Gold lease market participants Here entails the roles and responsibilities of the participants in the gold lease market as indicates in the flow chart.
Central banks
- Lease gold to earn interests (in terms of physical gold or money) and to reduce cost of holding gold
- Conservative manner in lending gold due to unregulated gold lease market. In order to manage counterparty risk, central banks are normally only willing to lease in short term maturity (e.g. 3 to 6 months) and to high credit rating gold dealers
Gold dealers
- To provide credit intermediation
- To provide maturity transformation (transform short term gold lease from lender into longer term gold lease to borrower)
- Finance / cover gold positions and hedge derivative positions
Gold miners
- Borrow gold from gold dealers and sell to market to raise funding
– to finance operations for gold mine development
– to deposits cash in USD to earn arbitrage interests if LIBOR > gold lease rate - Sell gold ores to gold refiners and repay back the gold loan with interests to gold dealers
- Hedge gold price by selling forward
Gold refiners
- Borrow gold from gold dealers and sell to market to raise funding
– to finance operations for refinery
– to pay gold miners for gold purchase - Refine gold ores, sell gold to market and repay back the gold loan with interests to gold dealers
Financial institutions
- Receive USD cash deposits from borrowers and repay back principals and interests to borrowers
Gold lease rate
- Lease rate for gold lending from central banks to borrowers
- Volatile, fluctuate 50-100 bp for 1-3 months maturities and increase sharply beyond short maturities (due to inelastic properties)
- Gold supply for lending by central banks is inelastic owing to gold reserve limitation and central bank gold lending conservatism
- the gold lease rate is normally maintained at very low level within 0.1%pa to 0.5%pa. Thus, there should be substantial arbitrage activity. Per information, 1,000,000 ounces gold lending with maturity range to 10 years is feasible to transact, although normally maturity is range for few months to half year
LIBOR
- Borrowers sell gold borrowed from gold dealers in market and deposit it in USD to earn LIBOR interest
Gold lease rate, LIBOR, gold forward/future price
The following equation entails the gold forward/future pricing model tight with the gold spot price, gold leasing rate, LIBOR and lending period.
F0 = S0 *e (r –q) T - r = continuously compounded risk free annual rate (LIBOR)
- q = continuously compounded paid per annum (gold lease rate)
- T = time to maturity (years)
- S0 = current underlying asset price (t=0)
- F0 = current forward price
Therefore, higher LIBOR and lower gold lease rate make gold forward/future price upswing.
It is normally in contango gold forward/future price curve in normal conditions when LIBOR > gold lease rates. It is only under special conditions that it become backwardation gold forward/future price curve when LIBOR <>
The following illustrates the driving factors relationships based on the above gold pricing model and underlying gold lending transaction activities. Gold spot price driven
Gold spot price driven
If gold spot price is in increasing trend, borrowers will decrease gold borrowing as selling the borrowed gold into the market at spot price will lock the selling price and profits. The decreasing borrowing will decrease the gold lease rate and it will widen the LIBOR – gold lease rate spread if LIBOR remains stable. It will steepen the gold forward / future price contango curve LIBOR driven
LIBOR driven
If LIBOR increase with gold lease rate remains stable, the spread becomes widen. It will steepen the gold forward / future price contango curve immediately, and increase the arbitrage activities for selling gold and makes USD deposits (assume the deposits have limited effect on LIBOR), it will decrease the gold spot price (assumed demand remains stable), and increase the gold lease rate later Gold lease rate driven．
Gold lease rate driven
If gold lease rate increase and LIBOR remains stable, borrowers (miners and refiners) will speed up gold production processes to reduce interest expenses in gold borrowing, increase gold supply in future, and make decreasing pressure for gold futures / forwards price and flatten the gold forward / future price contango curve.
If gold lease rate increase and LIBOR remains stable, the spread becomes narrow, and decrease the arbitrage activities for selling gold and makes USD deposits. It will increase the gold spot price (assumed demand remains stable).
Such pricing model is intrinsic and the spot and forward/future prices are highly influenced by the market spectacular cash flow and central bank manipulations. Therefore, the pricing is for reference only. However, such selling of gold by borrowers does increase the market pricing efficiency by enabling short positions of gold
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