Gold leasing

Market participants can borrow and lend gold in the gold lease market. Typical
lenders of gold in the lease market are entities with large stocks of physical gold on
which they wish to earn a rate of return, such as central banks. Typical borrowers
of gold are gold dealing desks.
Suppose you are a bank intermediating in the gold market. Let the spot gold price
(in US dollars) be Stó275.00, let the US dollar 6-month deposit rate be 5.6% and let
the 6-month gold lease rate be 2% per annum. The 6-month forward gold price must
then be
Ft,Tó 1ò0.056ñ0.02
2 · 275ó279.95
The gold lease rate plays the role of the dividend rate in our framework.
A mining company sells 1000 ounces gold forward for delivery in 6 months at the
market price of USD279.95. You now have a long forward position to hedge, which
you can do in several ways. You can use the futures market, but perhaps the delivery
dates do not coincide with the forward. Alternatively, you can lease gold from a
central bank for 6 months and sell it immediately in the spot market at a price of
USD275.00, investing the proceeds (USD 275 000) in a 6-month deposit at 5.6%.
Note that there is no net cash flow now.
In 6 months, these contracts are settled. First, you take delivery of forward gold
from the miner and immediately return it to the central bank along with a wire
transfer of USD2750. You redeem the deposit, now grown to USD282 700, from the
bank and pay USD279 950 to the miner.
As noted above, it is often difficult to take short positions in physical commodities.
The role of the lease market is to create the possibility of shorting gold. Borrowing
gold creates a ‘temporary long’ for the hedger, an obligation to divest himself of gold
6 months hence, which can be used to construct the synthetic short forward needed
to offset the customer business.
Futures
Futures are similar to forwards in all except two important and related respects.
First, futures trade on organized commodity exchanges. Forwards, in contrast, trade over-the-counter, that is, as simple bilateral transactions, conducted as a rule by
telephone, without posted prices. Second, a forward contract involves only one cash
flow, at the maturity of the contract, while futures contracts generally require interim
cash flows prior to maturity.
The most important consequence of the restriction of futures contracts to organized
exchanges is the radical reduction of credit risk by introducing a clearinghouse as
the counterparty to each contract. The clearinghouse, composed of exchange members,
becomes the counterparty to each contract and provides a guarantee of performance:
in practice, default on exchange-traded futures and options is exceedingly
rare. Over-the-counter contracts are between two individual counterparties and have
as much or as little credit risk as those counterparties.
Clearinghouses bring other advantages as well, such as consolidating payment
and delivery obligations of participants with positions in many different contracts.
In order to preserve these advantages, exchanges offer only a limited number of
contract types and maturities. For example, contracts expire on fixed dates that may
or may not coincide precisely with the needs of participants. While there is much
standardization in over-the-counter markets, it is possible in principle to enter into
obligations with any maturity date. It is always possible to unwind a futures position
via an offsetting transaction, while over-the-counter contracts can be offset at a
reasonable price only if there is a liquid market in the offsetting transaction. Settlement
of futures contracts may be by net cash amounts or by delivery of the
underlying.
In order to guarantee performance while limiting risk to exchange members, the
clearinghouse requires performance bond from each counterparty. At the initiation
of a contract, both counterparties put up initial or original margin to cover potential
default losses. Both parties put up margin because at the time a contract is initiated,
it is not known whether the terminal spot price will favor the long or the short. Each
day, at that day’s closing price, one counterparty will have gained and the other will
have lost a precisely offsetting amount. The loser for that day is obliged to increase
his margin account and the gainer is permitted to reduce his margin account by an
amount, called variation margin, determined by the exchange on the basis of the
change in the futures price. Both counterparties earn a short-term rate of interest
on their margin accounts.
Margining introduces an importance difference between the structure of futures
and forwards. If the contract declines in value, the long will be putting larger and
larger amounts into an account that earns essentially the overnight rate, while the
short will progressively reduce his money market position. Thus the value of the
futures, in contrast to that of a forward, will depend not only on the expected future
price of the underlying asset, but also on expected future short-term interest rates
and on their correlation with future prices of the underlying asset. The price of a
futures contract may therefore be higher or lower than the price of a congruent
forward contract. In practice, however, the differences are very small.
Futures prices are expressed in currency units, with a minimum price movement
called a tick size. In other words, futures prices cannot be any positive number, but
must be rounded off to the nearest tick. For example, the underlying for the
Eurodollar futures contract on the Chicago Mercantile Exchange (CME) is a threemonth
USD1 000 000 deposit at Libor. Prices are expressed as 100 minus the Libor
rate at futures contract expiry, so a price of 95.00 corresponds to a terminal Libor
rate of 5%. The tick size is one basis point (0.01). The value of one tick is the increment in simple interest resulting from a rise of one basis point: USD1 000 000 · 0.0001·
90
360ó25. Another example is the Chicago Board of Trade (CBOT) US Treasury bond
futures contract. The underlying is a T-bond with a face value of USD100 000 and a
minimum remaining maturity of 15 years. Prices are in percent of par, and the tick
size is 1
32of a percentage point of par.
The difference between a futures price and the cash price of the commodity is
called the basis and basis risk is the risk that the basis will change unpredictably.
The qualification ‘unpredictably’ is important: futures and cash prices converge as
the expiry date nears, so part of the change in basis is predictable. For market
participants using futures to manage exposures in the cash markets, basis risk is
the risk that their hedges will offset only a smaller part of losses in the underlying
asset.
At expiration, counterparties with a short position are obliged to make delivery to
the exchange, while the exchange is obliged to make delivery to the longs. The
deliverable commodities, that is, the assets which the short can deliver to the long
to settle the futures contract, are carefully defined. Squeezes occur when a large
part of the supply of a deliverable commodity is concentrated in a few hands. The
shorts can then be forced to pay a high price for the deliverable in order to avoid
defaulting on the futures contract.
In most futures markets, a futures contract will be cash settled by having the
short or long make a cash payment based on the difference between the futures price
at which the contract was initiated and the cash price at expiry. In practice, margining
will have seen to it that the contract is already largely cash settled by the expiration
date, so only a relatively small cash payment must be made on the expiration date
itself.
The CBOT bond futures contract has a number of complicating features that
make it difficult to understand and have provided opportunities for a generation of
traders:
Ω In order to make many different bonds deliverable and thus avoid squeezes, the
contract permits a large class of long-term US Treasury bonds to be delivered into
the futures. To make these bonds at least remotely equally attractive to deliver,
the exchange establishes conversion factors for each deliverable bond and each
futures contract. The futures settlement is then based on the invoice price,
which is equal to the futures price times the conversion factor of the bond being
delivered (plus accrued interest, if any, attached to the delivered bond).
Ω Invoice prices can be calculated prior to expiry using current futures prices. On
any trading day, the cash flows generated by buying a deliverable bond in the
cash market, selling a futures contract and delivering the purchased bond into
the contract can be calculated. This set of transactions is called a long basis
position. Of course, delivery will not be made until contract maturity, but the
bond that maximizes the return on a long basis position, called the implied repo
rate, given today’s futures and bond prices, is called the cheapest-to-deliver.
Ω Additional complications arise from the T-bond contract’s delivery schedule. A
short can deliver throughout the contract’s expiry month, even though the contract
does not expire until the third week of the month. Delivery is a three-day
procedure: the short first declares to the exchange her intent to deliver, specifies
on the next day which bond she will deliver, and actually delivers the bond on the
next day. 14