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Invest in Gold

Posted by Sathyamurthy www.sathyamurthy.com on December 24, 2008

I strongly consider Gold to be an excellent investment opportunity for the coming years. And my conviction has increased even more after reading Mr. Ajit Dayal at http://www.equitymaster.com/ . He has given the rationale on why Gold should move up.

I subscribe to his views. Besides the various statistics and points put forth by Mr. Ajit Dayal, my reason for “investing” in gold are below: (Mind you, I am saying “investing” and not buying the metal for your wife! – that is illiquid and usually make you to make a “spirited” run to the liquids of largely golden color 🙂 )

1. Its a scarce commodity

2. Two of the world’s most populous nations (China & India) and the women in the monied Arab world have enormous love for the yellow metal

3. It has not revalued itself for the inflationary effects – the price is almost inflation neutral for the past 27 years.

4. A scarce commodity with so much demand, must pick up speed in the price

5. If you are someone dealing in Indian Markets, the most important reason to buy Gold will be that neither the right parties nor the left parties can do anything about a gold price increase!

I suggest that one takes a serious look at the Gold Exchange Traded Funds and invest in Gold. Some of the listed funds are – Reliance Gold Fund, Benchmark Gold Fund, Quantum Gold Fund etc.

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All about Gold

Posted by Sathyamurthy www.sathyamurthy.com on June 20, 2007

Introduction

Gold is regarded auspicious; Gold is treated as wealth; Gold often represents social status in Indian society. India is traditional market for gold from the ancient times.

India is the largest consumer of gold in the world. Enactment of Gold Control Act in 1962 foreboded gold trade in any form, which continued for almost 30 years. Liberalization in 1991 saw efforts to slowly revive the gold market in the country, in sync with the other sectors of economy. Thus, since 1991, demand for gold has been increasingly met by official imports. The results are obvious in the form of reduced smuggling, unofficial premiums and enhanced government revenue, by way of customs and sales tariffs. The increasing gold trade deserved an efficient bullion exchange in India, for which there was a need to develop an efficient spot and forwards market, sufficient liquidity, regular, safe and cheap supply system with good delivery standards are some of the prerequisites for smooth functioning of a bullion exchange. Thus, trading on gold as a commodity started in 2003 with the set up of national level commodity exchanges in India. Presently gold in different form is traded widely on National Commodity and Derivatives Exchange Ltd. (NCDEX) and Multi Commodity Exchange of India (MCX) in India.

Gold is treated as an alternative for the paper currency worldwide. Agreement between European central banks, IMF’s action, recent announcement by the major economies of the world to increase their gold reserves etc. signifies the importance of the yellow metal in the world economic environment.

Why to invest in Gold:

Gold responds when you need it most

Recent independent studies have revealed that traditional diversifiers often fall during times of market stress or instability. On these occasions, most asset classes (including traditional diversifiers such as bonds and alternative assets) all move together in the same direction. There is no “cushioning” effect of a diversified portfolio – leaving investors disappointed. However, a small allocation of gold has been proven to significantly improve the consistency of portfolio performance, during both stable and unstable financial periods. Greater consistency of performance leads to a desirable outcome – an investor whose expectations are met.

Gold is highly liquid

Gold can be readily bought or sold 24 hours a day, in large denominations and at narrow spreads. This cannot be said of most other investments, including stocks of the world’s largest corporations. Gold proved to be the most effective means of raising cash during the 1987 stock market crash, and again during the 1997/98 Asian debt crisis. So holding a portion of portfolio in gold can be invaluable in moments when cash is essential, whether for margin calls or other needs.

Important features of gold:

1.      Internationally gold is considered as a ‘safe heaven investment’.

2.      Gold is used as hedge against inflation.

3.      Gold is traded as currency

Old myth and present scenario:

Relationship with the dollar and euro: Over a long period of time gold followed a strong negative correlation with the US currency and subsequently set a strong positive correlation with the euro. But analysis shows that the ratio between USD and Euro remains near 1.2 (+/- 5%). In recent time we have seen that gold-USD ratio has been weakening. Then what are the factors that are driving gold?

In fact these factors themselves tell us why gold is a very attractive investment option.

1.      Surging crude oil prices: the growing population and economy worldwide is indicating more and more use of crude oil in the coming days, which in turn is pointing towards the risk of increasing inflation. And gold is widely used as the hedge against the inflation.

2.      Geo-political tensions: Recent Iran and Nigeria issues taught us the effects of these. The conflicts between the major powers in the world over several issues viz. nuclear experiments, trade negotiations, geographical areas are not going to end. And gold is treated as the safe heaven investment.

3.      Gold reserve: major economies like China and Russia have been increasing their gold-forex reserve ratio. In fact a recent report shows that Russia’s gold reserve increased to $212 in early April than that in March.

4.      Supply demand mismatch: it is reported that the supply of gold is decreasing worldwide while, demand is growing to around 5000 tonnes. Investment demand in tonnage term rose to 26% in 2005. Jwellery demand also rose 14% in dollar terms in 2005 despite volatile prices. Latest figures show that even at higher prices India’s gold import rose to 730 tones.

5.      New investor: in India a new class of gold Investor is appearing and growing in importance, the gold Investor, buying gold not only because of Hindu tradition and trust in gold for financial security, but a buyer of gold because seeing it as a good long-term investment. This is bringing a new thinking to the Indian gold market. Driven by gold along and its cousin silver one of the commodity exchanges in India saw a total turnover of more than Rs 33000 crore within two days.

6.      Gold ETF: the Exchange Traded Funds (ETFs) are adding more glitter to gold and silver. Presently worldwide seven gold ETFs are running. These ETFs are attracting new investors into the market and these investors are not merely buying gold because of they want to but because of the dwindling world economy. World Gold Council (WGC) Sponsored gold ETFs accumulated 429 tonnes of gold within two years. Barclay’s ETF has an additional 32 tonnes of gold.

7.      Price: One interesting fact the investors should note that while the nominal all-time high for gold is $850, the inflation-adjusted all-time high is closer to $2,150. Comparing today’s price with that of 1980 fails to take into account the rise in inflation over the last 25 years.

8.      US interest rate: the FOMC has been increasing the interest rate gradually by 25 basis points since about last two years to protect its currency i.e. USD. However, in its last meeting the FOMC indicated that there might be a stop at 5%, one more increase from its present level of 4.75%. This is quite supportive for gold in the days to come. It is to be mentioned that the EURO zone interest rate is 2% and Japan’s interest rate is kept at zero and gold has good correlations with both euro and yen.

9.      Gold as an asset class itself provides good return on Investments. For example, in the year 2004, Gold prices rose almost 13%, which is much higher than investments like Fixed Deposits. Even in this year, so far gold prices rose nearly 20%.

10. In many of the countries gold has outperformed the equities.

The above points clearly justify gold as a good investment option in the coming days over many of the commodities as well as equities.

Indian Gold Market

India was the worlds’ largest gold market with Mumbai as the main trading center prior to 1962. The government enacted the Gold Control Act in 1962 prohibiting the citizens of India from holding pure gold bars and coins due to loss of gold reserves during the Indo-China war in 1962. Only licensed dealers were allowed to deal in pure gold bars and coins. It was this legislation, which killed the official gold market and a large unofficial market for gold sprung up dealing in cash only. The gold was smuggled in and sold through the unofficial channel wherein many jewelers and bullion traders traded in smuggled gold leading to the development of huge black market for gold. Gold was smuggled into India in the size of 10-tola bars (called a TT bar in trade parlance). The traditional Indian measure for gold is “tola“; a name derived from the Sanskrit word “tula” for scale or balance. One tola is equal to 11.664 grams..

Hence a 10-tola bar weighs 116.64 grams. The important feature of this 10-tola bar is that they don’t have serial number, unlike almost all other cast bars available on the international market. This made ten-tola bar the gold currency of choice, especially from 1947-1992 when India strictly regulated gold imports, giving rise to a massive black market.

During 50’s and 80’s, the government had a controlled economy wherein all the factors of production and resources were controlled and licensed. This led to the corruption and shortages resulting in profiteering by the businesses. It was in 1990 when India had a major foreign exchange problem; the Indian government pledged 40 tons of gold from their gold reserves with the Bank of England to save the day. Subsequently India embarked upon the path of economic liberalization.

India surpassed Italy and became officially the largest gold jewellery producer in the world in 2006 due to competitive production costs, better access to global markets due to lower customs tariffs, good product quality and a huge internal market, which they say is not accessible to Italian/European goods due to high tariffs and due to administrative barriers.

According to data from the precious metal consultancy, GFMS Ltd, India with gold jewellery production of 539 tonne in 2005 was numero uno followed by Italy with 228 tonne. Third spot went to China with 198 tonne and Turkey was fourth with 197 tonne. If scrap gold is included, India again emerged as No 1.

Current Scenario

Size of the Gold Economy: more than Rs. 30,000 crores

Number of gold jewelry manufacturing units: 1,00,000

Number of people employed: 5,00,000

Gems & Jewellery constitute 25% of India’s exports about 10% of our import bill constitute gold import.

Number of banks allowed to import gold: 17 (RBI is likely to give permission to more entities)

Official estimates of the stock of gold in India: 9,000 tons

Unofficial estimates of the stock of gold in India: 12,000 – 14,000 tons

Gold held by the Reserve Bank of India: 357.5 tons

Gold production in India: 2 tons per annum.

SUPPLY AND DEMAND DYNAMICS

Demand For Gold

India is the largest consumer of gold in the world. The recent figures of World Gold Council exhibit that Indian demand for gold in 2005 was 17% higher to in tonnage terms accounting for 723.7 tonnes than the year before. In rupee terms, this was equivalent to a 25% increase bringing the value of gold demand in India to a second successive annual record. Jewellery demand also experienced a second successive annual record of over 20% in rupee terms over 2004. This translated to an increase of 14% in tonnage terms, accounting for 589 tonnes. Net retail investment was less affected by the upward price movement and set a new annual record in tonnage terms, with a massive 34% increase over 2004. This is sure to surprise many when India is considered a very poor country with one of the lowest per capita incomes in the world. However, Evidenced by a consumer survey carried out for the World Gold Council at the end of 2005, the underlying strength of Indian gold demand remains robust and is underpinned by a strong economy and favourable demographics in gold’s key target markets. With more than 300 million people in the middle class category, the branded jewellery retailers have a huge market to satisfy. According to McKinsey, the celebrated market research organization, the branded jewellery market is growing at the compounded annual growth rate of 40 percent, and is estimated to go beyond two billion dollars by 2010. This may appear as huge, but it is still nothing compared to the overall size of the Indian jewellery market.

Source: World gold Council (WGC)

Rural India

India has the highest demand for gold in the world and more than 90% of this gold is acquired in the form of jewellery. The demand for jewelry mainly comes from rural sector; about 65-70% of the gold purchases are from rural India, which live upon agriculture for their livelihood. Since agriculture is highly dependent on the rains, the rural disposable income depends upon weather, hence a good year for agriculture assures higher demand for gold. The bulk of the Indian jewellery buying is still rooted in tradition and jewellery is sold in traditional designs.

The main reason for such high rural demand for gold is non-taxation of agricultural income. If the agricultural income were taxed, the disposal income would substantially reduce resulting in lower gold demand. In the rural areas, the womenfolk especially have a low level of education. Hence the middle-aged rural Male invests more of their savings in gold so that womenfolk can encash their wealth without any legal hassles. In south India, consumers prefer new designs with the change in fashion trends, hence they sell off their jewelry when they become out of fashion in exchange for new jewelry. In north India, new purchases are done only when the ornaments are broken and in some extreme cases. About 95% of purchases are done by women .The demand for gold in north India increases during festivals (mainly Diwali) and marriage season. The months from October to January, April and May constitute the main marriage season and also have a large number of festivals. Hence demand for gold is very strong during these months.

In south India demand is more or less uniform throughout the year as salaried people form the major chunk of purchasers who invest their savings regularly in gold purchases. The figures of the past few years show that Indian demand for gold has consistently been hovering around 25% of total world demand.

Urban India

Exposure to western influences and the media have spawned a consumerist culture. The entry of modern gadgetry like laptops, cellphones and white goods have grabbed away a part of the urban Indian’s disposable income. The lure of spending on these modern gadgets has taken precedence over the older virtue of saving. Adding to it, the urban Indian has been exposed to alternate forms of savings like equities and bonds via mutual funds, which have diminished their desire for gold. In effect, dampening the urban demand for gold. The passion for gold between the urban and the rural Indian has widened.

Demand For Investment

Private Holding of Gold bars in India were forbidden until 1990 due to Gold Control Act. There was physical investment in smuggled ten tola bars, but it was limited and often amounted to keeping a few bars ready to be made into jewellery. Gold investment essentially was in 22-carat jewellery.

Since 1990 (after Gold control Act was abolished), investment in small bars, both imported ten tolas and locally made small bars, which have proliferated from local refineries, has increased substantially. GFMS estimate that investment has exceeded 100 tons (3.2 million-oz) in some years, although it is hard to segregate true investment from stocks held by the 16,000 or more gold dealers spread across India. Certainly gold has been used to conceal wealth, especially during the mid-1990s, when the local rupee price increased steadily. It was also augmented in 1998 when over 40 tons (1.3 million-oz) of gold from bonds originally issued by the RBI were restituted to the public.

In the rural areas 22-carat jewellery remains the basic investment, while in the cities, gold is competing with the stock market, investment in Internet industries, and a wide range of consumer goods.

Factors Influencing Demand for Gold

Following are the factors influencing the demand for gold.

· The increase in the irrigation, technological change in agriculture (through mechanization and high yielding varieties), have generated large marketable surplus and a highly skewed rural income distribution is another factors contributing to additional demand for gold.

· Black money originating in the services sector, like real estate and public sector, has contributed to gold as store of value. Hence income generated in these service sectors can be treated as a determining variable

· Since bank deposits, Mutual funds, small savings, etc are alternative avenues for investing savings, the weighted return on these alternative assets can be considered as another influencing factors.

· Demand for gold also depends upon prices of other commodities. When there is an increase in general price level, it has two effects: first it reduces the purchasing power available for acquisition of jewellery and secondly, it reduces the real return on gold. It has depressing effect on the component of demand in both ways.

Inflation redistributes incomes in favour of non-wage income earners, leading to more skewed income distribution. With incremental income of non-wage earners, the demand for gold as a store of value can be expected to rise.

Supply of Gold

The main economic effects that arise from the changes in the supply of gold can be seen against the quantum of gold that is already in existence in the economy. During the forties the net import of gold was about 311 tons. The stock of gold in India at the end of 40’s was about 2,300 tons.

Unofficial imports of Gold flourished after the ban on import of gold. Illegal imports continued to take place at growing rates thereafter. On an average it worked out at 107.4 tons per annum during 1980’s and 1990’s as a result the stock of gold accumulated and stood at as much as 7,214 tons at the end of 1991.If the gold stock of Reserve Bank Of India is also included, the total gold stock in the country was about 7656 tons at the end of 1991.

The gold market also benefited because the government abolished the 1962 Gold Control Act in 1992 and liberalized gold import into India on payment of a duty of Rs 250 per 10 grams (presently Rs 100 per 10 grams). The government thought it more prudent to allow free imports and earn the taxes rather than to lose it all to unofficial trade -surprisingly a very pragmatic view. This expanded the gold market while reducing the quantum of trade and the profit margins in the unofficial channel. Figures of World Gold Council exhibit that, India officially imported more than 110 tons in 1992 with practically nothing in 1991, whereas smuggled gold maintained at about 160 tons in 1992 and gradually declined thereafter. The official imports gradually grew from the year 1992 with the official imports peaking at 663 tons at the end of the decade. During 2005 the import went up to a record level of 730 tonnes despite high prices. Import of gold and silver, which account for a share of 7.86 per cent in total imports, registered a tepid growth of 0.35 per cent during 2005-06 at $11,189.44 million ($11,149.99 million). According to the Gems and Jewellery Export Promotion Council (GJEPC), imports of gems and jewellery stood at US $ 13.0 billion during 2005-06, posting a growth of 11.8 per cent.

Sources of Supply

The supply of Gold in India arises mainly from domestic production, legal and illegal imports. Scrap gold, which is not an additional supply, supports the market requirements.

Domestic production

The main producers of Gold are Hutti Gold Mines and Bharat Gold mines Limited, which annually produce about two tons. This has been the case from the past two decades. There are no known gold reserves in India worth mentioning.

Hutti Gold Mines limited (HGML)

Hutti Gold Mines (Formerly Hyderabad Gold Mines Company) was founded in 1947, and contributed to more than 50 per cent of the total gold mined in India. Production of gold was around 1057.48-kg in1991-92 and increased to 1,847 kg during 2001.production estimate for 2002-03 was about 3,500 kg. The proved and probable reserves of ore at Hutti are 31.02 million tons, and the total gold reserves are estimated at 150.41 tons.

Bharat gold mines limited (BGML)

Bharat Gold Mines Limited (Kolar Gold Mines) is Government of India Enterprise under the administrative control of Department of Mines was incorporated in March 1972 as Public Sector Company to own and manage the Gold Mines with effect form 01.4.72. The Company is engaged over eleven decades in gold mining, mine construction and contract works manufacture and erection of mining machinery and equipment. Gold production was about 106 Kgs in 1991’s and came to nil in recent years. BGML have become uneconomic due to exhaustion of high-grade ore reserves. The Government approved closure of the company with effect from March 1, 2001. However, presently the government is thinking to float global tender to revive it. The mine, one of the deepest in the world, is having underground mining for 10,000 feet below the surface, was closed in 2001 due to mounting losses. More than 3,000 employees of mines were not paid since its closure.

Recycling of scrap gold arise from melting down of the old jewellery. Such molten is often bought back to correct cartage by adding to it small amount of new gold so that it could be fabricated again.

Imports

Domestic production being minuscule (Gold mine in Kolar and Hatti), practically the entire demand is met by imports and recycling of previously accumulated stock and scrap generated from it. The country has been long been importing substantial amounts of gold between 1831 and 1931, imports averaged 37 tons per annum. The 1930’s, the period of the great depression-were marked by an exceptionally large outflows of gold averaging around 140 tons a year. This tendency was reversed in the following decade, when there was a net import of gold of around 31 tons per annum. Thereafter despite the imposition of ban on gold imports in 1947, net imports (practically all of it illegally smuggled) increased progressively to 80-90 tons per annum during 1950’s and close to 150 tons per annum during 60’s and early 70’s. After the sharp decline in the 1970’s gold imports again surged in the 1980’s and following the lifting of the ban and permitting of imports in 1992, the rate of imports increased sharply in 1990’s.

There was a big spurt in the consumption following the Liberalization of gold imports in 1992. Consumption seems to remain around 400-425 tons in the next couple of years. Before resuming the rising trend, estimated consumption was more than trice the level recorded in 1990 and nearly 70% higher than in 1992.

Till 1991 practically all these imports were obtained by smuggling. But with Liberalization, the share of smuggled gold has progressively declined both in absolute terms (from an estimated 290 tons in 1994 to 94 tons in 1998), and even more so in relation to total consumption (from over 70 percent in 1990 to less than an 80 in 1998). This declined is the direct result of progressive realization of gold imports (subject to payment of 15% duty) and a considerable narrowing in the margin between international and domestic price of gold. This margin in 1998 was close to the import duty on gold. Note however that the volume of smuggling (90-100 tons a year) remains quite large. A smuggler who successfully escapes the customs net stills stands to make substantial profits.

A major step in the development of gold markets in India was the authorization in July 1997 by the RBI to commercial banks to import gold for sale or loan to jewelers and exporters. Initially, seven banks were selected for this purpose on the basis of certain specified criteria like minimum capital adequacy, profitability, risk management expertise, previous experience in this area, etc. At present, 17 banks and institutions are active in the import of gold –

  • MMTC Ltd
  • Handicraft And Handloom Export Corporation
  • State Trading Corporation Of India
  • The State Bank Of India
  • Allahabad Bank
  • Bank Of India
  • Canara Bank
  • Indian Overseas Bank
  • Bank Of Nova Scotia
  • HSBC
  • Abn-Amro Bank
  • Standard Chartered Bank
  • Corporation Bank and
  • Dena Bank.
  • ICICI Bank

The quantum of gold imported through these banks has been in the range of 500 tons per year.

World demand for gold was about 3200 tons in 2002. Corresponding to that in India was about 842 tons with imports occupying major chunk of 650 tons, domestic production 2 tons and remaining being recycled gold.

Total bullion import in India

Particulars

2000

2001

2002

2003

2004

Open General License

532

599

411

425

582

NRI

3

2

2

2

-**
Special Import License

4

1

Import for Re-Export

50

52

62

64

65

Govt. Sub total

589

654

475

491

647

Non government

115

55

29

5

0

Total

704

709

504

496

647

Source: GFMS

Channels for Import of Gold

Gold enters India via. a number of different routes. The trade routes are complex but can be classified into two broad categories – Direct flow (official) and Indirect flow (unofficial flows).

Direct flows include shipments, which mainly come from the refining centers of Europe, South Africa and Australia. Imports through direct flows are done in three ways:

1. Special import licenses

2. Non-resident Indians

3. Authorized banks and institutions.

Import of gold through Special Import License (SIL) and NRI route has been negligible after gold import through banks was permitted. The liberalized gold policy has brought most of the unofficial sector trade to official sector. The elimination of large unofficial market in forex has improved the policy effectiveness. It may also be noted that the Indian consumer of gold has been spared of huge transaction costs amounting to thousands of crores of rupees on account of the existence of the unofficial sector in the past.

Indirect flows

(unofficial) occurs place through two entry ports of Singapore, Sri Lanka and Dubai in the first instance.

The following are few of the factors that influence gold supply.

· Supply of gold follows the demand for gold hence the demand for gold is one of the important variables determining supply for gold.

· The differentials between domestic and international prices for gold acts as inducement for smuggling with the objective of earning large rupee income, thus this can be treated as one of the important factor influencing supply of gold.

Smuggling is operationally feasible only if the FOREX can be obtained outside the legal FOREX market which hawala market provides, thus hawala premium can be considered another factor influencing supply of gold.

RBI and Its Gold Policy Measures

The Reserve Bank of India (RBI) holds 357.75 tons of gold forming about 6 per cent of the current value of its total foreign exchange reserves. The evolution of the gold related policy since independence was centered around some major objectives, viz., weaning away people from gold, regulating the supply of gold, reducing the domestic demand and prices and curbing smuggling.

In the wake of the Chinese war, it was felt in some circles that it would be feasible to make a frontal attack on demand for gold in India. Accordingly, the Gold Control Order 1962 was issued, banning the making and selling of jewellery above 14 carats, making it compulsory for gold smiths to be licensed and submit accounts of all gold received and utilized by them etc., The measures met with lot of resistance and criticism. This coupled with complexities resulted in the failure of the Gold Control order.

Bullion imports and exports were also banned but restrictions on import of gold into the country resulted in the flourishing of smuggling and unofficial transactions in foreign exchange.

Official imports to discourage smuggling was first mooted in 1977 but viewed against the forex reserves available then, it was thought as an impossible proposition. The Government decided to sell confiscated gold in small quantities through the RBI. However, it did not have any major impact on smuggling.

Gold Mobilisation Schemes

The Government and RBI took several initiatives to tap the hoard of private gold in India by permitting commercial banks to take gold deposits of bars, coins or jewellery against payment of interest.

· The 15-year Gold Bonds at 6.5 percent introduced in November 1962 could mobilize only 16.70 tons of gold.

· A second attempt to garner gold was made through the 7 percent Gold Bond 1980 Scheme in March 1965, which could mobilise only 6.1 tons.

· The third attempt with National Defense Gold Bonds 1980 (1965) garnered 13.7 tons and the Gold Bond Scheme 1993 garnered 41 tons of gold.

· Gold Deposit Scheme launched in 1997 could mobilise only 7 tons of gold after two tears of its launch

· The government announced a new initiative in its 1999/2000 budget to tap the hoard of private gold in India by permitting commercial banks to take gold deposits of bars, coins or jewellery against payment of interest. Each bank can set their own interest levels with deposits period ranging in between three to seven years. Interest and any capital gains on the gold will be exempt from tax. The banks can lend the gold to local fabricators or sell it in the Indian market or to local banks. However, the depositor has to declare the origin of the gold, so that metal bought illegally to hide wealth cannot be deposited. The State Bank of India was the first to accept deposits. To date, the amount of gold collected under this scheme was 10 tons.

Unfortunately, the scheme has not evoked the expected response. A number of reasons can be cited for the low response, prominent among them being.

· Depositors’ losing the making charges spent on jewellery (as the banks would convert them into primary form before accepting as deposits) The low cartage of jewellery

· Low rate of return on deposit (as seen by the depositors)

· The low cartage of jewellery

The regulatory steps in the 1990s and the impact on Gold trade

The chart below, shows off take per thousand dollars of Indian GDP, and also the major steps taken by the Indian government over the course of the 1990s

Source: World Gold Council

Economic Implications of Gold Imports

Gold by it self does not add much to production or productive capacity. However the foreign exchange used for importing it in effect reduces the availability of this resource for other imports (including raw materials, intermediates and capital equipment) needed for current production and to expand productive capacity. In the Indian context, the magnitude of FOREX expended on gold imports has been large and growing in 1970, India’s imports at the prices prevailing in the world market at that time, would have cost $ 2.2 billion, equivalent to about one eighth of merchandise exports and 8 percent of merchandise imports and the corresponding figures for 1997 was $ 7.5 billion. (Equivalent to about one fifth of exports and one sixth of imports).

Prior to 1992, gold imports being illegal were financed by the proceeds of under invoicing of the exports, over invoicing of imports, earning of migrant workers remitted through hawala channels and smuggling of silver and contra brand drugs. These transactions did not figure at all in the country’s trade or payment statistics. After 1992, the value of legal gold imports cleared through the customs are included as part of merchandise imports in the balance of payments data (but not in the trade statistics) an equivalent amount being recorded as transfer receipts under invisible. The nature and sources of the latter are not indicated for lack of information. Clearly they, as well as the resources needed for the still substantial smuggled gold, must have been derived from one or the other of the extra legal sources cited earlier. Possibly their relative importance has changed in effect the hawala market continues to operate but with indirect legal sanction given by the gold import policy.

The magnitudes involved are large in relation to the size of the country’s foreign trade and payments: The gold stock of the country at the end of 2000 was close to 14,000 tons valued at current price at $ 165 billion. Their continued rapid growth can have significant consequences in the terms of scale and functioning of the hawala market, the availability of FOREX for other purposes and the health of the balance of payment.

The other characteristics of gold are that it is a highly liquid store of value. It represents command over both at home and at abroad which can in principle be invoked whenever necessary. Its physical depreciation is negligible and it can be readily converted in to cash by sale in the world market by acquiring other resources both at domestic and international market. Though it does not earn any interest and though it is no longer used as the standard for fixing currency values, the fact that there is a very well developed world market for metal and that its prices have until recently increased much faster than the general price level makes it a attractive asset.

So far Gold is treated as ornament, it can be treated as durable consumer good. But this function does not in any way dilute its advantage as liquid, risk free asset. In any case, not all gold is held in the form of ornaments; a large part of it is held in the form of bars. Altogether from country’s point of view, gold’s holding whether in the form of bars or ornaments, are no different from FOREX holdings. That the bulk of it is in the hands of private individuals who may or may not be willing to convert it into other assets is another matter, and does not detract from this feature. Of course, it is important to such a context, to understand why people prefer to hold gold and the conditions under which they will add or reduce the stock of it in their hands.

If accumulating gold, in principle, is no different from accumulation of FOREX reserves or investment in foreign financial assets, then they must be properly counted as part of the economy’s savings. The more so because investment in gold, in real sense, a substitute for investment in other assets. It is significant that during the last five years, the value of additions to gold stock accounts for over 20% of private non-corporate sector’s investment in financial instruments.

Exclusion of gold from the estimates of domestic savings thus understates the household and overall domestic savings rate, and this bias has been increasing from the last two decades.

Tariff Structure

The import duty on Gold was Rs.220 per ten grams upto January 1999,after which it was increased to Rs 400 per ten grams, this led to increased gold smuggling. As a result, India lost an estimated Rs 6,000 crores (Rs 60 billion) of foreign exchange. Smuggling gradually came down when the duty was reduced to Rs 250 per ten grams on April 2001 and subsequently to Rs 100 Per ten grams. The amount of duty released from gold imports indicates an annual figure varying from Rs. 1,000 to Rs. 2,000 crore per annum since 1997.

Major Markets in India

Mumbai

Mumbai is the major wholesale trading center in India, price quoting in Mumbai market is taken as reference price in most other parts of the country. Mumbai was losing its shine due to high sales tax of 2% prior to April 2002, but the rationalization of the local taxes in Maharashtra in April 2002 which brought sales tax level to 0.5% has it helped the gold trade to move back to Mumbai and it would not be a surprise to see Mumbai to reemerge as one of the largest gold trading centers in India and maybe the world. Mumbai and Ahmedabad together account for about 45% Indian gold trade.

Ahmedabad

The bullion market of Ahmedabad, became the largest landed destination in the country for the yellow metal after the Gold Control Act was scrapped in 1991-92.The Gujarat bullion market, which at 280 tonnes accounted for a high 40 per cent of the entire country’s 700-tonne market in 2000-01, had hit a trough in the 2001 fiscal with volumes crashing by over 50 per cent to less than 140 tonnes. In rupee terms, the Ahmedabad bullion juggernaut has slowed down perceptibly to Rs 6,000 crore worth of business in the last fiscal, a slump from Rs 12,000 crore worth of transaction in the previous year. However, after the VAT implication in Rajasthan and Gujarat there should not be major difference in the tax structure. Still Ahmedabad is considered one of the important bullion markets in the country. The physical delivery in bullion for the both NCDEX and MCX also generally takes place in Ahmedabad.

Jaipur

Jaipur is emerging as new destination for bullion traders in western India. The daily sales volume in Jaipur was around 7000 Ten tola bars per day during 2001.The entire credit goes to the changing dynamics in the gold market which has been fastened by the decision of the Sales Tax department of Rajasthan to offer a 0.5 per cent tax benefit to those banks and trading houses designated by the Government to trade in bullion provided they deposit Rs 1.25 crore per annum, irrespective of the size in business. Rajasthan Government is charging a sales tax of 0.46 per cent on bullion if one avails the composite tax saving scheme. It has become more attractive to these designated trading houses, as they need to pay the amount only on a monthly basis.

Another scheme called Green Channel Scheme was offered by the Rajasthan Government, under this scheme, the government has given total go by to the sales tax chargeable on a group of some 15 leading jewelers who deposit around Rs 3 Lakh or more per annum with the sales Tax department depending on their turnover.

Chennai

Chennai is a major destination for importing gold in India. According to the Chennai Air Commissionerate, a total of 72,390 kg of gold was imported in, 2001-2002, fetching a duty of Rs.180 crores, while the figure for April and May 2002-2003 was 3429.7494 kg, with a total duty of Rs.8.666 crores. Some of the regular importers such as the ABN Amro Bank were getting on average, about 6,000 bars a month through the Chennai airport. Chennai airport is losing its status as a preferred entry point for importing gold, following the introduction of multipoint sales tax by the Tamil Nadu Government, resulting in lower volumes of gold import through the city. The sales tax in Tamilnadu is about two percent tax, while that in Maharashtra is about 0.5 percent.

Delhi

Delhi is another major gold market in the country. Delhi prices command some prominence in some parts of the country. Delhi was gaining prominence when Mumbai was loosing its shine. Delhi Gold market constitutes about 15% of total Indian gold trade.

International Scenario

International bullion market was dominated by the official sector mainly by central banks in the last decade. Flat demand, declining prices along with institutional developments, had much to do with the changed attitude of central bankers particularly in Europe. The official sector sales, which amounted to 130 tons in 1994, progressively went up and recorded 470 tons in the year 2000. The official sector leasing, which was around 1,000 tons in 1991 went up to about 4,800 tons in the year 2000. Low inflation and soft interest rates have brought about a greater sensitivity among central banks regarding returns on their portfolios. The steady decline in gold prices few years before against the background of low inflation raised doubts on the importance of gold as a safe haven investment and hedge against inflation. Some central banks have resorted to offloading substantial quantities of gold, which they held as reserves.

Another significant development of the 1990’s was the spurt in central bank lending of the precious metal. Central banks are lending their idle stocks with a view to enhancing returns on reserves, which are bringing in good liquidity to the market to bridge the gap between supply and demand. A notable development in this regard is the signing of the Washington Agreement by some central banks in September 1999, which has placed an effective cap on such operations of central banks.

As a result of the clear trend that emerged in recent years of increased amount of central banks’ sales as well as lending, the official sector’s holdings as a percentage of total above-ground stocks fell from about 30 per cent in 1996 to 23 per cent in 2000. The central banks across the world were holding about 33,000 tons as at the end of 2000 as compared to about 36,000 tons at the beginning of 1991, which reflects substantial sale by many European central banks.

International Scenario

International bullion market was dominated by the official sector mainly by central banks in the last decade. Flat demand, declining prices along with institutional developments, had much to do with the changed attitude of central bankers particularly in Europe. The official sector sales, which amounted to 130 tons in 1994, progressively went up and recorded 470 tons in the year 2000. The official sector leasing, which was around 1,000 tons in 1991 went up to about 4,800 tons in the year 2000. Low inflation and soft interest rates have brought about a greater sensitivity among central banks regarding returns on their portfolios. The steady decline in gold prices few years before against the background of low inflation raised doubts on the importance of gold as a safe haven investment and hedge against inflation. Some central banks have resorted to offloading substantial quantities of gold, which they held as reserves.

Another significant development of the 1990’s was the spurt in central bank lending of the precious metal. Central banks are lending their idle stocks with a view to enhancing returns on reserves, which are bringing in good liquidity to the market to bridge the gap between supply and demand. A notable development in this regard is the signing of the Washington Agreement by some central banks in September 1999, which has placed an effective cap on such operations of central banks.

As a result of the clear trend that emerged in recent years of increased amount of central banks’ sales as well as lending, the official sector’s holdings as a percentage of total above-ground stocks fell from about 30 per cent in 1996 to 23 per cent in 2000. The central banks across the world were holding about 33,000 tons as at the end of 2000 as compared to about 36,000 tons at the beginning of 1991, which reflects substantial sale by many European central banks.

GOLD DEMAND IN KEY MARKETS WORLDWIDE

In thousands of Troy ounces*

(In millions of troy ounces)

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

India

8.36

14.61

13.03

13.34

15.34

16.3

23.69

26.2

26.97

27.5

Pakistan N/A N/A N/A N/A

1.39

1.73

2.63

3.16

3.92

3.83

Greater China*

12.11

16

13.5

13.95

13.74

12.04

13.08

10.11

11.04

10.59

Japan

7.75

6.53

7.57

7.35

8.75

4.89

3.44

3.55

3.92

3.15

South Korea

1.8

2.36

2.89

3.41

3.89

4.03

3.68

-5.22

3.81

3.87

Southeast Asia

7.38

7.48

8.06

9.8

10.44

10.6

6.56

1.66

8.54

8.59

Saudi Arabia

5.5

7.23

6.43

5.59

6.21

5.94

6.4

6.7

6.41

7.11

Gulf States N/A

3.26

2.65

2.83

3.36

3.79

4.57

4.64

4.65

5.07

Egypt N/A N/A N/A N/A

2.15

2.43

3.14

3.36

4.01

3.85

Turkey

3.6

4.12

5.14

2.6

4.48

4.92

6.49

5.53

4.47

6.66

USA

8.5

9.08

9.84

9.66

10.12

10.66

11.64

13.77

14.78

12.46

Brazil

1.13

1.32

1.67

1.61

1.74

1.9

1.86

2.06

1.83

1.93

Mexico

0.96

1.06

1.35

1.51

1

1.32

1.58

1.77

2.24

2.58

Italy

4.42

4.26

3.63

3.73

3.54

3.39

3.56

3.61

3.04

2.5

France

1.3

1.35

1.57

1.43

1.62

1.53

1.59

1.91

1.98

1.82

Germany

2.62

3.29

2.79

1.99

1.83

1.74

1.68

1.68

1.66

1.62

UK

1.29

1.11

1.06

1.32

1.49

1.51

1.89

2.15

2.07

2.09

* One Troy Ounce=31.10 Grams

*

*Greater China includes China, Taiwan, and Hong Kong.

SOURCE: WORLD GOLD COUNCIL, GOLD DEMAND TRENDS, FEBRUARY 1996, FEBRUARY 1998, AND FEBRUARY 2001.

World Gold Production Pre-1840

Time Annual Average Production* Location
Sumer Civilization 3000 BC 0.03 Moz. Asia Minor/Africa
Egyptians 2000 BC 0.10 – .13 Moz. Africa/Saudi Arabia/Asia Minor/China
Roman Empire 0.19 – .29 Moz. Africa/Asia Minor/Spain/Portugal
500 – 1100 0.06 – .10 Moz. Africa/Germany/Austria/China
1100 – 1500 0.10 – .16 Moz. Africa (mainly Gold Coast)/China
1500 – 1600 0.16 – .32 Moz. Africa (Gold Coast)/China/South America**
1600 – 1700 0.32 – .39 Moz. Africa (Gold Coast)/China/South America
1700 – 1800 0.48 – .80 Moz. Africa (Gold Coast)/Brazil and other SouthAmerican countries/Russia
1800 – 1840 0.80 – 1.61 Moz. Africa (Gold Coast)/Brazil and other SouthAmerican countries/Russia

World Gold Production 1840-2000

(in millions of troy ounces)

Country 1840-1850 1851-1875 1876-1900 1901-1925 1926-1950 1951-1975 1976-2000
Australia

0

51.7

39.7

54.5

22.9

22.4

122.1

Canada

0

2.2

4.8

21.2

85.1

87.8

93.7

South Africa

0

0

20.7

178.4

292.3

582

488.9

Russia/Former USSR

7.5

22.6

29.1

24.6

73.2

134.9

137.7

USA

5.2

58.4

51

93.9

66.8

40.4

155.7

All Other Countries

5.2

19.1

37

104.9

159.9

117.9

456.2

World Total

17.9

154

182.3

477.5

700.2

985.4

1454.35

World gold mine production by region

(in million of troy ounces)

Region

2000

2001

2002

2003

2004

2005

2006

Africa

19.48

19.24

19.48

18.23

17.31

16.03

17.54

America- Latin

11.88

11.87

12.42

12.24

12.41

13.97

15.29

America – North

16.46

15.9

14.46

13.93

13.19

12.46

12.71

Asia

17.8

18.7

18.14

19.04

17.46

19.92

19.79

Europe – Eastern

5.276

5.696

6.239

5.722

5.726

5.555

5.432

Europe – Western

0.554

0.672

0.807

0.855

0.79

0.746

1.028

Oceania

12.47

11.65

11.02

11.61

11.07

11.02

11.91

Others

0

1.021

1.2

1.197

1.27

0

0

Total

83.92

84.74

83.77

82.81

79.22

79.7

83.69

Source: Reuters

World official gold holdings

The following table gives an illustration of gold in possession of Central banks, top 10 countries holding gold; their official gold reserves & gold as a percentage of their total reserves.

Country Tonnes % Share of reserves
United States

8,135.00

75.1

Germany

3,427.80

62.9

IMF

3217.3

2.6

France

2,790.90

64.8

Italy

2,451.80

66.7

Switzerland

1,290.10

43.3

Japan

765.2

1.8

ECB

719.9

21.5

Netherlands

654.9

57.9

China

600

1.4

Spain

457.7

49.5

*India

357.7

4.6

Source: World Gold Council

About 31,000 tons of world’s gold (25-30%) of above ground stocks is lying in Central bank vaults.

90% of the gold above- ground has been mined since 1848, when the California gold rush began.

About 40% of the total gold above – ground is in the form of reserves

Note:

Figures are updated up to June 2006

* Indian ranks #15

Major Gold Markets in the World

· London Gold Market

· Hong Kong Gold Market

· New York Gold Market

· Zurich Gold Market

London Gold Market

London is a major market for gold since the late 17th century. The oldest member of the market, Scotia-Mocatta, was founded in 1671 by Moses Mocatta. Several other members trace their origins to the 19th century, including N.M. Rothschild, where the daily London gold fixing prices still offer a daily bench-mark for the price, while London remains a prime trading forum and the essential clearinghouse for global dealing, with delivery of metal in London (known as loco London). In this role it has a unique asset and ally in the Bank of England, which has itself been the crossroads for gold for three centuries and has more in-house expertise about Gold than any other central bank. The London Bullion Market Association (LBMA) represents the interests of the wholesale bullion market, which comprises 10 market-making members, 44 ordinary members and 24 international associates. The LBMA also controls the Good Delivery List of refiners whose bars are accepted on the London market, and publishes monthly the clearing turnover of its market-making members.

Hong-Kong Gold Market

Hong Kong gold market fits into the time zone between the largest two Gold Markets in the world, New York and London. It is eight hours ahead of London and thirteen hours ahead of New York.

London 3 a.m. | Hong Kong 10 a.m. | New York 10 p.m.

Major Gold Markets are closed between 2:30 a.m. and 3 p.m., Hong Kong time. If any significant newsbreak occurs during this period, international investors may take the advantage of the news by trading through Hong Kong Gold Market.

New York Gold Market

New York has only come into its own as a gold market in 1974 when Americans were once again permitted to buy and sell gold freely for the first time since 1933. In the intervening years the gold business had been strictly licensed through a handful of banks, such as Republic National Bank of New York and Rhode Island Hospital Trust National Bank, which supplied gold to authorised jewellery and industrial fabricators. The concept of futures application to gold came only in the 1970s, initially at the Winnipeg Commodity Exchange in Canada, but then on COMEX (Commodity Exchange Inc.) in New York and at the Chicago Board of Trade and the Chicago Mercantile Exchange from 1975. They brought a completely new dimension to gold trading, but ultimately it was COMEX which set the pace, so that today it is COMEX (now a division of NYMEX) that is the heart of America’s gold market in parallel with COMEX as the great terminal market, however, an increasing amount of gold trading is done outside the exchange by market makers in spot, forward and over the counter options. So COMEX remains supreme in terms of a formal market with its transactions closely recorded and observed by analysts.

Zurich Gold Market

Switzerland has been at the heart of the gold business as a center for physical gold wholesaling, for gold investment in private banks and for refining. Swiss Bank Corporation was a buyer at the third London gold fixing after its inauguration in 1919.

Swiss Bank Corporation, the country’s central bank, holds the sixth largest official stock and has a long history as a strong ally of gold. Much has changed in the 1990s, the main Swiss banks have moved much of their gold trading from Zurich to London, the private banks no longer recommend gold as 10% of any portfolio and even the Swiss National Bank is selling its gold since May 2000.

When the era of high inflation and gold investment was over, Gold production in South Africa and the old Soviet Union was declining, while major new output came from Australia, the United States, Latin America and southeast Asia and did not flow naturally to Switzerland. Going into the new millennium, the Swiss gold market was a shadow of its former self, even though it retained an important role in the physical bullion trade.

Major Participants in the World Market

Bullion bank plays a crucial role in the international market. They act as buyers, sellers, stockholders, and distributors of gold. They actively quote two-way prices, provide credit for all bullion banking transactions, trade finance for consumers, project financing, day-to-day hedging facilities for producers.

Following Banks are the members of International Bullion Trading Community

ABN-Amro, Mitsui,
AIG International, MKS,
Barclays Bank, Morgan,
Chase Manhattan, Stanley,
Citibank, N M Rothschild,
Commerz bank, Phibro Bullion,
CSFB, Prudential-Bache,
Deutsche Bank, Rabobank,
Dresdner Bank, Scotia Mocatta,
Goldman Sachs, Societe Generale,
HSBC, Standard Bank,
J P Morgan, Sumitomo,
MacQuarie Bank, UBS,
Mitsubishi, West LB

Gold in Correlation with other financial instruments

a) Correlation with the USD

Traditionally, gold has been a proxy for currencies & a perfect hedging instrument. So, whenever the dollar weakened, investors would sell the greenback & buy gold. This means gold prices rose whenever there was a weakness in the dollar; or in other words “A negative correlation”.

The following chart illustrates the correlation between gold & the US dollar since 1986.

b) Correlation with Silver

The price relationship with silver varies widely between 40 & 100. In other words, there is no fixed price relationship between the two precious metals. The prices of gold & silver are viewed differently in different market environments. During the period between 1990- 1998, the price of silver was rising consistently. This is because in a booming economy where silver has a number of industrial uses, the commodity was considered to be much more valuable to gold & hence preferred to gold.

From 1998 through 2005, starting with the Hedge Fund and Asian crises, through the Y2K scare and the economic collapse of 2000, through the start of the Iraq war, Gold began to be accumulated more than Silver. Suddenly Gold as money was deemed an important crisis commodity. As fear replaced confidence, Gold relative to Silver increased in value, doubling from 40 times silver in 1998, to 80 times silver in 2003 & 60 times silver in 2005. From early 2004 to now, the Gold- Silver ratio varied between 50 and 70, stabilizing and narrowing towards a mean of 60, which is about where we are now.

The following chart illustrates the correlation between gold & silver since 1980

c) Correlation with oil

One of the most powerful historical interrelationships in commodities exists between oil and gold.  Oil is the most important commodity on earth since almost everything tangible that we physically move burns oil in the process.  And gold has been the ultimate form of money through six millennia of human history, utterly immune to the inevitable debasement and inflation that all paper currencies eventually suffer.

The Gold/ Oil Ratio or GOR simply takes the market price of gold divided by the market price of oil and the result is charted across time.

The following chart illustrates the price correlation between gold & crude oil since 1983

Global exchanges

Exchange

Website

New York Mercantile Exchange (NYMEX) www.nymex.com
Tokyo commodity exchange (TOCOM) www.tocom.or.jp
Chicago Board of Trade (CBoT) www.cbot.com
Multi commodity Exchange (MCX) www.mcxindia.com
National commodity & derivatives Exchange (NCDEX) www.ncdex.com
Dubai gold & commodities Exchange (DGCX) www.dgcx.ae
Brazilian Mercantile & futures Exchange www.bmf.com.br

Price fixing

London fixing is the usual benchmark for price fixing of gold. The Fixings are an open process at which market participants transact business on the basis of a single quoted price. Orders can be changed throughout the proceedings as the price is moved higher and lower until such time as buyers’ and sellers’ orders are satisfied and the price is said to be ‘fixed’.

From its inception in 1919, the gold price fixing is done twice-daily; approximately at 10.30 am & 3 pm GMT, by a committee consisting of five representatives, all of whom are market making members of the London Bullion Market Association (LBMA). The meeting was chaired by the representative from N M Rothschild & Sons from 1919 to 2004. In May 2004, Rothschild announced its intention to withdraw from the committee and was replaced by Barclays Bank, and the chairmanship is now rotated annually. The other four representatives are: The Bank of Nova Scotia, HSBC, Deutsche Bank & the Societe Generale

In addition to the gold fix, there is active gold trading based on intra-day spot price. These are derived from multiple gold-trading markets around the world as they open and close throughout the day.

Today, like all investments, the price of gold is ultimately driven by supply and demand, including hoarding and dis-hoarding. Unlike most other commodities, the hoarding and dis-hoarding plays a much bigger role in affecting the price, since almost all the gold ever mined still exists above- ground in one form or the other. Given the huge quantity of above ground hoarded gold, compared to the annual production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production or gold jewelry demand.

Gold lease rates

Gold has long been available for lease. Recently, leased gold has played an important role by some gold mining companies. These companies short their own product, to the detriment of shareholders. While this practice may have started innocently as a means to hedge risk in a down market, for some it quickly degenerated into an orgy of speculation, with some mines betting against as much as a decade of future production. By leasing gold very cheaply, then shorting it, they hoped to profit from the difference between today’s price and a lower future price. Other participants involved in leasing include hedge funds, bullion banks, and others who seek to manipulate the market in order to protect these powerful interests who positioned themselves to profit from a continued decline in the price of gold.

Short-term rates are usually lower than longer-term rates, because a leaser can more confidently predict the immediate future than the remote future. Movement of all rates down together indicates a copious supply that players think more than sufficient to meet anticipated needs. Upward movement as a group indicates a clear and present shortage of physical gold with no relief in sight.

Example:

During the month leading up to the third Bank of England auction on November 29th, it was widely known that 25 tons of gold would hit the market. Therefore, during November the one-month lease rates were exceptionally low at 0.74%. Right after the auction, however, one-month rates joined the other lease terms averaging 1.85%.

Gold price calculation

Gold spot rate in the international market is multiplied with USD/INRrate to get the Rupee value of gold in India (off land cost).

Landing cost: to be added to the off land cost

· Bank commission is 0.10%on the off land cost

· Bank charges a paise over and above the USD/INR rate

· Bank commission includes the handling charges.

· Custom duty is Rs. 100 per 10 Gram.

Note:

· There is a premium of $0.75 per ounce to the London gold spot rate.

Trading Strategy

Type of participant

Strategy

Traders Sell or buy futures
Investors Sell or buy futures
Sugar producers Hedging (Sell futures)
End user companies Hedging (Buy futures)

Hedging strategy for gold producers

Example:

Suppose in April a gold mine had committed to deliver ‘X’ quantity of gold to a buyer in a future date say in June. However, the mine thinks that during the delivery period prices may come down due to its production resulting into a loss. Let us assume gold kg futures July contract was trading at Rs 9750 per quintal in April. Seeing the volatility and probable downfall in price the mine adopted a hedging strategy by selling 10 contracts (1 lot= 1 kg) of gold kg at the NCDEX at the current price. Thus, by locking the price at the current level the mine minimized its price risk.

Futures price of gold kg July contract in April = Rs 9750 per 10 gm

Futures price of gold kg July contract in June = Rs 8550 per 10 gm

Spot price of gold in April = Rs 9700 per quintal

Spot price of gold in June = Rs 8500 per per quintal

If the mine had not hedged its position it would have incurred a loss of

Rs (9700-8500)*100*10 = Rs 1200000

But since it hedged it earned Rs (9750-8550)*100*2 = Rs 1200000

Therefore net loss = Rs (1200000- 1200000) = Rs 0

However, practically unlike the above example both futures and spot price may not move exact equally. Also there would be certain charges in futures market, but loss if any would be minimum as the direction of prices in both the markets remains same.

Hedging strategy for end-users (jewellers)

Example:

Suppose in February, 2006 a jeweller required to buy ‘X’ quantity of gold for making jewellery. The buying period would spread almost 3 months. However, the jeweller thinks that during this period prices may go up resulting into a loss. Let us assume gold kg futures May contract was traded at Rs 7800 per 10 kg in February. Seeing the volatility and probable rise in price the jeweller adopted a hedging strategy by buying 5 contracts (1 lot= 1 kg) of gold kg at the NCDEX at the current price. Thus, by locking the price at the current level the jeweller minimized its price risk.

Futures price of gold kg contract in February = Rs 7800 per 10 gm

Futures price of gold kg contract during May = Rs 10200 per 10 gm

Spot price of gold in February = Rs 7750 per 10 gm

Spot price of gold in May = Rs 10150 per per 10 gm

If the jeweller had not hedged its position it would have incurred a loss of

Rs (10150-7750)*100*5 = Rs 1200000

But since it hedged it earned Rs (10200-7800)*100*5 = Rs 1200000

Therefore net loss = Rs (1200000- 1200000) = Rs 0

However, practically unlike the above example both futures and spot price may not move exact equally. Also there would be certain charges in futures market, but loss if any would be minimum as the direction of prices in both the markets remains same.

Conclusions:

Hedging through futures enabled an entity to lock-in its prices at a particular level, which is acceptable to it. All the subsequent event that may have a bearing on the prices of gold would not affect the entity as it hedged its price risk through futures. Thus, hedging through futures reduces the variability in prices.

Hedging the price risk brings in certainty. Companies prefer certainty to uncertainty and hence resort to hedging. In other words, hedging price risk using futures tends to reduce the volatility of net income substantially. Every hedger always prefers this as it enables him to plan his actions better.

Speculation using futures:

A professional investor closely tracking the gold prices, feels that the prices have peaked-off and are on a correction mode. His analysis based on fundamental and technical aspects makes him feel that the prices should correct till 8500 levels and the rally up will continue. Hence they decided to take a position of buy at 8600 levels on 17th of April 2006 in anticipation of upward rally till May 2006.

Premise- since the market expectation of the firm is bullish the firm has to go long to get the maximum benefit of the move. The company will lose if the market moves against the expectations.

Objective is to make profit out of the bull move of the gold market.

Strategy followed is take a long position in the May contract and watch the market movements. If any move is strongly negating the upward move come out of the market.

17/04/2006: Buy gold in the NCDEX May futures 8850.

Payoffs:

The market movement was as expected till middle of May and touched 10700 level where it took a correction down. The down movement continued, which made the investor a little worried. They analyzed the market and found market is expected to move down further. They liquidated their position on 18th of May and came out of market before expiry.

Date Position Price Anticipated Difference
17/04/06 Buy

8850

10500

1650

18/05/06 Liquidated

10200

The expected profit was 1650 per contract and actual was 1350 per contract and total it is 135000 for all 100 contracts.

Conclusion:

Speculation is a risky game and this is only for those who are very actively tracking the market. Since the investor could able to judge the market move in time, he is out of loss and made a little profit.

Contract specification (for NCDEX)

Gold Kg

(Applicable for contracts expiring in June 2006 and onwards)

Basic information

Basis Ex-Mumbai inclusive of Customs Duty and Octroi, excluding Sales Tax
Unit of trading/ Lot size Rs/ 1 kg
Quotation/ base value Rs/ 10 gm
Delivery centre Mumbai
Additional delivery centre Ahmedabad

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