by Jonathan Buhalis
Exchange Traded Gold
Equity type products Gold is traded in the form of securities on stock exchanges in Australia, France, Mexico, South Africa, Switzerland, the United Kingdom and the United States. By design, this form of securitized gold investment is expected to track the gold price almost perfectly. Unlike derivative products, the securities are 100% backed by physical gold held mainly in allocated form and are generically referred to as exchange traded gold. The securities are all regulated financial products. Financial advisors and other investment professionals can provide further details about these products.
Futures and options Gold futures contracts are firm commitments to make or take delivery of a specified quantity and quality of gold on a prescribed date at an agreed price. Investors may take or make delivery of the gold underlying the contract on its maturity although, in practice, that is unusual. The major benefit is that such contracts are traded on margin; that is, only a fraction of the value of the contract has to be paid up front. As a result an investment in a futures contract, whether from the long or the short side, tends to be highly geared to the price of bullion and consequently more volatile.
Futures prices are determined by the market's perception of what the carrying costs ought to be at any time. These costs include the interest cost of borrowing gold plus insurance and storage charges. Where the future price is greater than the spot price, as is almost invariably the case, the difference is known as the contango. Very rarely, the future price is lower than the spot price in which case the difference is known as a backwardation.
The cost of a futures contract is determined by the initial margin, that is the cash deposit that has to be paid to the broker. This is only a fraction of the price of the gold underlying the contract, thus enabling the investor to control a value of gold that is considerably greater than the cash outlay. In the event of significant movements in the gold price that could lead to losses, the broker will call for additional, so called variation, margin.
While such leverage can be the key to significant trading profits, it can also give rise to losses in the event of an adverse movement in the price of gold.
Futures contracts are traded on regulated commodity exchanges. Two of the largest are the CME Group's New York Mercantile Exchange (NYMEX) and the Tokyo Commodity Exchange (TOCOM).
Gold options give the holder the right but not the obligation to buy (call option) or sell (put option) a specified quantity of gold at a pre-determined price by an agreed date. The cost of such an option depends on the current spot price of gold, the level of the pre-agreed price; known as the strike price, interest rates, the anticipated volatility of the gold price, and the period remaining until the agreed date.
As is the case with futures contracts, an option position can give the holder substantial leverage. Of course, if the strike price is not achieved then there is no point in exercising the option and any loss is limited to the premium initially paid for the option.
Futures and options can be traded through brokers, just as shares can. Note that when calculating options prices, the higher the strike price, the less expensive call options become and the more expensive put options become. Both call and put options become more expensive the longer the time to expiration.
Warrants Gold warrants originated in the mid-eighties and were mostly related to gold mine issues. These days, they are commonly issued by leading investment banks and give the buyer the right to buy gold at a specific price on a specific day in the future, for which the buyer pays a premium. Warrants can usually be sold back to the issuer at any time prior to the expiry date. Despite their resemblance to options, warrants are securitized instruments and trading them is less complex than options trading. Some warrants are traded on stock exchanges.
Although warrants are generally leveraged to the price of the underlying asset (in this case, gold), this is not necessarily the case. Although purchasers of warrants may choose to take delivery of the underlying asset, in practice this is unusual.
COINS AND SMALL BARS
King Croesus in Lydia struck the first gold coins during his reign between 560 and 547 BC. Gold coins have continued as legal tender since that time. Today, bullion coins and small bars offer private investors an attractive way of investing in relatively small amounts of gold. In many countries, gold purchased for investment purposes is exempt from VAT (this includes the whole of the European Union).
Bullion coins Although the Krugerrand was the first bullion coin to be marketed as an investment product, today investors can choose from a wide range of bullion coins issued by various governments throughout the world. Such coins are legal tender in their country of issue, although this would be for their face value rather than for their gold content.
Gold bullion coins range in size from 1.5 grams to 1000 grams, although the most common weights (in troy ounces of fine gold content) are 1/20, 1/10, 1/4, 1/2, and 1 ounce. The market value of bullion coins is determined by the value of their fine gold content, plus a premium or mark-up that varies among coins and dealers and tends to be higher for smaller denominations, as one would expect.
Bullion coins should not be confused with commemorative or numismatic coins, whose value depends on their rarity, design, and finish rather than on their fine gold content. Many dealers sell both.
Numismatic Coins older coins, which fit the description of collectibles, have a premium to the value of gold included in the coin. The holder is dependent upon an accurate and fair appraisal.
Small gold bars Gold bars may be bought in a variety of weights and sizes, ranging from as little as one gram to 400 troy ounces (1 kilogram is equivalent to 32.1507 troy ounces), the size of the internationally traded London Good Delivery bar The term "small bars" refers to bars weighing 1000g or less.
According to the publishers of The Industry Catalog of Gold Bars Worldwide, there are currently 89 active manufacturers, accredited to significant international and national gold exchanges and associations, producing more than 500 standard small bars, denominated in grams and in ounces. Their gold purity is normally between 99% and 99.99%.
There are two types of gold accounts: allocated and unallocated.
Holding gold in an allocated account is rather like keeping it in a safety deposit box. Specific bars (or coins, where appropriate), which are numbered and identified by hallmark, weight, and fineness, are allocated to each particular investor, who has to pay the custodian for storage and insurance.
Many investors prefer to hold gold in unallocated accounts, which are conceptually similar to foreign exchange accounts. Unless investors take delivery of their gold (usually within two working days), they do not have specific bars ascribed to them. An advantage of unallocated accounts is that investors do not incur storage and insurance charges. However, they are exposed to the credit-worthiness of the bank or dealer providing the service in the same way that they would be if they had any other type of account.
As a general rule, bullion banks do not deal in quantities less than 1000 ounces. In this sense, they can be thought of as wholesalers or business-to-business entities. Their customers are institutional investors, private banks acting on behalf of their clients, central banks and gold market participants wishing to buy or borrow large quantities of gold. Major bullion banks are members of the London Bullion Market Association and their contact details are available on the "List of Members" section of the LBMA website.
However, other opportunities exist for investors wishing to open gold accounts representing less than 1000 ounces. The minimum investment requirement of the Perth Mint Certificate program is USD 10,000.00 (approximately 32 ounces), while the minimum investment requirement for Gold Pool Accounts is one ounce. Bullion Vault takes orders for as little as one gram and has no limit on maximum size. More information about the Perth Mint Certificate Program is available from the Perth Mint and Kitco.
Gold Accumulation Plans Gold Accumulation Plans (GAPs) are similar to conventional savings plans in that they are based on the principle of putting aside a fixed sum of money every month. What makes GAPs different from ordinary savings plans is that the fixed sum is invested in gold.
Key Advantages Monthly fixed sums can be as small as one likes, while avoiding the premium normally charged on small bars or coins.
Because small amounts of gold are purchased over a long period of time, investors reduce the risk of investing a large sum of money at the wrong time.
GAPs are managed electronically, making them very easy to use.
A Bit of History The Gold Accumulation Plan was first introduced by Tanaka Kikinzoku Kogyo in Japan in 1980 and has subsequently been marketed by other bullion dealers, mining companies, trading houses and banks. A major breakthrough came when Sanwa Bank, a major commercial bank in Japan, launched its own GAP in 1988, followed by Fuji Bank in 1990. Thereafter, the product was widely promoted at major regional banks all over Japan in the early '90s. Currently, there are more than 200 tons of gold accumulated by various operators of the Japanese GAP program.
How Do Gold Accumulation Plans Work? A Gold Accumulation Plan is set up just like most other savings accounts. The investor commits to investing a fixed amount every month, usually for a minimum period of one year, although about 90% of contracts are rolled over (extended) when the one-year term is complete. Once the Plan is set up, installments are withdrawn from the investor's bank account automatically. The monthly amount is then used to buy gold every trading day in that month (not simply a one-off monthly purchase). The advantage of this is that less gold is bought when the price is high, and more is bought when the price is low, since the daily amount of money invested is fixed.
At any time during the contract term, or when the account is closed, investors can get their gold in the form of bullion bars or coins, and sometimes even in the form of jewelry. Of course, they can also get cash should they choose to sell their gold.
Historically, gold certificates were issued by the U.S. Treasury from the civil war until 1933. Denominated in dollars, these certificates were used as part of the gold standard and could be exchanged for an equal value of gold. Although they are now collectibles, these gold certificates have been out of circulation for many years. They were initially replaced by silver certificates, and later by Federal Reserve notes.
Nowadays, gold certificates offer investors a method of holding gold without taking physical delivery. Issued by individual banks, particularly in countries like Germany and Switzerland, they confirm an individual's ownership while the bank holds the metal on the client's behalf. The client thus saves on storage and personal security issues, and gains liquidity in terms of being able to sell portions of the holdings (if need be) by simply telephoning the custodian.
The Perth Mint also runs a certificate program that is guaranteed by the government of Western Australia and is distributed in a number of countries.
Gold Oriented Funds
A number of collective investment vehicles specialize in investing in the shares of gold mining companies. The term "collective investment vehicles" as used here should be taken to include mutual funds, open-ended investment companies (OEICs), closed-end funds, unit trusts, and so on.
A wide range of such funds exists and they are domiciled in a number of different countries. These funds are regulated financial products and as such it is not possible to go into any details on specific funds.
Funds are likely to differ in their structure - some may invest simply in mining stocks, some may invest in companies that mine minerals other than gold, some may invest in futures as well as mining equities and some may invest partly in mining equities and partly in the underlying metal(s).
It may be misleading to equate investment in a gold mining equity with direct investment in gold bullion.
The appreciation potential of a gold mining company share depends on market expectations of the future price of gold, the costs of mining it, the likelihood of additional gold discoveries and several other factors. To a degree, therefore, it depends on the future earnings and growth potential of the company.
Most gold mining equities tend to be more volatile than the gold price. While they are subject to the same risk factors that influence the demand for gold itself, there are additional risks that are specific to the mining business generally and to individual mining companies specifically.
Gold Mining Stocks Individual stock ownership of a company traded on one of the exchanges. The price movement is dependent not only upon the price of gold, but also upon the future of the corporation and management. Its price movement is almost always more than the movement of gold itself.
Gold Mining Claims Ownership of a claim allows the party holding it to explore for gold or other precious metals on the land that is staked as part of the claim. There are various types of claims. Such claims are filed with the appropriate county, state, and federal mining and land authorities and have proven to be extremely valuable to many individuals and companies in the past.
Jewelry Jewelry is not thought of as an investment in the US, but in many parts of the world it is a significant family asset. Representing the largest consumption of gold each year, jewelry is a major method of savings in developing economies. The Indian market alone, which prizes high carat gold, has consistently demanded over 500 metric tons annually. Chinese demand continues to grow and now surpasses that of India.
This section deals with forwards and structured products such as gold-linked bonds, which are traded on a principal-to-principal basis. Although some warrants are traded on an over-the-counter basis, others are traded on exchanges.
The market for structured products is dominated by professional (institutional) investors, or, in the case of forwards, by gold market professionals, since minimum investment levels may be rather high. The information provided here is intended to provide a general overview of what these products typically look like and how they work, again, in a generic sense. Professional (institutional) investors and private client advisors wishing to learn more about how to execute trades should contact the gold dealing desks of London Bullion Market Association Members directly.
Forwards Like futures, forward contracts are agreements to exchange an underlying asset, in this case gold, at an agreed price at some future date. Consequently, futures and forward contracts may be used either to manage risk or for speculative purposes. However, there are important differences between forwards and futures:
A forward contract is negotiated directly between counter parties and is therefore tailor-made, whereas futures contracts are standardized agreements that are trade on an exchange.
Although forward contracts offer a greater flexibility and are private agreements, there is a degree of counter party risk, whereas futures contracts are guaranteed by the exchange on which they are traded.
Because futures contracts can be sold to third parties at any point prior to maturity, they are more liquid than forward contracts, the obligations of which cannot be transferred to third parties.
Gold-linked Bonds and Structured Notes A number of the world's largest bullion dealers and investment banks issue gold linked bonds in various forms. Typically, these products provide investors with some combination of:
- Exposure to gold price fluctuations
- A yield
- Principal protection
Structured notes tend to allocate part of the sum invested to purchasing put/call options (depending on whether the product is designed for gold bulls or bears), with the balance invested in traditional fixed income products such as the money market in order to generate the yield. Such products may be structured to provide capital protection and a varying degree of participation in any price appreciation depending on market conditions and investor preferences.
Gold Is Not Overvalued in Today's Dollars
The current price of gold (orange) has been seen before when measured in current dollars (brown).
The History of Gold
Why Invest in Gold?
How to Buy Gold