Current Buy and Sell transactions are executed on terms of spot with the value date (date of entry/writing-off of metal and currency) being the second day after that of settling a deal. The international market of current transactions is known as a spot market. Standard lot volume on the spot market is equal to five thousand troy ounces. A troy ounce is a generally accepted measure of weight of precious metals; it is equal to 31.1034807 grams. Such operations are aimed at forming precious metals equity of lending institutions and processing clients’ requests. The gold price parameters are set at loco London market. The term “loco” means the place of metal delivery. It is the most important condition for operations with precious metals
The term “swap” is frequently used in economic literature. When it comes to the gold market, it can be interpreted as buying or selling a metal followed by an immediate opposite operation. The volume of such transactions is larger than that of spot transactions, because a gold swap does not have such influence on the precious metals market as spot operations. A standard operation includes thirty two thousand troy ounces (one ton).
There are three types of spot operations with gold:
Swap by time (financial swap)
It is a classic type of swap operation(s). It corresponds to a combination of cash and fixed-date transactions: buying (selling) of one and the same metal amount on conditions of swap and selling (buying) on conditions of forward. The closer date of operation’s execution is called a value date, and a further date is known as a swap expiration date. An agreement can be concluded for any period of time: from one day to several months. The terms a swap agreement is usually made for are one, three, six months and one year. The essence of such operations consists in the possibility of converting gold into a currency while keeping the right to buy gold back after the swap expires. Before the contract expires, the parties can agree to extend the contract or eliminate the swap making opposite calculations. Swap operations have become very popular. First of all, the benefit from attraction of financial resources is obvious in comparison with attracting USD deposits, because the rates of swap interest are lower. Moreover, there is a possibility to easily attract gold which can be used by banks for managing remains on metal accounts, for example. Finally, these operations are very popular with central banks. If central banks want to convert their own gold reserves, they can be sure that their activity will not seriously influence the gold market; so, instead of being sold directly on the market, gold moves between contractors.
Swap by metal quality
Sometimes, under certain conditions, a market participant needs purer gold than he actually has. This wish can be met through a swap by metal quality. Such swap implies buying (selling) of one quality metal against selling (buying) gold of another quality simultaneously. The party that is selling metal of higher quality receives a reward depending on the deal’s volume and risk related to substitution of one type of gold for another.
Swap by place
Such a swap implies buying (selling) gold at one place against selling (buying) it at another place. One of the parties receives a reward, because the gold price varies depending on the location.
Being a financial asset, gold can yield revenue if lent. Such operations are executed when it is necessary to attract a metal in the account or deposit it for a certain period of time. Gold deposit rates are usually lower than currency rates, which can be explained by high currency liquidity. Standard deposit periods are one, two, three, six and twelve months, but they can be changed. Bank attracting precious metals within deposit contracts can use them for making profit during some time, for instance, at gold mining financing schemes or arbitrage operations etc. Owners of gold get income from the metal invested and avoid expenses of storing a physical metal.
Besides the operations mentioned above, other transactions can be executed on the world market. For instance, there are forward deals implying metal delivery during more than two business days. Making such a deal, a buyer insures himself against gold price increases on the spot market in future. Insurance implies fixing the price which mutual settlement will be executed at. However, such a deal does not allow using more auspicious conjuncture. A forward cannot be cancelled; it can be only counterbalanced by buying or selling of the stipulated by the deal amount of metal at the current price and then selling it at a price stipulated by the forward contract. Such transactions are rare on the interbank gold market. If selling a metal for exact period is necessary, a seller works it off under conditions of spot and then makes a swap deal: he buys a metal on conditions of spot and, at the same time, sells it on conditions of forward.
Transactions with CFDs
We have had a look at organization and principles of physical metal markets. However, there is another interesting point — trading virtual instruments.
There are hardly any events that have had such tremendous influence on the financial markets as the introduction of CFDs. The era of unprecedented interest and exchange rates started in the 1970s and gave rise to the need for new financial instruments which could be used for managing higher risks. Prosperity of the derivatives industry is explained by its ability to respond to changing market tendencies fast and effectively. Eventually, a virtual section of the gold market became an independent field with huge turnover, which was many times bigger than that of the physical market.
Future (futures contract) is a legal contract binding the parties; one party agrees to execute and the other to accept delivery of a certain amount of goods (and of certain quality) at a definite time in future at the price set when concluding the contract. Gold futures contracts are traded on several stock exchanges; the biggest amount of gold contracts is concluded on COMEX in New York. Operations with gold on COMEX have been executed since 1974. The main goals of futures operations are hedging and speculation. What makes such deals especially attractive is that you do not need to have much money or many goods. Small investments can bring much profit provided the conditions are suitable.
Another popular form of fixed-term contracts is gold options introduced in 1976. They have been widely spread after they became commonly used in the USA in 1982.
Option is a fixed-term contract. The client can either buy a call option or sell a put option of a certain standard amount of goods at a fixed price on the exact date (European options) or during the whole specified period (American options). The seller of an option sells the contractor the right to execute the transaction or cancel the deal. The buyer of an option pays for this right to the seller – option premium. The buyer has the right to exercise an option at a fixed price. Therefore, the active party is the buyer, because this person makes a decision on fulfilment of the conditions of an option contract.
Option transactions are often used for hedging. So, if the investor hedges against risks of increases in the gold price, he will be able to buy a call option or sell a put option; if the investor hedges against risks of decreases in prices, he will be able to sell a call option or buy a put option. Compared to other instruments of hedging, an option is attractive because, besides fixing the exercise price to hedge against adverse changes in market conditions, it gives the opportunity to take advantage of favourable conditions. In addition, options promote development of speculative operations. The maximum size of losses the buyer might suffer is limited by the paid the premium, the gains are potentially unlimited. The situation for the seller is vice versa
Options can be traded on the over-the-counter market. Such options are called dealer options. These are issued not by an exchange, but by an actual legal entity that guarantees option execution.
Dealer options can be divided into two groups:
Options meant for selling on the retail market to meet the private speculative demand. Initially, trading these options was associated with increased risk as in the second half of the 70s in the USA there were a lot of cases of fraud involving options because of high market volatility. The reaction of authorities was introduction of new requirements to organization of trading dealer options. Particularly, gold and option premium for the dealer could be deposited to the custodian bank before execution of an option or after expiry of its validity. Gold options. These options are popular with gold miners, industrial customers, and large-scale dealers.
Gold options are usually of large volumes and they are active during a longer period of term. The purpose of such options is to smooth the price risks producers and consumers of the metal may face; in other words, it is not about speculation, but about hedging. Unlike stock options characterized by possible transparency of information about its key parameters, dealer options are sold either directly or through a dealer network. Anyway, all the deals with options must be accompanied by appropriate accounting, which ensures fulfilment of the option contract conditions and reduction of risks participants are exposed to.
The volumes of trading futures and options (paper gold) considerably exceed the turnover of buying and selling the noble metal (the latter amounts to some few percent). At the same time, being secondary to the economic meaning of the physical gold market, the industry of derivatives has recently had a huge impact on the underlying asset price dynamics because of the volume superiority. The participants of gold stock deals are interested in high market volatility as it provides opportunities for boosting the profit. These actions of speculators tend to move the market. For instance, there was a fantastic rise in the gold price in 1980 and its rapid downfall in 1997-1999.
Gold price fluctuations
As a rule, the gold price depends on the global economic situation. Moreover, the gold price has always been an indicator of effectiveness or unprofitability of alternative investment instruments. Gold would depreciate in the period of rising turnover and extensive use of various instruments. On the contrary, in case of economic stagnation, downturn or recession, gold seemed to be the most stable and liquid instrument of capital fixation and its future saving. The analogy can be drawn to the foreign exchange market: gold can be compared to the Swiss franc, which is considered a safe-haven asset to ride out high volatility.
In other words, when bulls are ruling the market, consumption is rising pulling all the economic sectors up, gold pales into insignificance. But it is temporary... Russia was going through a tough period: treasury bills depreciation, oil crisis, and subsequent rouble devaluation hit everybody. That time Russians, trying to save their money, bought almost all gold at banks and did not regret it. Since August 1998 the price of a troy ounce has tripled. Even though the 20% VAT was charged at that time, gold justified investor hopes. However, during that period, individuals were able to buy gold only at Russian banks. Meanwhile, the price of an ounce was forming on the internal market, and so it was higher than on the world market due to a limited number of providers and high demand within Russia. Presently, Russians can buy gold on the world open market, regardless of crisis locality. It became possible not only because financial and stock institutes developed in Russia, but because numerous brokers appeared providing opportunities to enter the international markets.
As for the current crisis, it has fundamental features. It not only runs through the economic structure of different countries, but provokes recession as well. That is why buying gold is considered to be one of the safest way of capital saving. Last year gold quotes exceeded $1,000. The prices of other precious metals are also close to highs. Silver approached the level of $21 per ounce for the first time over the last 30 years. Platinum and palladium rose in prices up to $2,273 and $582 respectively. Later however, prices of precious metals started declining, except for gold. Despite production downturn and persistent demand for gold among companies, gold holds steady at a high price due to its speculative and capital saving characteristics.
There are other factors influencing the gold price, such as the US dollar and the oil price. The gold price movement is inversely related to the US Dollar and directly related to the oil price dynamics. It is explained by the fact that when the foreign exchange market volatility and the US Dollar rate are decreasing, gold appears to be an alternative investment harbour. While the price of an oil barrel is increasing, gold is regarded as the means of petrodollars accumulation.