-1999 $billion % Change

1997 1998 1999 2.62 1.56 1.09 -40.6 -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*
450 400 350 300 250 Cash Costs 200 150 100 1991 1992 1993 1994 1995 1996 1997 1998 1999
* weighted average of mining cash and total costs.
Gold Price
Total Costs

4
Gold Survey 2000, GFMS, London, 2000.

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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.
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Real Price of Gold in USD, CAD, Rand, and AUD

140 130 120 110 Rand 100 90 80 70 60 50
Ja n-9 0 Ja n-9 1 Ja n-9 2 Ja n-9 3 Ja n-9 5 Ja n-9 6 Ja n-9 7 Ja n-9 8 Ja n-9 9 Ja n-0 0 Ja n-9 4
AUD CAD USD
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 year5 . 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 golds 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 6
Gold Survey 2000, Gold Fields Mineral Services, London, 2000. Gold Survey 2000, Gold Fields Mineral Services, London, 2000.
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 jewellery6 . 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) Private Investment (25,200) Unaccounted (1,300) Above-ground Stocks, end-1999 = 140,000
Jewellery (67,300)
* Excluding lent gold
Official Holdings* (30,500)
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 womans 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.
Real Price of Gold in Selected Key Gold Consuming Countries

150 130 110 90 70 50 Italy 1995=100 Turkey
USA
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Real Price of Gold in Selected Key Gold Consuming Countries

280 1995=100 230 180 130 80 30 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 23 India Japan Indonesia
China
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
Jan-00
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.
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.
Total Official Sector Gold Holdings, 1970-1999 Developing (Tonnes) Other developed
40000 35000 30000 25000 20000 15000 10000 5000 0 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 Institutions Western Europe North America countries countries
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 banks holding today7 . 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
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.
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by 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.
Central Bank Gold Holdings, 1978 and 1998

1998 tonnes 10,000
(Logarithmic Scale) Dots above the line represent countries whose reserves rose between 1978 and 1998
1,000
100
Dots below the line represent countries whose reserves fell between 1978 and 1998
10
1 1 10 100 1,000
1978 tonnes 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.
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Largest Official Gold Holdings (end 2000)

Tonnes 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 United States Germany IMF France Italy Switzerland Netherlands Japan ECB Portugal Spain United Kingdom Taiwan China Russia Austria India Venezuela Lebanon Belgium All countries WAG Euro-System 8,137 3,469 3,217 3,025 2,452 2,420 912 764 747 607 523 480 421 395 382 377 358 319 287 258 28,871 15,603 12,427 Gold as a % of foreign exchange holdings 57% 35% n/a 42% 40% 40% 46% 2% 14% 39% 13% 9% 3% 2% 12% 19% 9% 16% 30% 19% 12% 29% 30%
Source: IMF, World Gold Council
The price subsequently recovered in September 1999 after the announcement of a pact between fifteen central banks8 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.
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.
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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.
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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
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 producers hedge book is likely to be influenced heavily by managements 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
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 elses 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.
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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 years 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
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 %, 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.
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 producers perspective. From the banks 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 contracts value
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
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 assumptions1 , 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.
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.
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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 options 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
(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
Gold Price US$/oz
70 50 30 10 -10 -30 -50 -70
410 390 Contracts 370 350 330 310 290 Gold price 270 250 Jan-98 Jan-99 Jan-00
Long
Short -90 Jan-97
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
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% 2 Total 81,875 100%
Source: BIS, November 2000 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.
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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 gold3 . 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.
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.
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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 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 golds 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 borrowing4 . 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%.
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.
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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 banks 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 producers desire to hedge with a central banks 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 todays spot price plus the interest on the deposit less any interest paid to the central bank.
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.
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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%.
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of the average lease rate over the next five years is %, then the producer taking on a floating lease rate deal would face an uncertainty in the price it receives in five years of 2%. 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 2% 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 producers 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.
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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 time7 . 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 todays 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.
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 Tufanos paper Who Manages Risk? An Empirical Examination of Risk Management Practices in the Gold Mining Industry Journal of Finance (September 1996).
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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 forward8 . 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 companys accounts.
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.
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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 companys annual production revenue9 . 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 years production will on average have been built up 1 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 years revenue. A more precise calculation which accurately reflects the build up of the hedge book would give a similar answer.
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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.
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 companys 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
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 companys 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 Australia N. America Africa Total 2000 2.72 0.80 6.60 2.24 3.85 3.50 13.17 6.54 2001 2.87 0.87 4.70 1.34 0.91 2.22 8.48 4.43 2002 2.57 0.72 0.68 1.20 1.06 2.40 4.32 4.32 2003 2.81 0.96 0.75 0.80 2.67 1.52 6.23 3.27 2004 + 11.82 3.78 1.15 7.88 3.20 2.28 16.17 13.93 Total 22.78 7.13 13.89 13.45 11.69 11.92 48.36 32.50
Source: figures in the table are drawn from Gold and Silver Hedging Outlook, Fourth Quarter 1999 (Scotia Capital)
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.
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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).
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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
Producer Short Positions and Real Gold Price

0 -500 -1000 -1500 -2000 -2500 -3000 -3500 -4000 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 position1 . 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.
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Supply/Demand Balance for Physical Gold 1990/99 (tonnes/year, average)

Demand Fabrication less Scrap Bar hoarding Total Supply 3,287 Mine production 630 Official sector sales 2,657 Net producer hedging 235 Net disinvestment 2,892 2,332 309 238 13 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
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
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 repo2 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.
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
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. Murenbeeld3 estimates an average price elasticity for jewellery demand of about 1. Veneroso4 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, produc3
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.
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.
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.
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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 GFMSs own analysis. The data are available quarterly, going back to the beginning of 1994.
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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
-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)
R 2 = 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
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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)

R2
= -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 R2 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?
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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 Deltat-1 + 0.7 Deltat - 1.2 Deltat+1 + error (5.10) (3.0) (3.1) (2.7)
R2
= -5.15%
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The model as a whole has no explanatory power (the R 2remains 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
by 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
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
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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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Impact of Hedging on Gold Price

Cumulative abnormal return
1.5% More Hedging 1.0% 0.5% Less Hedging
0.0% -6 -0.5% -1.0% -5 -4 -3 -2 -1 0 1 2
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 errors1 ):
Abnormal Return Day T Day T-1 to T+1
Increased Hedging -0.66% (0.30%) -1.05% (0.55%)
Decreased Hedging +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.
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(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 Domes 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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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
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
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 standards2 . 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
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.
2
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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 countrys 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 Drexels 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 ones 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.
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,
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 previously3 . 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.
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lower than it was previously. This means that any rise in todays 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
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
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 involuntary4 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.
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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 Metallgesellschafts 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 relevant5 , 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 markets 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.
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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 markets 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: Mean rate: Mean: Standard Deviation: % < 0: 1 month 1.34% 3 months 6 months 12 months 1.45% 1.55% 1.73% Differences: 0.12% 0.10% 0.18% 0.28% 0.22% 0.21% 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.
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Gold Forward Lease Rates 1993-99 5.0 Rolling monthly averages (%) 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 93 94 95 96 97 98 99
1 mth 7-12 mth
1 mth 2-3 mth 4-6 mth 7-12 mth
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 rates6 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:
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r (t + 1,1) + r (t + 2,1) r (t ,1) = + 1 [ f ( t ,2 3) r (t ,1)] + 2 r (t ,1) 2

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 months 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:
[A] 1993-99: [B] 1993-97: 0.49% (0.14%) 0.06 (0.16) 1 -0.08 (0.21) 1.10 (0.34) adj R 2 -0.37 20.2% (0.08) -0.15 29.0% (0.09) (Standard errors in parentheses)
2
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 R2 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
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.
6
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remains 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 markets 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% 5.19% 5.30% 5.52% (1.34%) (1.45%) (1.55%) (1.73%) Differences: Mean: 0.11% 0.11% 0.22% (0.12%) (0.10%) (0.18%) Standard 0.17% 0.16% 0.21% Deviation: (0.28%) (0.22%) (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.
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 1 m a r k e t sc o mewi t ht h ei n t r o d u c t i o no ft h es i mpl e s ti n s t r u me n t s ,f o r w a r dc o n t r a .c t s 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.
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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
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 producers 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
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, returns1 . Speculators2 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.
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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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 S0 , the forward price today for delivery at T denoted by F0,T , and the riskless rate of interest r (also continuously compounded) by the formula:
F0,T = S 0e ( r b )T
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.
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 agents 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 todays 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 todays 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 mine4 . 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.
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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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
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 term1 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.
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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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.
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 market6 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.
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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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
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
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
require 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
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
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
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
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.
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 oneday 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.
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.
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.
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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
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
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
Bansal, V.K., Pruitt, S.W., and Wei, K.C., An Empirical Reexamination of the 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, 1629-1658. 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.
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.
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.
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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.
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 producers 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

2000 45.4 3.5 9.3 0.7 54.8 4.2 2001 32.0 4.3 -8.2 -1.1 23.8 3.2 2002 3.5 0.6 -7.8 -1.4 -4.3 -0.8
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)
buyers (m oz eq) sellers (m oz eq) all (m oz eq)

1
2003 2004+ 14.1 23.9 3.0 6.1 -5.9 -22.1 -1.2 -5.6 8.2 1.8 1.7 0.5
Total 119.0 -34.7 84.3
Vegas were calculated using Mertons 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.
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.
117
APPENDIX 3 The Washington Agreement on Gold

THE SIGNATORIES Oesterreichische Nationalbank Banque Nationale de Belgique Suomen Pankki Banca dItalia Banque Centrale du Luxembourg De Nederlandsche Bank Banque de France Deutsche Bundesbank Central Bank of Ireland Banco do Portugal Banco de Espaa Sveriges Riksbank Schweizerische Nationalbank Bank of England European Central Bank
THE PRESS RELEASE Press Communiqu - 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.
WGC CENTRE FOR PUBLIC POLICY STUDIES

No. 1 Derivative Markets and the Demand for ties and Gold: New Market Constraint? by Helen Gold by Terence F Martell and Adam F Gehr, Jr, B. Junz and Terrence F Martell, September 1997 April 1993 No. 17 An Overview of Regulatory Barriers to The No. 2 The Changing Monetary Role of Gold by World Gold Trade by Graham Bannock, Alan Doran and David Turnbull, November 1997 Robert Pringle, June 1993 No. 3 Utilizing Gold Backed Monetary and Fi- No. 18 Utilisation of Borrowed Gold by the Mining nancial Instruments to Assist Economic Re- Industry; Development and Future Prospects, by form in the Former Soviet Union by Richard W Ian Cox and Ian Emsley, May 1998 Rahn, July 1993 No. 19 Trends in Gold Banking by Alan Doran, No. 4 The Changing Relationship Between Gold June 1998 and the Money Supply by Michael D Bordo and Anna J Schwartz, January 1994 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. 21 The Swiss National Bank and Proposed Gold Sales, October 1998
No. 6 Advantages of Liberalizing a Nations Gold No. 22 Gold As A Store of Value by Stephen Market by Professor Jeffrey A Frankel, May 1994 Harmston, November 1998 No.7 The Liberalization of Turkeys Gold Market by Professor Ozer Ertuna, June 1994 No. 23 Central Bank Gold Reserves: An historical perspective since 1845 by Timothy S Green, November 1999
No. 8 Prospects for the International Monetary System by Robert Mundell, October 1994 No. 24 Digital Money & Its Impact on Gold: Technical, Legal & Economic Issues by Richard W No. 9 The Management of Reserve Assets Se- Rahn, Bruce R MacQueen and Margaret L Rogers. lected papers given at two conferences, 1993 No.25 Monetary problems, monetary solutions and No. 10 Central Banking in the 1990s - Asset the role of gold by Forrest Capie and Geoffrey Management and the Role of Gold Selected pa- Wood, April 2001 pers given at a conference on November 1994 No. 26 The IMF and Gold ( revised) by Dick Ware, No. 11 Gold As a Commitment Mechanism: Past, May 2001. Present and Future by Michael D Bordo, JanuSpecial Studies: ary 1996 No. 12 Globalisation and Risk Management Switzerlands Gold, April 1999 Selected papers from the Fourth City of London A Glittering Future? Gold minings importance Central Banking Conference, November 1995 to sub-Saharan Africa and Heavily Indebted Poor Countries , June 1999 No. 13 Trends in Reserve Asset Management by Diederik Goedhuys and Robert Pringle, SepProceedings of the Paris Conference Gold and tember 1996 the International Monetary System in a New Era, No. 14 The Gold Borrowing Market: Recent De- May 2000 velopments by Ian Cox, November 1996. No. 15 Central Banking and The Worlds F i nancial System, Collected papers from the Fifth City of London Central Banking Con ference, November 1996 No. 16 Capital Adequacy Rules for Commodi20 Questions About Switzerlands 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
World Gold Council Offices

Headquarters: UK China (Shanghai Office)
45 Pall Mall London SW1Y 5JG, UK Tel. +44.(0)20.7930.5171 Fax.+44.(0)20.7839.6561 Room 203B, Central Place No. 16 He Nan Road (S) Shanghai, PRC 200 002 Tel. +86.21.6355.10078/9 Fax. +86.21.6355.1011
Middle East
Regional Office & UAE
Dubai World Trade Centre P.O. Box 9209 Level 28 Dubai, UAE Tel. +971.4.3314.500 Fax. +971.4.3315.514 gold@wgcdubai.org.ae
Website:
www.gold.org
Indonesia
Tamara Center Level 6, No 602 Jenderal Sudirman Kav 24 Americas/Europe Jl. Jakarta 12920 Regional Office & USA Tel. +62.21.520.3693/94/95 444 Madison Avenue Fax. +62.21.520.3699 New York, NY 10022 Tel. +1 212.317.3800 Malaysia Fax. +1 212.688.0410 Menara Dion No. 12-05 27 Jalan Sultan Ismail Brazil 50250 Kuala Lumpur Avenida Paulista 1499 Tel. +60.3.381.2881 Conj. 706 Fax. +60.3.381.2880 01311-928 Sao Paulo Tel. +55.11.285.5628 Thailand Fax. +55.11.285.0108 14th Floor, Thaniya Plaza, 52 Silom Road, Bangrak Mexico Bangkok 10500 Consejo Mundial del Oro Tel. +662.231.2486/7 Av. Reforma No. 382, Despacho 701, Col. Juarez Fax. +662.231.2489 Delagacion Cuauhtemoc Taiwan 06500 Mexico D.F. Room 808, Tel/Fax +52.5.514.5757/2172 205 Tun Hwa N. Road, Taipei Tel. +886.2251.47.400 Fax +886.2251.47.466
Turkey
Mim Kemal ke Caddesi Dost Apt. 8/4 Nisantasi, 80200 Istanbul Tel. +90.212.225.1960/22 Fax.+90.212.225.1913
India
Regional Office & Mumbai
101, Maker Chamber VI 10th fl., 220 Nariman Point Mumbai 400 021 Tel. +91.22.230.1323 Fax. +91.22.230.1324
India (Chennai Office)

B-2 Alexander Square 34/35 Sardar Patel Road Guindy Chennai 600 032 Tel. +91.44.230.0083/0084 Fax. +91.44.230.0086
East Asia
Regional Office & Singapore
6 Battery Road No. 24-02A Singapore 049909 Tel. +65.227.2802 Fax. +65.227.2798
Vietnam
No 6 Phung Khac Khoan St, Room G7 District 1, Ho Chi Minh City Tel. + 848 8256 653/654 Fax + 848 8221 314
China (Beijing Office) Regional Office & Room 1706, Scitech Tower Japan 22 Jian Guo Men Wai Da Jie
Beijing 100 004 Tel. +861.0.6515.8811 Fax. +861.0.6522.7587
Japan/Korea
India (New Delhi Office)

47, Basant Lok Vasant Vihar New Delhi 110 057 Tel. +91.11.614.9394/95 Fax. +91.11.614.8281
Shin Aoyama Building / W21F, 1-1-1 Minami-Aoyama Minato-ku, Tokyo 107 0062 Tel. +81.3.3402.4811 Fax. +81.3.3403.2477
India (Calcutta Office) China (Hong Kong)

13th Floor, Printing House 6 Duddell Street, Central Hong Kong Tel. +852.2521.0241 Fax. +852.2810.6038 120
South Korea
19th Floor, Young Poong Bldg. 33, Seorin-dong, Jongro-ku Seoul 110 752 Tel. +82.2.399.5377 Fax. +82.2.399.5372
World Trade Center Calcutta Somnath Building, 4th Floor 8/1A, Sir William Jones Sarani Calcutta 700 016 Tel. +91.33.249.4318 Fax. +91.33.292.793 Gold Derivatives: The market impact

Gold Derivatives The Market Impact

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Gold Derivatives The Market Impact

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WO R LD G O L D CO U NCI L

Anthony Neuberger, London Business School

Gold Derivatives: The market impact

Anthony Neuberger Associate Professor of Finance London Business School

Gold Derivatives: The market impact

Gold Derivatives: The market impact

Gold Derivatives: The market impact

Gold Derivatives: The market impact

About the author

The steering group

Gold Derivatives: The market impact

The impact of the derivatives market on spot supply

The impact of accelerated supply on price

Gold Derivatives: The market impact

The wider impact of the derivatives market

Gold Derivatives: The market impact

The size of the derivatives market in future

Gold Derivatives: The market impact

CHAPTER 1 THE PHYSICAL GOLD MARKET

Gold Derivatives: The market impact

Gold Production Annual Average 1900-1999

Source: Bannock Consulting, World Gold Council

60.00 50.00 40.00 30.00 20.00 10.00 0.00

The Real Price of Gold 1900-2000 in 1900 $

Source: Bannock Consulting, World Gold Council

Breakdown of Production in 1968

13% USSR 67% South Africa

Source: Gold Fields Mineral Services

Breakdown of Production in 1999

Other Latin America 10%

5% 12% Australia 6% China 6% Canada

Source: Gold Fields Mineral Services

Gold Exploration Expenditure 1997-1999 $billion % Change

Source: Gold Fields Mineral Services

Gold Survey 2000, GFMS, London, 2000.

Gold Derivatives: The market impact

Gold Derivatives: The market impact

Real Price of Gold in USD, CAD, Rand, and AUD

AUD CAD USD

Source: World Gold Council

Gold Derivatives: The market impact

* Excluding lent gold

Official Holdings* (30,500)

Source: Gold Fields Mineral Services

Real Price of Gold in Selected Key Gold Consuming Countries

Source: World Gold Council

Real Price of Gold in Selected Key Gold Consuming Countries

Source: World Gold Council

Gold Derivatives: The market impact

Central Bank Gold Holdings, 1978 and 1998

1978 tonnes 10,000

Source: IMF; World Gold Council calculations

Gold Derivatives: The market impact

Largest Official Gold Holdings (end 2000)

Source: IMF, World Gold Council

Gold Derivatives: The market impact

1.4 Data issues

Gold Derivatives: The market impact

CHAPTER 2 THE PAPER MARKET

2.1 What makes gold special?

Gold Derivatives: The market impact

2.2 Gold derivative contracts