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GOFO And The Gold Wholesale Market

An essay on the relationship between GOFO, gold forwards, the gold lease rate and the US dollar interest rate.

In order to continue to reveal essential information about the physical and paper gold markets around the world, first I would like to expand on the inner workings of the gold wholesale market. In this post we’ll use the Gold Forward Offered Rates, in short GOFO, as an excuse to illuminate the most vital gears that drive the gold market engine. For, if we truly understand GOFO we also understand gold leasing, forwards and swaps, which are the building blocks of the gold wholesale market. Therefor, the goal of this post is to achieve a thorough understanding of  GOFO.

GOFO officially “represents rates at which the market making members will lend gold on swap against US dollars”, but GOFO also resembles the gold forward rate and the difference between the US dollar interest rate and the gold lease rate. The purpose of this post is to explain all this in a simplified way.

Let us start discussing gold forward contracts and work our way through this. Please be aware this post requires some studying and is not an easy read.

Gold Forward Contracts

In the gold market there are several possibilities to enter into contracts for buying or selling gold at a future date. These contracts can be used by gold market participants to lock in a future gold price or for speculation. The most common contracts are forwards and futures. On exchanges (organized markets) such as the COMEX gold futures contracts are traded, in the over the counter (OTC) market gold forwards are traded. For this post we’ll mainly focus on forwards.

Below is a chart in which I’ve plotted an exemplar gold forward curve based on mid market rates. In addition, I’ve added a table in the chart with the the bid and ask quotes (that set the mid market rates). The bid quotes represent the prices at which market making members are willing to buy gold at a pre-determined date in the future. These are the same prices at which we the market takers are willing to sell gold at a corresponding date in the future. The ask, or offer, quotes represent the prices at which market making members are willing to sell gold at a pre-determined date in the future (market takers buy at these prices). The mid market rate is the mid-point between the bid and ask price. Have a look at the chart and the table.

Forward curve gold price
Chart 1. Gold forward curve. The slippage is $0.15.

Please note, forward prices reflect what the market expects now about the future based on present circumstances. Forward prices do not determine what the actual spot price in the future will be.

We can see the bid-ask spread in this example is a constant $0.3 for every gold forward contract. In reality these spreads can vary and are determined by the liquidity of the forward contract. For liquid contracts, which are traded in high volumes, the spread is thin (meaning the spread between the bid and ask quotes is small). For illiquid contracts the spread is wide.

Furthermore, the difference between the mid market rate and the bid (or ask) is called the slippage.

Let’s have a look at a simplified example how a gold forward contract can be used. Say, a gold mining company anticipates the gold price will decline in the future. The miner has a steady output of 1,000,000 fine ounces a year and his annual expenses are 1.3 billion dollars, all to be paid at the end of the year. His business is viable starting at a gold price of $1,300 dollars an ounce. To ascertain to stay in business over one year’s time the miner can choose to enter into a 12 months forward contract in order to sell gold for $1,310.74.

The seller of a forward contract is said to be short, the buyer of the contract is said to be long. The total amount of shorts and the total amount of longs are always equal with respect to forward and futures contracts. The total amount of outstanding contracts is what is referred to as the open interest.

The long, in example, is a jewelry company that in turn seeks to lock in a future price for the well being of his enterprise. Perhaps it makes economic sense for the jeweler to borrow gold for the fabrication of gold ornaments, in the now, a loan he’s required to repay in one year’s time. Not to be exposed to future swings in the gold price he can choose to buy 12 months gold forward, assuring him to be able to repay the gold loan when it comes due.

Let us move on to the workings of the gold lending (/lease) market.

The Gold Lease Market

In a free market any currency can be lent out. Whether it’s the US dollar, euro, Norwegian krone or gold. Interest is paid from the borrower to the lender to stimulate supply, compensate for the risk of defaulting on the loan and postponement of using the currency. It’s true precious metals safely stored in a vault do not yield, however, when metal is lent out it will accrue interest. Gold lending in the gold wholesale market is referred to as gold leasing, and the acronym for the gold lease rate is GLR.

The interest on a gold loan can be settled in gold or dollars, although most often the latter is agreed. From the London Bullion Market Association we can read:

Market convention is for the interest payable on loans of precious metals to be calculated in terms of ounces of metal. These ounces are then generally converted to US dollars, based upon a US dollar price for the metal agreed at the inception of the lease transaction.


In the past decades the most prominent gold lenders have been central banks. During perceived economic stability it was thought to be safe for central banks to lend large portions of their official gold reserves. Though, in recent years these leases have been unwound to a great extent.

A borrower in the gold market can be, in example, the jewelry company mentioned in the previous chapter. In need of funds for production goods the jeweler can borrow dollars at ie 6 % from a bank, or he could directly borrow gold at ie 2 %. Historically, the normal state of the gold market offered a lower GLR than US dollar interest rate.

Below is a chart with an exemplar gold lease curve – showing the mid market GLR for several tenors. The gold lease bid is the interest rate market making members are willing to pay for borrowing gold (and the rate market takers are willing to receive for lending gold), the gold lease ask is the interest rate market making members want for lending gold (and we the market takers are willing to pay for borrowing gold).

Gold lease rate curve
Chart 2. Gold lease rate curve. 

Usually interest rates in financial markets are calculated on a 360 days a year basis.

Let us move on to combine currency lending, spot and forward markets, and come to grips with how these are interrelated and how the wholesale market in general functions.

Interest Rate Parity

Free markets that cater liquid venues for lending currencies, spot exchange and trading in forward contracts give rise to a concept called interest rate parity. This concept can be tough to get your head around, therefor I will describe it first and then show the math to clarify it.

Let us start at the base: the interest rate of any currency affects the forward value of this currency, because loans based on the interest rate grow into more supply of the currency over time. In example, a $5,000 US dollar loan at a 6 % US dollar interest rate grows into $5,300 in 1 year.

The theory of interest rate parity suggests that the interest rates of two currencies determine the forward relationship between the values of these two currencies (/the forward price of either currency denominated in the other). As, both interest rates generate a return in the future, the volumes of which determine the forward price. With respect to gold, interest rate parity suggests the forward gold price is firmly correlated to the gold lease rate and US dollars interest rate.

We should get familiar with the math that clarifies interest rate parity. We’ll work with the following exemplar market: the spot gold price is $1,200, the US dollar interest rate is 6 % and the GLR is 2 % – we’ll ignore bid-ask spreads for now. From here it can get complicated. Suppose, a trader borrows $1,200 for 6 months (180 days) at the annual US dollar interest rate of 6 %. When the loan comes due the trader is obliged to repay the principal plus interest to the US dollar lender. In the following formula we can see the principal (1,200), the interest rate (0.06) and the tenor (180/360) going in:

$1,200(1+0.06(180/360)) = $1,200(1.03) = $1,236

With the dollars borrowed the trader can buy 1 ounce of gold on spot and lend it for 6 months. When the gold loan matures the trader will get back the principal plus interest. In the next formula we can see the principal (1 oz), the interest rate (0.02) and the tenor (180/360) going in:

1(1+0.02(180/360)) = 1(1.01) = 1.01 oz

Remarkably, as we know the spot gold price and the volumes the loans grow into, we can compute the 6 months forward gold price: the gold lend by the trader will grow into 1.01 ounces over a 6 months time horizon and his dollar loan will grow into $1,236 over the same period, so consequently the 6 months forward gold price is $1,223.76.

$1,200/1       = $1,200         = spot gold price

$1,236/1.01 = $1,223.76   = forward gold price

As mentioned above, “both interest rates generate a return in the future, the volumes of which determine the forward price”.

In one formula it will show the 6 months forward gold price is:

$1,200(1+0.06(180/360)) / (1+0.02(180/360)) = $1,223.76

We can see the forward gold price is higher than the spot gold price because the GLR is lower than the US dollar interest rate.

Interest rate parity

The market will set the 6 months forward gold price at $1,223.76, because any undervalued or overvalued forward gold price (bellow or above $1,223.76) would immediately be arbitraged (interest rate parity is said to be “a no-arbitrage condition”).

Let’s have a look at an arbitrage trade in case the forward gold price would diverge from the forward price suggested by the theory of interest rate parity. Suppose, interest rates and the spot gold price are the same as above, but now the quoted forward gold price is too low at $1,220. To arbitrage this opportunity you want to buy (long) this cheap forward gold. Spot–forward arbitrage requires the opposite trade in the spot market – or one would just enter into a forward contract – in this case sell spot gold. If you don’t have spot gold you can borrow it. We can identify two legs in our arbitrage trade:

sell spot gold = buy spot dollars

buy forward gold = sell forward dollars

The chronological order to arbitrage undervalued forward gold would be:


  • borrow 1 ounce of gold for 6 months at 1 % (an annual GLR of 2 % divided by 2. In this example the gold interest will be settled in gold)
  • sell 1 ounce of gold on spot for $1,200
  • lend the $1,200 for 6 months at 3 % (an annual 6 % US dollar interest rate divided by 2)
  • buy long a 6 months gold forward contract for 1.01 ounce at the quoted forward gold price of $1,220 per ounce to repay the gold loan plus interest. The 6 months forward contract will have a notional value of:

1.01*$1,220 = $1,232.2

Then, in 6 months time,

  • receive $1,200 plus interest for the dollar loan:

$1,200*1.03 = $1,236

  • settle the gold forward contract by paying $1,232.2 for 1.01 oz
  • repay the gold loan with 1.01 oz

The total revenue of the arbitrage trade is $1,236 dollars. Having to settle the forward with $1,232.2, leaves a profit of $3.8:

$1,236−$1,232.2 = $3.8

The arbitrage opportunity will be taken advantage of until it’s closed, at that point in time the 6 months forward gold price is $1,223.76. For more clarity I should add that the closing of the arbitrage opportunity happens in the now, not in 6 months time. In addition, when the arbitragers step in the forward gold price could be pushed up from $1,220 to $1,223.76, as we’ve seen in the example trade, though in reality the other variables, such as the spot gold price or the GLR, can give way as well until interest rate parity has manifested. Interest rate parity suggests the spot, lending and forward markets are strongly linked. If one market is moving the others will move accordingly.

In reality everything is more complicated than in our exemplar market because of additional costs involved such as collateral/margin requirements and transaction/shipping/insurance costs (and because interest rate parity is just a theory, which does not always hold).

James Orlin Grabbe, the author who inspired me to pen this post, wrote in the late nineties: 

The forward price of gold – the price agreed now for gold to be purchased or sold at some time in the future – is a function of the gold spot price, and the interest rates representing alternative uses of resources over the forward time period.

James orlin grabbe 2
James Orlin Grabbe.

Introducing GOFO

So, we can compute the forward gold price from the spot gold price, US dollar interest rate and GLR. The formula can be written as:

F(T) = S(1+r(T/360)) / (1+r*(T/360))

F(T) = the forward gold price over a time horizon T days (up to 360 days)

S = the spot gold price

r = US dollar interest rate

r* = GLR

From this equation there is more to reveal. In our exemplar market the spot gold price is $1,200 and the 6 months forward gold price is $1,223.76. Ergo, the 6 months gold forward premium in percentages (/the forward rate) is:

($1,223.76/$1,200)−1 = 0.0198 = 1.98 %

The 6 months forward rate is by approximation 2 % and consequently the annualized forward rate is by approximation 4 %. The difference between the US dollar interest rate (6 %) and the GLR (2 %) is also 4 %. Meaning, the forward rate equals the difference between the US dollar interest rate and GLR. Why? Math. If we play with the formula above we get a nominal forward premium of:

F(T)−S = $1,223.76−$1,200 = $23.76

And by using (r−r*) as difference between the US dollar interest rate and GLR, we get:

S(r−r*)−S = $1,200(0.03−0.01) −$1,200 = $24

The forward rate equals the difference between the US dollar interest rate and the GLR. At this point I would like to bring up GOFO. Grabbe wrote:

Gold forward rates are sometimes referred to as “GOFO” rates, because GOFO was the Reuters page that showed gold forward rates.

Although this is not the official definition of GOFO, it is true that GOFO resembles the forward rate. I say ‘resembles’ and not ‘equals’, because there is a tiny difference we will discuss in the final chapter about GOFO.

Finally, we have explained two descriptions of GOFO mentioned in the introduction of this post. Namely, GOFO resembles the gold forward rate and the difference between the US dollar interest rate and the gold lease rate. The official and exact definition of GOFO we’ll save for last.

GOFO ≈ US dollar interest rate − GLR

GLR ≈ US dollar interest rate − GOFO

US dollar interest rate ≈ GOFO + GLR

GOFO, GLR and US$ interest rate
Chart 3. A positive gold forward rate is called contango.

When the forward rate is negative this is called backwardation. A negative forward rate implies gold for immediate delivery is trading at a premium to gold for future delivery. This can be caused by tightness in supply now or by market expectations the price will fall in he future. Backwardation is the opposite of contango, a positive forward rate. Historically contango has been the normal state of the gold market whereby the GLR is lower than the US dollar interest rate.

Because GOFO resembles the gold forward rate, negative GOFO implies backwardation in the gold forward price. Unfortunately, GOFO is not being published anymore after it was negative for long periods in 2013 and 2014. The LBMA writes on its website:

GOFO … was discontinued with effect from 30 January, 2015, following discussions between the LBMA and the contributors to the dataset, the LBMA Forward Market Makers.

So much for transparency.

In the chart below we can see GOFO went negative repeatedly in 2013 and 2014. The cause was presumably tightness in spot gold supply, as every time GOFO went sub-zero the spot gold price was pushed up.

GOFO 2013 and 2014
Chart 4. The 1, 2, 3, 6 and 12 months GOFO rates from July 2013 until April 2014.

In the interest rate parity chapter we examined an arbitrage trade that surfaced when the forward gold price was too low in relation to the prevailing US dollar interest rate and GLR in our exemplar market. Naturally, a comparable arbitrage opportunity arises when the forward gold price is too high in relation to the prevailing US dollar interest rate and GLR. Say, the 6 months forward gold price in our exemplar market is not $1,223.76, but higher at $1,300. This time we want to sell overvalued forward gold and buy spot gold to strike a profit:

buy spot gold = sell spot dollars

sell forward gold = buy forward dollars


  • borrow 1,200 dollars for 6 months at 3 % (an annual US dollar interest rate of 6% divided by 2)
  • buy 1 ounce spot gold for 1,200 dollars
  • store the gold for a storage fee of $5 for 6 months
  • sell short a 6 months gold forward contract at $1,300 for 1 ounce. The forward contract will have a notional value of:

1*$1,300 = $1,300

In 6 months time,

  • settle the forward: deliver 1 ounce of gold and receive $1,300
  • pay storage costs $5
  • repay the initial dollar loan:

$1,200*1.03 = $1,236

The proceeds of the gold forward are $1,300. Total expenses of the dollar loan ($1,236) and storage costs ($5) are $1,241, which leaves a profit of $59.

$1,300−$1,236−$5 = $59

The trade can also be executed by buying spot gold end lend the metal for 6 months instead of storing it. In that case the profit would be higher as the storage costs would be replaced by interest accrued on the gold loan. A 6 months gold loan of 1 ounce would grow into 1.01 ounce. When this gold loan is settled in dollars, the return would be the interest in ounces converted to dollars based on the spot gold price:

0.01*$1200 = $12 (dollar return on 6 months gold loan)

Using a dollar return on the gold loan would give a profit in our previous arbitrage trade of:

$1,300−$1,236+$12 = $76

The difference in profit ($76 – $59 = $17) is of course equal to the storage costs plus the dollar return on the gold loan ($5 + $12 = $17).

More on the pricing of commodity forward/futures contracts and the interaction between the theory of interest rate parity and the theory of storage will be discussed in a forthcoming post.

Gold Forward Swaps & GOFO

We’ve arrived at the official definition of GOFO, the swap. From the website of the London Bullion Market Association we can read the following official definition of GOFO:

GOFO represents rates at which the market making members will lend gold on swap against US dollars.

In parlance of the precious metals markets the word swap usually refers to a forward swap, whereby gold is sold spot and bought forward, or bought spot and sold forward. Essentially this is what GOFO is all about, a forward swap. The swap always has two legs, namely a spot and a forward leg. Consequently, the swap rate equals the forward rate.

gold swap rate = gold forward rate = US dollar interest rate − GLR

When market makers are willing to “lend gold on swap against US dollars” in the official definition of GOFO, they’re willing to execute a forward swap by selling gold spot and buying gold forward. The word “lend” in the official definition can be slightly deceiving, as strictly speaking there is no lending, the swap simulates lending: a gold loan to the market taker collateralized with dollars.

When a swap is executed and the market maker (dealer) sells spot gold to the market taker (client) and simultaneously signs a forward contract to buy it back in due time, the client buys that spot gold with dollars (collateral) and is obligated to return the metal through the forward contract at a fixed price. From the client’s perspective the process can be viewed as borrowing gold (collateralized with dollars), from the dealer’s perspective the process can be viewed as lending gold (on swap against dollars).

In the official definition of GOFO the dealer is the lender of gold but naturally he offers the reverse swap as well, whereby the dealer is the borrower. Let’s have a look at an example trade in which the dealer borrows gold: a central bank owns gold that it wants to put up as collateral for a 1 year dollar loan. The central bank and its dealer agree on a swap transaction. Based on the data from our exemplar environment the central bank will sell gold on spot to the dealer at $1,200 an ounce and then buy back the metal in 1 year’s time at $1,248 an ounce.

$1,200*(1+(0.04(360/360))) = $1,248

Essentially, the central bank has borrowed dollars for 1 year at 4 % instead of 6 % because it has collateralized the loan with gold (/lend its gold simultaneously at 2 %). Again, the swap rate is the difference between the US dollar interest rate and the GLR.

Let’s take it one step further and add bid-ask spreads to learn what GOFO is exactly. In more academic literature (The Non-Investment Products Code, NIPS code) we can read:

GOFO is the Gold Forward Offered Rate and is the rate at which dealers will lend gold on the swap against US dollars. As such it provides an international benchmark and is the basis for the pricing of gold swaps, forwards and leases. …

From GOFO rates, indicative mid-market gold lease rates can be determined as:

Mid-market lease rate = (US dollar LIBOR less 0.0625%) minus (GOFO plus 0.125%)

To explain the equation mentioned in the NIPS code, we should compare it to the one I penned in the previous chapter:

GLR ≈ US dollar interest rate – GOFO

The formulas are to a great extent similar. Though, the NIPS code uses LIBOR as the US dollar interest rate, which it corrects downwards by 0.0625 % because LIBOR is an offer rate – LIBID is its related bid. To compute the mid market US dollar interest rate the slippage, in this case 0.0625 %, is subtracted from LIBOR. In turn, GOFO is increased by 0.125 % because a “lend gold on swap against dollars” deal from a market maker’s perspective is based on the mid market spot leg, while the forward leg is the bid (in the official definition of GOFO the market maker buys forward, so the forward leg is the bid). To calculate the mid market forward leg GOFO must be increased by the slippage, which according to the NIPS code is 0.125 %. In the Nips code formula LIBOR is adjusted to come to the mid-market US dollar interest rate and GOFO is adjusted to come to the mid-market swap rate, in order to compute the mid-market GLR.

In the end both formulas are:

Mid-market gold lease rate = mid market US dollar interest rate – mid market gold swap rate

Hopefully by now you can see how understanding GOFO helps understanding the essential workings of the gold wholesale market – which is very valuable for understanding gold in general.

Chinese Gold Demand Dropping

It has been a bit silent on In Gold We Trust for a few days as I was working on moving this website to a new server, which didn’t happen as planned. Yesterday the website has been offline for hours due to transition. I was forced to move because the old server couldn’t handle the repeated DDoS attacks, the new one is supposed to be better armed providing visitors, finally, stable and faster access.

Anyway, I still owe you guys un update on withdrawal numbers from the SGE, published last friday April 18. SGE withdrawals, which equal Chinese wholesale demand, in week 15 (08-04-2014/11-04-2014) accounted for 21 metric tonnes. A lot of gold but the lowest numbers since March 2013 – also due to the fact the SGE was closed on April 7, leaving only four days of trading in week 15. Nonetheless, demand has been in a downtrend for six weeks in Shanghai and premiums have been sub zero since late February, which doesn’t hint at a supply shortage on the SGE. At the same time we saw GOFO rates being negative in week 15 in western markets, which does hint at supply shortages. This situation illustrates the PBOC’s gold policy; gold is allowed to be imported but not exported.

GOFO 2013 - 2014

Overview Shanghai Gold Exchange data 2014 week 15

– 21 metric tonnes withdrawn in week 15 (08-04-2014/11-04-2014)

– w/w – 16.7 %

– 606 metric tonnes withdrawn year to date

My research indicates that SGE withdrawals equal Chinese wholesale gold demand. For more information read this.

Shanghai Gold Exchange withdrawals 2014 week 15

This is a screen shot from the weekly Chinese SGE trade report; the second number from the left (blue – 本周交割量) is weekly gold withdrawn from the vaults in Kg, the second number from the right (green – 累计交割量) is the total YTD.

SGE withdrawals

This chart shows SGE gold premiums based on data from the SGE weekly reports (it’s the difference between the SGE gold price in yuan and the international gold price in yuan).

SGE premiums

Below is a screen shot of the premium section of the SGE weekly report; the first column is the date, the third is the international gold price in yuan, the fourth is the SGE price in yuan, and the last is the difference.

SGE premiums

GOFO Turned Negative AGAIN: The Consequences

Today (April 3, 2014) the one month Gold Forward Offered Rate (GOFO) turned negative again. This is the seventh time since July 8, 2013 this has happened. I would like to share a few thoughts on this.

A few weeks ago when I wanted to see and download GOFO rates these were easily accessible on the LBMA website. This site, however, recently suffered a makeover. A few days ago I couldn’t find the GOFO rates at all, then when I did find them I noted they weren’t allowed to copy! I directly emailed the LBMA about it, this was their response:

The LBMA do not own the gold and silver prices, we publish the prices on our website under an agreement with the London Gold and Silver Fixing companies, who own the data and who are responsible for setting the gold and silver prices on a daily basis. When we launched the new website, this was on condition that we prevented the data from being downloaded or scraped from the site. If you would like to be able to download the data you will require a licence from the Gold and Silver Fixing Companies.

Nice one, no more GOFO data for the average Joe to analyse. I immediately requested a license at the London Gold and Silver Fixing companies to be able to download the GOFO rates. In the meantime I spent a couple of hours manually writing the rates one by one in my excel sheet from the new LBMA website.

Gofo Rates On LBMA site

The LBMA also changed the order of the rates; the last date is now at the top. Just to make things a little easier.

What Is GOFO?

I will just skim the surface here, I will write about GOFO in detail in coming posts. First lets have a look at some equations and what factors determine GOFO to help us understand what GOFO is.

LIBOR (USD loan) – GLR (Gold Lease Rate, XAU loan) = GOFO


LIBOR is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. It’s a benchmark for fiat money interest rates all over the world. Many consumer interest rates like mortgages and credit card loans are derived from LIBOR.

The gold lease rate (GLR) is the interest rate on gold. If a central bank chooses to lend (lease) some of its gold reserves, it agrees on an interest rate with the borrower. For example, the US Treasury, which is the owner of the gold on the Fed’s balance sheet, decides to lend 3 metric tonnes for 1 year to a jeweller against a 2 % interest rate. A year later the jeweller has to repay the US Treasury 3,06 metric tonnes. In this transaction paper gold would be created out of thin air, as at the start of the lease the gold would be physically transported to the jeweller but would remain on the Treasury’s balance sheet as gold receivable (assuming the Treasury would disclose the distinction between gold and gold receivables). Double counting the same gold creates gold. When the gold loan is payed back by the jeweller the created gold vanishes. Just as in fractional reserve banking at commercial banks.

Gold loans exist in various forms, they can also be done through a book entry at a bullion bank without physically moving gold. The GLR is determined by supply (gold lenders) and demand (gold borrowers) in the gold market.

The Consequences Of Negative GOFO

From looking at the equations we can conclude GOFO is the difference in interest rate between US dollars (USD) and gold (XAU). When the three months GOFO is negative, it means the interest rate to borrow XAU for three months is higher than the interest rate to borrow USD for three months; there is more demand for XAU than USD. This suggests the value of gold expressed in dollars will rise.

Bear in mind we live in a ZIRP bubble bath, there is such USD supply (out of thin air) that LIBOR is exorbitant low.

Nevertheless in the following chart we can see that when GOFO is trending down the price of gold (XAUUSD) is pushed up.

GOFO goldprice

In the above chart I made the negative GOFO periods grey. The gold price (right axis) tends to go up in these periods. If GOFO persists to trend lower it’s very likely the price of gold will rise. When we look back a couple of years, we can see that every time GOFO dipped in negative territory a strong bull market in gold followed. I expect to see the same in coming years.

GOFO history


Deutsche bank that recently announced to stop participating in the London gold fix (and is one of the banks under investigation of manipulating the London gold fix) wrote this on GOFO, from their Quarterly Commodities Report April 2013:

Historically, GOFO rates have only been negative twice since 1999, but have frequently moved into negative territory over the past year. We believe this is a result of on going large shift of gold from the west to the east. More recently, with GOFO turning positive, it suggests that physical tightness has eased at least in the near term.

Well guess what, GOFO is back negative again and the west to east gold exodus is long from over.

Guest Post: The Gold Market, Part 4

Look in the side bar of this website for the first three parts.

Written  by James Orlin Grabbe in the late nineties.

Part 4

“There’s been a bomb at the World Trade Center.”

We all looked over at Kelley, one of the gold traders. She was quoting the Telerate news ticker off the monitor on her desk. There was no further information.

We then looked past Kelley, out the seventh floor windows of 222 Broadway, and down the half block of a side street to No. 4 World Trade Center (WTC). The COMEX, where gold futures are traded, was on the 8th floor of No. 4 WTC, and Kelley and one of the other gold traders had open phones lines to the trading floor.

The background voices at the COMEX, heard over the speakers where we were, sounded normal. The street scene outside looked normal also.

“Why don’t you ask the floor if there’s anything unusual over there,” I suggested to Kelley. We had two brokers on the COMEX floor.

Nothing out of the ordinary, they said. No bomb here. One opined he had felt a small shake of the building. The other one hadn’t noticed even that.

Those of us at 222 Broadway went back to work, filing away this interesting, but seemingly irrelevant piece of information: a bomb at the World Trade Center. It was, in fact, another hour before smoke began to fill the elevators at No. 4 WTC, and COMEX traders were ordered to evacuate the building. In the meantime, Kelley kept us updated as more news hit the ticker.

“It was centered in the garage area,” she announced.

For the first time, someone looked concerned. “I’m parked over there,” he said.

Tom wandered by my desk. “Want to go take a look?” he asked. Tom was a PhD chemist who had turned option trader. He had a natural curiosity about explosions.

I declined the invitation. Where there is one bomb, there may be two, and I preferred to wait until the excitement was over. If the bomb was in the parking garage, I doubted there was anything to see, anyway. Tom shrugged and left by himself. He returned with a report: the bomb had collapsed the lobby floor of the Vista Hotel on the ground floor of the tower at No. 1 WTC, as well as the floor below that, and a 20- foot crater now extended out to the street beside the tower. From our windows, we couldn’t see the activity taking place because No. 4 WTC blocked our view. I reflected that I had passed through the Vista Hotel lobby the previous day, en route to the walkway connecting the World Trade Center to the World Financial Center located on the other (wharf) side of Manhattan’s Westside Highway.

As it turned out, the WTC bomb had been planted by an FBI informant, whose FBI handler had insisted he use real explosives, and not fake that part of the “sting”. This was reported in the New York Times before Louis Freeh’s media handlers went to work and quashed reports of the FBI connection, and diverted all attention to the supposedly purely foreign nature of the “Middle Eastern terrorists” (with U.S. intelligence connections) whose operation the FBI had been assisting under the guise of conducting a “terrorist sting”.

It was claimed the bombers had intended to bring down the tower at No. 1 WTC. Though in fact the van filled with explosive (alleged, but not shown, to be urea nitrate) had done no damage to the building structure. Explosive pressure drops off approximately with the cube of the distance, so to do serious damage with a low-power explosive, you need to attached it to the building columns.

What the explosion had done was to take out two floors in a particular area vertical to the van location, and to fill the building cavities with smoke. Most of the 1000 or so injuries resulted from smoke inhalation, and were basically confined to those taking the commuter trains from New Jersey into the train station in the basement of the WTC. That is, to passers-through trapped in smoke, and not to people actually working at the WTC.

By the end of the day, Tom and I were discussing ANFO bombs instead of options. Where I had grown up in Texas, ammonium nitrate was widely used as fertilizer. It was just one of those things prevalent in the environment, like gasoline and butane, that you used and treated with respect. I had never known anyone killed with ammonium nitrate, although I had known two people, including one neighbor, who had blown themselves up welding “empty” butane tanks.

No, the FBI-assisted terrorists hadn’t done much damage to the World Trade Center, relatively speaking, aside from the Vista Hotel. But for a few hours on Feb. 26, 1993, they had shut down the COMEX, and– London trading having finished for the day–most of the world’s gold market along with it.

Gold Futures

Gold futures are traded at the COMEX in New York (which merged with the NYMEX on August 3, 1994, and is now known as the “COMEX Division” of the New York Mercantile Exchange), at the TOCOM in Tokyo, and–until recently– at the SIMEX in Singapore. Gold futures are also traded at the Chicago Board of Trade (CBOT) and at the Istanbul Gold Exchange. (The latter is mostly a market for spot gold. For example, over 8 million ounces of gold were traded spot at the Istanbul Gold Exchange in 1997, but only about 43,000 ounces were traded through the futures market.)

Gold futures are priced much like the gold forwards we discussed in part 3. That is, in their relationship to the spot price, futures show little difference from forwards. But there are many other ways in which futures contracts differ from forwards, and it is important to understand what these are.

Forward gold is traded for contract settlement at standardized intervals from spot settlement, in intervals that correspond to foreign exchange forward contracts: 1, 2, 3, 6, and 12-month forwards are typical. Spot gold traded on Wednesday June 24 will settle on Friday, June 26. A one-month forward trade on June 24 will take us to July 26, which is a Sunday, so settlement of a one-month forward will be on Monday, July 27. A two-month forward trade on June 24 will take us to August 26, which is a Wednesday, so settlement of a two-month forward contract will be on August 26. And so on.

Futures, by contrast, are traded for fixed dates in the future. At the COMEX and CBOT, gold is traded for settlement in February, April, June, August, October, and December, as well as the current and next two calendar months. Istanbul trades the next six months for Turkish lira-denominated contracts, or the next 12 months for U.S. dollar-denominated contracts. The last trading day for a futures contract is the fourth to last business day in the delivery month (at the CBOT or Istanbul), or the third to last business day (at the COMEX). That is, the August 1998 COMEX gold future trades until the third to last business day in August 1998. At the TOCOM, there are futures for the current or next odd month, and all even months within a year. The last trading day is the third to last business day, except for December, when the last trading day is December 24.

Despite the different trade date conventions, however, if futures and forward settlement dates happen to correspond, forward and futures prices are the same, subject to slight differences related to delivery grade or location (Manhattan, say, versus London).

How Futures Markets Deal with Credit Risk

The main different between futures and forwards is the way futures markets handle credit risk. In the forward market, a credit evaluation must be made of the counterparty–evaluating the counterparty’s ability to pay cash if gold was purchased forward, or the ability to deliver the gold, if gold was sold forward.

The futures market don’t worry about such customer credit evaluations. Instead, a futures contract is configured as a pure bet, based on price change. So one is asked to post a security bond, called “margin”, which covers the typical variation in the value of a contract for several days. Going long a futures contract is a bet that the price is going up, while going short is a bet the price is going down. Cash flows from price changes take place daily. So those who post the required margin against possible losses (and who replenish this margin if necessary) are considered credit-worthy, while those who can’t post margin aren’t credit-worthy. Customers post margin with member firms of the futures exchange, who in turn post margin with clearing member firms. The clearing member firms post margin (on the customer’s behalf) at a clearinghouse. This way of dealing with credit risk is a much cleaner structure than in the forward market world of customer credit evaluations, accounting reports, and other types of intrusive financial reporting. (Of course, exchange member firms and, especially, clearing member firms still have to undergo the usual sorts of credit checks.)

To close out a long position, one sells (goes short) an off-setting contract. To close out a short position, one buys (goes long) an off-setting contract. The opening and subsequent closing of a futures position is referred to as a “round turn”. Brokerage fees are usually charged per round turn, at the time the future contract is closed out.

At discount brokerage firms in the U.S., in June 1998, the typical customer margin on a 100 oz. gold futures contract was about $1350, while there was a typical brokerage charge of $25 per round turn.

The size of the futures bet depends on the stated size of the futures contract. The cash flow will be the change in price multiplied by the contract size.

At the COMEX, CBOT, and the SIMEX, the contract size is 100 ozs of gold with a fineness of .995. So if gold (of that fineness) went from $299/oz at contract opening to $297.50/oz as the day’s futures settlement price, a long contract would lose $150, while a short contract would gain $150. (The calculation on the short position is $299 minus $297.50, multiplied by 100.)

The TOCOM trades 1 kilo bars (32.148 ozs) of .9999 fineness. The price is stated as yen/gram. So the daily change in value of a single contract is the change in the yen price per gram, multiplied by 1000 grams.

The Istanbul gold futures contract is for 3 kilograms of gold of .995 fineness, quoted either in terms of U.S. dollars per ounce, or Turkish lira per gram. The daily change in value of a U.S. dollar- denominated contract is the change in dollars per oz, multiplied by 96.444 ozs. The daily change in value of a Turkish lira-denominated contract is the change in the Turkish lira price per gram, multiplied by 3000 grams.

The “initial” margin that must be posted as a security bond is large enough to cover several days expected/loss or gain, and is thus related to the standard deviation of daily contract value changes. The margin is held by a clearinghouse which thus “guarantees” that the losing side of the daily futures bet pays the winning side. For every customer that goes long a contract, the clearinghouse takes the other side, going short. For every customer that goes short a contract, the clearinghouse takes the other side, going long. The clearinghouse thus is in a position to move cash from the losing side of any futures bet to the winning side.

If the initial margin is depleted by losses, it eventually reaches a “maintenance” margin level, below which the customer is required to replenish the margin to its initial level. For example, at discount brokerage firms in the U.S. in June 1998, a typical maintenance margin level for gold futures contracts at the COMEX was $1000 per contract. So if the posted margin dropped below $1000 per futures contract, additional margin had to be posted to bring the total back to at least $1350 per contract (the typical initial margin level).

Customers typically may post margin in the form of cash, or U.S. government securities with less than 10 years to maturity. Clearing members may post cash, government securities, or letters of credit with the clearinghouse. The details differ at different exchanges.

The Equilibrium Futures Price

The equilibrium futures price is that point where the market clears between longs and shorts. Arbitrage, however, forces the futures price to track the forward price (and vice-versa). Similarly, arbitrage between the futures market and the spot market on the final day of trading forces the futures price to converge to the spot price. On the final trading day at the SIMEX, where no gold can actually be delivered on a futures contract, the settlement price is set as the loco London price of the A.M. London price fix. This forces convergent of the futures price to the price in the London spot market. At the COMEX and CBOT, the open longs take delivery of spot gold, which accomplishes the same thing.

(On January 9, 1998, the SIMEX removed trading of its gold futures contract from the floor of the exchange. The contract is still available on the SIMEX Automated Trading System.)

Delivery at the COMEX and the CBOT is one 100-oz bar (plus or minus 5 percent) or three 1-kilogram gold bars, assaying not less than .995 fineness. (Note that 3 kilo bars is about 96 ounces of gold. The dollar amount actually paid at delivery depends, of course, on the specific amount of gold delivered, which must be within 5 percent of the hypothetical 100 ozs per contract.) Delivery at the CBOT takes place by a vault receipt drawn on gold deposits made in CBOT-approved vaults in Chicago or New York. Gold delivered against futures contracts at the COMEX must bear a serial number and identifying stamp of a refiner approved by the COMEX, and made from a depository located in the Borough of Manhattan, City of New York, and licensed by the COMEX. As noted previously, there is no delivery at the SIMEX. The futures contract is purely cash- settled, with the final settlement price determined by the London A.M. gold fix.

In part 3, we saw the U.S. dollar forward price of gold would be related to the U.S. dollar spot price of gold by the relationship

F(T) = S [1 + r (T/360)] / [1 + r* (T/360)].

where the spot price is S, the forward (or futures) price is F(T) for a time-horizon of T days, the eurodollar rate is r, and the gold lease rate is r*. If the eurodollar rate r is higher than the gold lease rate r*, then the forward (futures) gold price will be higher than the spot gold price. Historically gold lease rates have always been lower than eurodollar rates, so forward gold (or a gold futures contract) always trades at a higher price than spot gold. The same is not true, for example, in the silver market. During the year 1998, silver lease rates have frequently exceeded eurodollar rates, so forward silver has traded at a cheaper price than spot silver.

Different terms are used to refer to the relationship between forward or futures prices and spot prices. If forward gold (or a gold future) has a higher price than spot gold, the forward gold or gold future is said to be at a premium, or (in the London market) in contango. If forward gold has a lower price than spot gold, the forward gold or gold future is at a discount, or (in the London market) in backwardation.

As we noted before, forward gold has in recent history always been in contango, or at a premium, because dollar interest rates have always been above gold lease rates. We saw in part 3 that the difference between the forward price and the spot price, F(T)-S, is the swap rate. Since the forward price of gold has always been at a premium in recent years (since 1980, in particular), the swap rate has always been positive. A related term that is used in the U.S. futures markets is basis. Basis is the spot price minus the futures price, or S-F(T), which is just the swap rate with the sign reversed. The gold basis has always been negative in recent years. The Federal Reserve Bank of Cleveland, for example, publishes monthly charts of the gold basis. Reverse the sign on their chart, and you are looking at the swap rate.

Exchange for Physicals

While forward gold is traded in the form of swaps, which combines a spot trade (buy or sell) with the reverse forward trade (sell or buy), gold futures can be traded in the form of EFPs (exchange for physicals), which combine a futures trade with the reverse spot trade. EFPs are traded for the same months as gold futures. The EFP price represents the difference between the futures price and the spot price for the combined trade.

For example, a marketmaker may quote the August EFP at the COMEX as $1.10-$1.30 in 100 lots. This means the marketmaker’s prices are good for a standard trade involving 100 futures contracts (10,000 ozs of gold). The marketmaker will “buy” the EFP at $1.10/oz, or “sell” the EFP for $1.30/oz.

This quotation implies that for $1.10/oz. the marketmaker offers to buy from you 100 gold futures contracts, while simultaneously selling to you 10,000 ozs of spot gold. For $1.30/oz. the marketmaker will sell to you 100 gold futures contracts, while simultaneously purchasing 10,000 ozs of spot gold. To summarize: the marketmaker’s bid price is the price he will buy futures versus selling spot, while the marketmaker’s asked price is the price he will sell futures versus buying spot. The EFP price is thus simply a different way of looking at the basis or the swap rate.

On June 24, 1998, the mid-market price (average of bid and asked prices) of the EFP associated with the August 1998 COMEX gold contract was a positive $1.25, while the mid-market price associated with the Dec 1998 COMEX gold contract was a positive $5.60. By contrast, the EFP associate with the July 1998 COMEX silver contract was a negative $2.00. This reflected the fact that gold lease rates were below eurodollar rates, while silver lease rates were above.

Interest rates in the gold market are a principal concern of gold dealers and gold mining companies.

In Parts 3 and 4, we saw how two interest rates– gold lease rates and eurodollar rates–determine the relationship between the dollar price of spot gold and the dollar price of gold forwards and futures. In the forward market, these two interest rates give rise to the swap rate, while in the futures market they determine the EFP price. Both swaps and EFPs involve a spot sale or purchase of gold, along with the reverse trade in the forward market (if a swap) or futures market (if an EFP).

Because eurodollar rates have historically always exceeded gold lease rates, gold forward and futures have always traded at a premium (have always been in contango). There is nothing inevitable about this relationship, however.

But there are many contracts in the gold market that do not involve the spot, forward or future price of gold, but rather are simply written in terms of gold interest rates. These include gold forward rate agreements (FRAs), gold interest rate swaps, and gold interest rate guarantees (IRGs). Let’s examine each of these contracts in turn.

James Orlin Grabbe

Guest Post: The Gold Market, Part 3

Where Grabbe uses the term eurodollar rate he refers to what we nowadays call the LIBOR interest rate on fiat money. Read gold libor as gold lease rate.

Written by James Orlin Grabbe in the late nineties.

Part 3

Now that we have seen how spot gold is priced “loco London,” we can examine how other local markets, and other types of gold contracts, are priced in reference to the London spot market. This includes other spot delivery locations, gold forward and futures contracts — such as the gold futures contract at the NYMEX in New York — and gold swaps, forward rate agreements, and options. (In 1994 the COMEX merged with the NYMEX, and the principal gold futures contract now trades there.)

London is only one of many important centers for gold trading. The second principal center for spot or physical gold trading, for example, is Zurich. For eight hours a day, trading occurs simultaneously in London and Zurich — with Zurich normally opening, and closing, an hour earlier than London. During these hours Zurich closely rivals London in its influence over the spot price, because of the importance of the three major Swiss banks — Credit Suisse, Swiss Bank Corporation, and Union Bank of Switzerland — in the physical gold market. Each of these banks has long maintained its own refinery, often taking physical delivery of gold and processing it for other regional markets.

(On December 8, 1997, Swiss Bank Corporation and Union Bank of Switzerland announced plans to merge, the combined bank to be known as United Bank of Switzerland. The net effect such a merger would ultimately have on the Zurich gold market is not yet clear.)

In addition to other gold delivery locations, there are other weight and quality standards which create differential prices. Examples include the London and Tokyo kilobars (which are 32.148 ozs., instead of the circa 400 oz. “large bars”), the 10 tola bars (3.75 ozs.) popular in India and the Middle East, the 1, 5 and 10 tael bars (respectively 1.203, 6.017, and 12.034 ozs.) found in Hong Kong and Taiwan, and the baht bar (0.47 ozs) of Thailand. Gold content is another difference. The London good delivery bar is only required to have a minimum of 995 parts gold to 1000 parts total. But a gold content of 9,999 parts gold to 10,000 parts total (“four nines”) is commonly traded, as is a content of 990 parts to 1,000 total (the baht bar being an example of the latter ratio). Gold purity is important to industry. Jewellers might want gold in the form of grain for alloying, while electronics firms may require “five nines” — meaning .99999 purity.

Pricing Nonstandard Contracts

Nonstandard contracts can be priced by reference to the standard loco London good delivery bar, by taking into account the simple arbitrage relationships that would turn one into another. The primary variables to keep track of are the costs of shipping gold from one location to another, the cost of refining gold to different purity levels, and the interest or financing cost for the time required to accomplish these activities.

Suppose a dealer is offered non-good delivery bars of .995 purity loco Panama City. Here is one chain of calculations the dealer might go through to come up with a price quotation. First the dealer notes that London good delivery bars of .9999 purity can be sold in Tokyo for $.50/oz premium to the standard loco London price. He knows that if he buys the bars in Panama, he could sell them in Tokyo, but first he would have to ship them to an appropriate location to upgrade their purity.

The dealer also knows that he can upgrade to London large bars for good delivery, and have the gold content refined to .9999 purity, for $.50/oz at the Johnson Matthey refinery in Salt Lake City, Utah. There is a two-week turnaround time for the upgrade. Shipping time is one day from Panama City to Salt Lake, and two days from Salt Lake to Tokyo.

The dealer calculates the cost of shipping and insurance from Panama to Salt Lake as $.40/oz, while shipping from Salt Lake to Tokyo is $.70/oz. The total time consumed would be 15 days, which at 6 percent interest and spot gold at, say, $300/oz amounts to 300 x .06 (15/360) = $.75/oz.

So the dealer adds up: shipping costs $1.10, plus interest cost $.75, plus refining cost $.50, minus selling premium in Tokyo of $.50. The net cost to the dealer to sell the Panama bars in Tokyo is $1.85/oz.

Therefore the dealer’s best, or break-even, quotation to the person offering him non-standard gold bars in Panama City would be the spot price for good delivery loco London minus $1.85. If spot gold were at $300/oz. bid, the most the dealer could afford to bid for the Panama bars would be $298.15/oz.

The Gold Lease or Gold Libor Rates

Gold bears interest. Positive interest. Many people do not know this. They are used to the notion of storing their gold with some bank or warehouse, and paying for storage cost. They then view the storage and insurance cost as a negative interest rate. But this has little to do with the way gold is priced or traded in the wholesale market.

The forward price of gold — the price agreed now for gold to be purchased or sold at some time in the future — is a function of the gold spot price, and the interest rates representing alternative uses of resources over the forward time period. So before we discuss gold forward prices, we should discuss gold and dollar interest rates.

This brings us to the gold lease rate, or the gold interest rate paid on gold deposits. Another term that is used is gold libor, by analogy with the London Interbank Offered Rate for eurocurrencies traded in London. Despite the apparent literal connotation of each of these labels, “gold libor rates” and “gold lease rates” are alternative descriptions that refer to the bid-asked gold interest rates paid on gold. The bid rate (deposit rate, borrowing rate) is the gold interest rate paid for borrowing gold (that is, on gold deposits), while the asked or offered rate is the gold interest rate quoted for lending gold. The expressions “bid-asked gold lease rates” or “bid-asked gold libor rates” are thus interchangeable.

If the gold borrowing rate is 2 percent per annum, for example, then 100 ozs of gold borrowed for 360 days must be repaid as 102 ozs of gold. (Gold interest rates, like most money market rates, are nearly always quoted on the basis of a 360-day year.) In the early 1980s gold deposits rarely yielded over 1 percent, but in recent years have rarely yielded less than 1 percent.

Because of large central bank gold holdings, gold loans are one of the cheapest financing sources for the gold mining industry. A mining company borrows gold and sells it on the spot market to obtain funds for gold production. The interest installments on the gold loan are payable in gold. And when the loan matures, the principal (and any final interest due) is repaid directly from mine production.

Central banks are the major lenders of gold. They accounted for around 75 percent of the gold on loan, estimated at around 2,750 tonnes, at the end of 1996. Central banks in recent years have been under pressure to earn a return on their gold holdings, and therefore lend to, for example, gold dealers who have mismatched books between gold deposits and gold loans. (The practice of central bank gold lending first became newsworthy in 1990, when the investment banking firm Drexel, Burnham, Lambert went bankrupt while owing borrowed gold to the Central Bank of Portugal.)

The gold lending (or borrowing) rate, then, is one of the components that determine the gold forward price. Let’s see how this works.

The Gold Forward Price

Suppose the spot price of gold is $300/oz. The gold lease rate for 180 days is 2 percent per annum. And the eurodollar rate for 180 days is 6 percent per annum. (For simplicity here, we ignore all bid-asked spreads. But they are easily included in the following calculations.)

I borrow $300 at the eurodollar rate. In 180 days I will have to repay the dollar borrowing with interest in the amount $300 (1+.06(180/360)) = $300 (1.03) = $309.

With the borrowed money I can buy 1 oz. of gold, and place it on deposit for 180 days. The amount of gold I will get back is 1 (1+.02(180/360) = 1 (1.01) = 1.01 oz.

Thus, 1 oz. of gold with a spot price of $300 has grown into 1.01 ounces in 180 days, with a value of $309. This translates into a 180-day forward value of $309/1.01 = $305.94.

Spot price: $300.00

180-day Forward Price: $305.94
Notice that both the gold lease and the eurodollar rate have gone into this calculation. Specifically:

$305.94 = $300 [1+.06 (180/360)] / [1+.02 (180/360)].

In general, if the spot price is S, the forward price is F(T) for a time-horizon of T days (up to a year), the eurodollar rate is r, and the gold lease rate is r*, we have the relation

F(T) = S [1 + r (T/360)] / [1 + r* (T/360)].

Notice that in the numerical example we just used, the forward price $305.94 is approximately 2 percent higher than the spot price of $300. That is, the 180- day forward premium of $5.94 is approximate 2 percent of the spot price of $300. (An exact 2 percent would be $6.) Why is this?

To see what is involved, let’s subtract the spot rate S from both sides of the above equation. The left- hand side will be the forward premium F(T) – S. Simplifying the right-hand side, we obtain:

F(T) – S = S [( r – r*)( T/360)] / [1 + r* (T/360)].

That is, the forward premium (F(T)-S) is approximately equal to the spot rate S multiplied by the difference between the eurdollar rate r and the gold lease rate r* (once we have adjusted this rate for the fraction of a year: T/360).

Since in the numerical example the eurodollar rate was 6 percent, while the least rate was 2 percent, the forward premium at an annual rate is approximately 6-2 = 4 percent. For 180 days, or half a year, it is approximately 2 percent.

So, as long as we are talking about an annual rate — that is, before we do the days adjustment — the gold forward premium in percentage terms is approximately the difference between the eurodollar rate and the gold lease rate.

We can view this same relationship in other ways: given a eurodollar rate and a gold forward premium (in percentage terms), we can back out the implied lease rate.

Looking back at the chart from Kitco, above, it is easy to see that subtracting the gold lease rate from the “prime rate” gives us approximately the gold forward rate. (Note that “prime rate” is a misleading term to use: the relevant interest rate in the gold market is the eurodollar rate by which banks borrow and lend among themselves, not the commercial “prime” lending rate — which is often an administered, rather than a market, interest rate.)

Gold forward rates are sometimes referred to as “GOFO” rates, because GOFO was the Reuters page that showed gold forward rates.

Gold Swaps

There are many different hedging and trading operations in the gold market, all of which bring us back to the same relationship between forward and spot rates we saw in the previous section.

For example, gold dealers will buy gold forward from mining companies. The mining companies, thus assured of a fixed forward price at which to sell their production, go to work producing. Meanwhile, the gold dealers, to hedge themselves against movements in the gold price, borrow gold and sell it in the spot market. (To repeat, dealers “borrow” gold by taking in gold deposits, and paying out the gold lease rate.)

Restated, gold dealers buy gold forward from mining companies at a price F(T). To hedge themselves, the dealers borrow gold at an interest rate r*, and sell it in the market at a price S. They earn interest on the dollar proceeds of the spot gold sale at an interest rate r.

Thus, for each ounce of gold purchased, the dealer must pay

F(T) [1+ r* (T/360) ].

While for each ounce of gold sold, the dealer earns:

S [1 + r (T/360)].

All excess profit (beyond bid-asked spread) gets eliminated when these amounts are equal. Which gives

F(T) [1+ r* (T/360) ] = S [1 + r (T/360)].

This is, of course, exactly the same formula as before.

Generally speaking, gold dealers will quote forward prices to their customers (these are called “outright” forwards), but forward trades beween dealers mostly take place in connection with a simultaneous spot transaction. That is, in the form of “swaps.” A swap transaction is a spot sale of gold combined with a forward repurchase, or a spot purchase of gold combined with a forward sale. This type of trading requires less capital and is subject to less price risk. The swap rate is F(T)-S, and as we saw before, this difference is (when quoted as a percentage of the spot price) essentially the difference between the eurodollar rate and the gold lease rate.

A spot sale of gold combined with a forward purchase is also called a cash-and-carry transaction. The transaction provides immediate cash, the cost of which is the carry, or the difference between forward and spot rates. The dollar lender (who buys the gold), meanwhile has possession of the gold as security. So a cash-and-carry (one form of a swap) boils down to a dollar loan collateralized with gold.

The typical dealing spread between eurodollar deposits is 1/8 of 1 percent, or .125 percent, while the typical spread between gold deposit and loan rates is .20 percent. This translates into bid-asked swap rate, or cash-and-carry, spreads of about .30 percent. For example:

_______________Eurodollar rates          Gold lease rates      Gold swap rates
1 month                   3.0625-3.1875               0.50-0.70                     2.35-2.65
3 months                 3.1250-3.2500               0.55-0.75                      2.40-2.70
6 months                 3.3125-3.4375               0.70-0.90                      2.45-2.75
12 months                3.5625-3.6875              1.00-1.20                      2.35-2.65

Note that the gold swap rate can be independently viewed as the collateralized borrowing rate. A small central bank, for example, with plenty of gold to spare, could borrow dollars for 3 months and pay — not the 3-month asked eurodollar rate of 3.25 percent — but rather the gold swap rate of 2.70 percent.

James Orlin Grabbe