Bullish on bullion

Gold

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Amid the pessimistic start to the year, which saw faltering capital markets, further massive losses among investment banks and increasingly vocal predictions of a looming global recession, the gold market has emerged as one of the few beneficiaries of the gloomy financial outlook.

Bullion made headlines in January after hitting a series of record highs in the early part of the month. The active month gold futures contract for three-month delivery on the New York Commodities Exchange (Comex) closed at a record high of $932.80 an ounce on January 28, having traded at $668.90 on August 16, 2007. A weakening dollar, ongoing interest rate cuts by central banks globally, and concerns about falling yields on US Treasury bonds have all combined to thrust gold prices to unprecedented levels.

Beneath the headlines, however, a wholesale transformation in the way the gold market operates has been apparent for a number of years. Gold's steady appreciation since 2002, and the recent rapid price acceleration from August 2007, has presented significant challenges as well as opportunities for gold derivatives traders, as rising prices have rendered older and more established trading strategies obsolete.

Until the early part of this decade, when bullion hovered below $300 an ounce, the gold derivatives market was dominated by the gold carry trade. Typically, bullion banks would borrow gold from the reserves of central banks keen to earn interest to cover the cost of warehousing bullion. The gold forward (Gofo) rate at which central banks lent was very low, usually 1-2%, enabling bullion banks to sell the gold they had borrowed in the spot market then invest the proceeds in higher-yielding investments such as US Treasuries.

At the expiry of the contract, the bullion bank would buy back gold to repay the central bank and realise a small profit - as long as the price of gold held steady or decreased. Many bullion banks engaged in forward contracts with gold producers to minimise the risk of loss and guarantee a profit.

However, gold prices began to rise in late 2002, making the carry trade less attractive. Rising spot prices meant bullion banks were paying more for gold to repay the central bank at the end of the lease term, while falling interest rates meant they were able to get less return on their investments. In response, the 12-month Gofo rate was lowered to as little as 10 basis points, where it stayed until August last year, but to no avail. Simultaneously, gold producers began to unwind their hedge books as they sought to take advantage of appreciating gold directly through the spot market rather than committing to forward prices.

"The carry trade died because you need a stable market or one that is trending downward, so when you sell gold and invest the proceeds, you need bullion to be at the same price or less when you buy gold back. In a contango market, you're picking up money every time you do that, but only as long as the market is going down or sideways. If the market is going up faster than you're picking up your carry, then you're losing money," explains Brian Olson, head of metals trading at Barclays Capital in London.

Given the use of the carry trade by bullion banks and forward selling by producers depended largely on flat prices, it is hardly surprising both strategies all but died out as bullion's value climbed. "There was a period three or four years ago when the market activity in derivatives was quite low as we were seeing below-average volume investor flows and an absence of producer activity," says Ray Key, head of metals trading at Deutsche Bank in London.

However, the recent climb in prices has attracted hedge funds, pension funds and individuals, and has contributed to a sea change in the make-up of the gold market. In fact, some analysts suggest the entry of institutional investors into the commodity markets has contributed to the strong rise in gold prices.

In March 2007, the California Public Employee Retirement System announced its intent to move into commodities for the first time, following other large funds, including Ireland's National Pensions Reserve Fund and Dutch pension giant ABP. Meanwhile, a survey by Barclays Capital in December revealed that more than half of institutional investors questioned intend to have 10% of their assets held in commodities within the next three years, with commodities assets under management reaching $175 billion in 2007 - a $41 billion increase on the previous year.

"If you take just 1-2% of hard asset pension fund money earmarked for commodities and put that into gold, you can project much higher prices in the future than even where we are today," says Robert Gottlieb, head of precious metals at Bear Stearns in New York.

The variety of new participants entering the market has meant that gold derivatives traders have had to develop a wide range of new product offerings to meet clients' investment needs. One significant step has been the emergence of coupon-paying notes that offer exposure to gold, without investors actually trading the metal directly.

"The range of products investors are utilising goes all the way from plain vanilla spot trades to private customers seeking to deposit dollars with interest linked to the price of gold, to more sophisticated products including baskets of commodities and volatility-based variance swaps," says Florent Teboul, head of precious metals sales at Societe Generale in Paris.

The diversity of products now available is testament to the variety of participants entering the gold space. Barrier options, for instance, have been popular with hedge funds keen to leverage their exposure. More specifically, investors are buying options that knock out if the price of gold falls below a predetermined barrier, enabling them to express a view that gold prices will not decrease significantly in the short term, and by doing so, reduce the premium they have to pay for the option.

Metals traders report wide variation in the barriers used by investors. Short-term knock-out options with a time horizon of just a few months are being sold with barriers as little as $40 beneath the current spot price, while 12-month contracts are being traded with barriers as much as $150 to $200 below the fixing price.

Variance swaps on gold have also seen strong interest in recent months as investors seek to capitalise on gold market volatility. "Higher volatility has helped fuel the market. As funds buy calls, market-makers need to cover their delta by buying more gold as the price goes up, and in addition variance swaps have recently been issued to buy options on volatility," says Gottlieb

According to the World Gold Council, price volatility increased from 12.4% at the end of the third quarter of 2007 to 25.4% on December 4, before easing back to 18.8% by the year end. The Chicago Board of Trade (CBOT) put volatility even higher, at 32% on December 12.

"Variance products can be tailored and designed with a net volatility positive or negative structure. The market has come to grips with the higher price as volatility on an implied basis is lower than it was during gold's first spike through $600-700," says Olson.

Some participants argue the flood of new entrants into the gold market is the main driver behind the rise in prices and rampant volatility. "Larger institutions are moving in and out of the gold market, making their returns, closing their positions then re-entering. They are creating money-making opportunities for themselves since they're creating volatility in the spot market just by investing in these exotic options," says Teboul.

Despite this volatility, price spreads on gold futures and options on the CBOT and New York-based Comex have remained tight. "Those tight spreads allow you to see the capacity for arbitrageurs to spread those markets as efficiently as possible then arbitrage out any excess that might be in the bid/ask spread and bring it down to the minimal tick size. When markets get extremely volatile, spreads tend to widen but we're not seeing that now, which is a sign of both aggressive arbitrage activity to keep them in line and increased user numbers in the market place," says Bob Ray, group managing director at the Chicago Mercantile Exchange.

A glance at open interest volumes on Comex gold futures reveals that increased numbers of participants are entering the market. Open interest for futures and options in January 2007 stood at 351,381 and 305,051 contracts, respectively. By December, those figures had risen to 541,854 contracts for futures and 384,705 for options.

Trading volumes have also surged, with 3,837,099 gold futures contracts trading on Comex in November 2007 - an increase of 199% over November 2006. Growth in options was more modest, with a 50% increase in volume between November 2006 and 2007.

"I would still say we're seeing lots of activity around gold options but not quite as much as the futures, and I think that may be because options have not migrated to electronic trading with the same ease that futures have," says Ray.

Electronic commodities trading is now available at both the CBOT and Comex, allowing investors to trade quickly and efficiently. Ray contends that automation has allowed arbitrageurs to take on a more significant proportion of the volume and has played a large part in the increase in open interest growth and the tightening of gold spreads.

Despite the variety of products now in the market, the vehicle that has seen the sharpest growth and the largest investment volumes in the recent gold rally has been gold exchange-traded funds (GETFs). "GETFs have been tremendously popular as an instrument to express a view on gold because they have a broad audience, all the way from private individuals to portfolio managers. Whether they're the future of gold investment I'm not sure, but they are the most popular means of taking a view for the largest share of market participants," says Tim Wilson, head of metal derivatives at JP Morgan in London.

Overall gold assets under management in GETFs are estimated to be in the region of $20 billion, with around $18 billion lying in the hands of StreetTracks, the fund backed by the World Gold Council and brought to market by State Street in November 2004. Investors in the fund range from individuals with small holdings all the way up to financial giants such as investment firm BlackRock, which disclosed in a recent filing to the Securities and Exchange Commission that it has 9.2 million shares in the fund, worth $734 million.

As well as proving popular as a passive means of accessing the market, GETFs also play an important role in stabilising the market, say dealers. "They give tremendous support to the market since they allow the public to invest in gold and allow equity funds that aren't chartered to trade commodities to actually purchase gold," says Bear Stearns' Gottlieb. "If the gold price falls from $900 to $880, some funds that are long might not have deep enough pockets to hold their position and may look to sell. For GETFs, which hold denominations in tenths of ounces, however, a decrease from $90 to $88 will not necessitate public investors to sell, so the tolerance for pain provided by GETFs has delivered great rigidity to the gold market as a whole."

After the initial breach of the $900 mark gold in mid-January, gold prices have continued to march upwards. Interest rate cuts provided a strong stimulus in the market in the second half of 2007 and it seems likely that the Federal Reserve's surprise 75bp rate cut on January 22 and follow-up 50bp cut on January 30 will only spur prices ever higher. 2008 may turn out to be a vintage year for gold.

"It's very hard to say where or when the gold price will stop," says Olson. "Could it drop back to $800? Absolutely. Could it breach $1,000? Absolutely. At this point anything is possible."

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