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How do gold market derivatives work...?

by Sonia Singh for Commodity Online

A DERIVATIVE such as a future or option on the Price of Gold is a financial product whose value is derived from the value of one or more underlying variables or assets.

   It's set up as a contract between two parties, the buyer and the seller. The underlying asset can be equity, forex, commodity or indeed any other tradable asset.

Gold futures & options: Types of derivative contracts

Gold Forwards: A forward contract is an agreement between two parties to buy or sell the underlying asset at a future date at today's future price.

Gold Futures: Futures contracts, on the other hand, differ from forward contracts in the sense that they are standardized and exchange traded.

Gold Options: There are two types of options – call and put. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Put give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Gold Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts.

Gold futures & options: Who uses derivative contracts?

Gold Hedgers: These participants are in the position where they face risks associated with the price of the underlying asset, in this case gold. They use derivatives to reduce or eliminate risk. For example, a gold miner may sell forward a portion of his future gold output, to avoid the risk that gold prices will fall. A farmer may use futures or options to establish the price for his crop long before he harvests it.

Various factors affect the supply and demand for that crop, causing prices to rise and fall over the growing season. The farmer can watch prices discovered in trading at the commodity exchange and when they reflect the price he wants, sell futures contracts to assure him of a fixed price for his crop.

Hedging usually presupposes that the current "spot" market and the futures markets of any commodity move in the same direction and by almost the same magnitude. But this relationship depends on the storage costs till the maturity month of the futures contract. Normally when the stock of the commodity is abundant, the futures price will exceed the spot price by the cost of storage till the maturity month of the futures contract. This is called as "contango". The cost of storage declines toward the maturity month of the futures contract thereby resulting in convergence of futures price with the spot price.

This "contango" is always the situation in the Gold Market. But at times the futures price of other commodities may fall below the spot price, due to scarce stocks perhaps or when there seems to be uncertainty in deliveries. This is called as "backwardation".

Gold Speculators: Speculators wish to bet on the futures movement in the price of an asset. They use derivatives to get extra leverage. A speculator will buy and sell in anticipation of future price movements, but has no desire to actually own the physical commodity.

Arbitrageurs: These participants are in the business of taking advantage of a discrepancy between prices in two different markets. If, for example, they see the future prices of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. There is little chance for arbitrage in the Gold Market, as it is so closely watched and heavily traded.

Gold futures & options: The uses of derivative markets

Derivative markets perform a number of economic functions. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices.

Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market most usually witnesses higher trading volumes because more players join in who would not otherwise participate for lack of an arrangement to transfer risk.

In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets.

Derivatives markets also help increase savings and investment in the long run. The transfer of risk enables market participants to expand their volume of activity.

Gold futures & options: Benefits to derivatives traders

  • Hedging price risk
  • Spaced out purchases are possible, rather than large cash purchases and storage
  • Efficient price discovery prevents seasonal price volatility for farmers
  • Greater flexibility, certainty and transparency in procuring commodities would aid bank lending
  • Facilitate informed lending
  • Hedged positions of producers and processors would reduce the risk of default faced by banks
  • Commodity exchanges act as a distribution network for banking finance to reach rural agricultural households

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Adrian Ash runs the research desk at BullionVault, the physical gold and silver market for private investors online. Formerly head of editorial at London's top publisher of private-investment advice, he was City correspondent for The Daily Reckoning from 2003 to 2008, and is now a regular contributor to many leading analysis sites including Forbes and a regular guest on BBC national and international radio and television news. Adrian's views on the gold market have been sought by the Financial Times and Economist magazine in London; CNBC, Bloomberg and in New York; Germany's Der Stern and FT Deutschland; Italy's Il Sole 24 Ore, and many other respected finance publications.

See the full archive of Adrian Ash articles on GoldNews, or get more from Adrian Ash on Google+

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