Yesterday, I said that I would explain how gold futures work. And this is that post.

But before I get there, some updates on the gold saga (and you should read the Gold Rout post if you haven’t already!):

  • HSBC has issued a list of 6 reasons why they think the gold price is falling. They listed all the usual suspects: “the release of Federal Reserve meeting minutes”, “Cyprus”, “a gradual trend away from commodities”, “lower demand for gold by ETFs”, “the Bank of Japan” and “the price fell below $1,500, which is a psychological barrier”. And proved, in the process, that their analysts are a bit useless. I mean – they should at least aim for a reasonable explanation of how this all suddenly happened when most of their “reasons” have already been floating around in the finance news for weeks. And as for “the price fell because the price fell below $1,500” story… OMG. Talk about tautology*.
  • Also, Central Banks are “the biggest losers” in the gold rush-out. I think that this may go without saying (they hold 19% of the world’s gold reserves). But I do have a new favourite quote from Guy Debelle, the assistant governor of the Reserve Bank of Australia: “If you think about the intrinsic value of gold, there’s not a lot. Gold often has a high price because people believe that other people believe that it’s worth a lot. When you describe other markets like that, the word ‘bubble’ gets thrown about”.
  • Sri Lanka has said that it might use this opportunity to increase its gold reserves. I just like that someone is seeing an (ironically) silver lining.
  • Tanzania is concerned that the falling gold price will cause gold mines to shut.¬†Frankly, I think that South Africa should also be concerned about that.

Right – back to Gold Futures.

The theory of how the Gold Future price is set…

Any finance book will tell you that the future price of gold is determined by the interaction of the spot gold price and interest rates (almost certainly: Libor). And if there is a discrepancy between the futures price and those two things, then some clever person out there will engage in an arbitrage** trade to restore the relationship.

Disclaimer: this may get technical. Here’s the argument:

  1. Let’s say that I have an ounce of gold in my pocket.
  2. The spot gold price today is $1000, and the interest rate is 10%. This implies that the 1 Year future gold price should be $1,100.20130417-095458.jpg
  3. Let’s say that, for some reason, the 1 year future price is actually $1,050.
  4. What would I do if I still just wanted to hold my ounce of gold in a year’s time?
  5. Well, I would immediately sell my ounce of gold for $1,000 and invest it in bank account earning 10% interest. I would also, immediately, buy a gold future (being the right to buy gold in a year’s time at $1,050).
  6. In a year’s time, I would have cash in my bank account of $1,100.
  7. I would use $1,050 to settle my gold future and buy back my ounce of gold.
  8. And I would have $50 in profit for having done nothing too exciting!

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So if such a situation occurred, people would start selling physical gold and buying up futures. Higher supplies of gold on the market would push the price of gold down. And the higher demand for futures would push the price of futures up. Also, the higher investments in the banks would drive down interest rates. Eventually, the equilibrium would be “restored” with a lower gold price, a lower interest rate and a higher futures price.

Which is really the point – if I choose to buy gold from you today, but I only want to collect it and pay you for it in a year’s time, then the only price difference should be interest. With,¬†maybe, some compensation for you having to store it.

The Problem with the Theory

I think that there is a fundamental issue here – the theory is dependent on the buyer of futures actually wanting to hold gold at some point. In today’s world, most traders just want “gold exposure” in their portfolios. This moves the whole futures market into strongly speculative areas – in much the same way that Credit-Default Swaps were just insurance until everyone started to use them to place bets on default.

As a case in point: this academic paper (The Golden Dilemma) that suggests that the fair value of gold is actually around $800, based on the historic relationship between the gold price and inflation. The current gold price, even after the collapse in the last week, is almost double that***. Doesn’t that imply a bubble?

Besides – George Soros has declared it to be a “bubble”.

It’s my own version of a tautologous argument.

*The “water is wet because it’s water” approach to argument. Commonly used by parents; generally accompanied by the catchphrase “because I said so”.

**Arbitrage refers to a situation where I can make money “for free” by simply structuring my position differently.

***I realise that you can find an academic paper saying almost anything that supports your point of view. But I’m ignoring that.