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The Gold Market

Part 5

by J. Orlin Grabbe

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.

Gold FRAs

A gold forward rate agreement (FRA) is a contract whose payout depends on whether the market interest rate diverges from an agreed "contract rate". It is called a "forward rate" agreement, because the interest rate applies to a gold deposit or loan starting at some time period in the future. That is, the interest rate in question is the gold lease rate (also called gold libor). Recall that we used the gold "lease" rate as a generic term to refer to both the bid rate for taking in gold deposits and the offer rate for making gold loans. Recall also that the interest in this case is typically paid or received as so many ounces of gold. Similarly, a gold FRA will be typically settled with one party paying the other in gold.

A typical FRA contract in this regard might be a gold deposit that begins three months from today, and lasts for three months (ending six months from today). This would be called a 3 vs. 6 FRA. The terminology "3 vs. 6" implies the contract starts in 3 months and ends in 6 months.

What is agreed to is a contractual interest rate: the FRA rate. If the actual realized market rate turns out to differ from the FRA rate (as it almost inevitably will), then one makes or receives payment depending on the terms of the contract.

There are five principal parts to an FRA contract: the contract rate, the notional amount of gold in a contract, the fixing date when the market interest rate is compared to the contract rate, the start date of the deposit (or loan), and the maturity date of the deposit (loan).

One can buy or sell this contract. The settlement amount S paid to the buyer of the FRA from the seller is calculated as follows:

S = notional amount x (market rate - contract rate) x (days in period)/360.

If the market rate is below the contract rate, so that the sign on the amount S is negative, then the FRA buyer pays the FRA seller the absolute value of S.

The calculation above assumes that payment is made at the end of the FRA period (on the maturity date). But if (as is normally the case) payment is made on the start date instead, the settlement amount S given above is discounted by the market rate at which the contract was settled:

S/[1 + market rate x (days in period)/360].

Let's do an example.

Example: Consider a depositor who will have one ton (32,000 ounces) of gold available in 3 months, but will not be utilizing the gold for another 3 months after that. He wants to lock in the interest rate he will receive on his gold deposit now. He asks for a quote of the 3 vs. 6 months FRA, and receives the quotation:

3 vs. 6 FRA 1.50-1.80 %

This quotation means he can "sell" the FRA at a contract rate of 1.50 percent (.015), or "buy" the FRA at a contract rate of 1.80 percent.

So, in this case, he sells the FRA with a contract rate of 1.50, and a notional amount of 32,000 ounces of gold.

Three months from today, on the fixing date, he will determine the best market rate available, and this will be compared to the contract rate to determine the FRA settlement amount. (The fixing date will typically be two business days prior to the conceptual start date of the deposit or loan.) Suppose the best deposit rate at that time is 1.00 percent (.01). Suppose also that the three- month deposit period from start date to maturity date is 92 days. The settlement amount S is then calculated as:

S = 32,000 x (.01-.015) x (92/360) = - 40.889 oz.

The sign here is negative, which means the FRA buyer pays the FRA seller (our hypothetical depositor) 40.889 oz. of gold on the maturity date (if payment is made then). If payment is made on the start date, it is discounted by the time period of the deposit:

40.889/[1+.01 x (92/360)] = 40.785 oz.

So in this event the FRA buyer pays the FRA seller 40.785 oz. of gold on the start date.

Now if the depositor deposits his ton of gold at the market rate of 1.00 percent for three months, he will end up with an equivalent interest rate of 1.50 percent, the FRA rate, because the difference has been paid out on the FRA contract.

The same would have been true if the depositor had lost, rather than gained, from the FRA contract. For in that case the market rate paid on deposits would be higher than 1.50 percent, but the depositor would lose the difference on the FRA contract.

Similar examples could be done for gold borrowers. Gold borrowers typically borrow at the gold lease (gold libor) rate plus a margin: say

market rate + .75%

and make periodic gold interest payments at intervals of 6 months. By using FRAs for 6 month intervals (such as 6 vs. 12, 12 vs. 18, 18 vs. 24, etc.), the next few interest payments on this loan can be locked in as

FRA rate + .75%

if that seems desirable.

Gold Interest Rate Swaps

It is important not to get the word "swap" as used here confused with "swap" in the gold forward market. There the term referred to the relationship between spot and forward prices. Here, in "interest rate swap," we are referring to a trade of a fixed interest rate for a floating interest rate.

The swap "buyer" in an interest rate swap agrees to pay a fixed interest rate to another party, and in return receives at periodic intervals an interest rate that fluctuates (floats) with the market. That is, the buyer pays a fixed gold rate and receives the market- determined gold lease rate (or some equivalent).

The other side of the interest rate swap contract is the seller who receives fixed and pays floating.

If, for example, the floating rate is the 3-month gold lease rate, then every 3 months there will be a net interest payment whenever the market lease rate diverges from the fixed rate. If the market rate is above the fixed rate, then the swap buyer (who pays fixed) will receive an interest payment representing the positive net difference of floating minus fixed. If the market rate is below the fixed rate, then the swap seller (who receives fixed) will receive an interest payment representing the positive net difference of fixed minus floating.

In essence, then, a gold interest rate swap is just a series of gold FRAs. If the floating rate in the market is above the fixed rate, the swap buyer (who pays fixed) is in the same positon as the buyer of an FRA. If we equate the "fixed rate" with the "contract rate" in an FRA, then the FRA buyer receives a positive cash flow if the market rate is above the fixed rate.

So buying a gold interest rate swap represents the purchase of a series of gold FRAs at a single contract rate (fixed rate), while selling a gold interest rate swap represents the sale of a series of gold FRAs at a single contract rate (fixed rate).

Why would someone want to do this? Let's consider an example.

Example: Consolidated Gold Nuggets has an existing loan of 1 million ozs. of gold with two years remaining to maturity. It pays floating interest at the 3-month gold lease rate plus a margin of 1.75 percent. However, gold lease rates have fallen, and the treasurer wishes to lock in a low fixed rate. Renegotiating the loan will involve contractual penalties. The treasurer shops the market and determines she can buy a two- year gold interest rate swap, paying 2 percent fixed against the floating 3-month gold lease rate flat. She does the swap.

Her swap payments are

2% - 3-month gold lease.

Her loan payments are

3-month gold lease + 1.75%.

The net interest payment is the sum of these:

2% + 1.75% = 3.75% .

So by doing the gold interest rate swap, she has turned the floating rate loan into a fixed rate loan of 3.75 percent.

Gold Interest Rate Guarantees

Gold IRGs are a form of insurance. Typically they take the form of a floating rate, with a guaranteed maximum or minimum. The gold borrower might prefer to borrow floating, and hence have the ability to profit from falling interest rates, but nevertheless want a guarantee that the floating rate paid will not rise above some maximum or ceiling level.

In a similar vein, a gold lender might prefer to lend at floating rates, in order to profit from rising interest rates, but desire a guarantee that the rate received will not fall below some minimum or floor level.

These types of guarantee contracts are analytically equivalent to interest rate options. Hence we will defer their discussion until we have discussed options in general in the context of options on the gold price.

(to be continued)

This article appeared in Laissez Faire City Times, Vol 2, No 22.
Web Page: http://www.aci.net/kalliste/