FACTS’N’FIGURES — Derivatives and the gold market

The phenomenal growth in derivative products during the past few years is about adding value. But is it possible to add value to gold?

The dealing community has set about doing precisely that by taking plain-vanilla forwards, futures and options and putting them together in increasingly exotic combinations.

The instruments that arose are transactions in which one party who is exposed to an unwanted risk can pass that risk to another party and assume a different risk (one they find more acceptable), or pay cash, in return. The value of these contracts derives from the value of an underlying asset, hence the name “derivatives.”

These transactions are not as mystifying as they might seem. Each derivative product is built up from just two elements, forwards and options. Derivatives based on forwards include exchange-traded futures, regular forward transactions, historical price rollovers or spot deferreds, and swaps. Derivatives based on options include exchange-traded options on futures and privately negotiated over-the-counter options, including caps, collars, average-price options, knockouts, look-backs, and options on forward and swap contracts.

The really exotic-sounding deals are constructed by blending several of these relatively simple elements in different ways.

One of the primary ways in which derivatives enhance the gold market is by serving as a vehicle for investing in gold to anyone who, for one reason or another, is not permitted (or simply does not want) to buy, sell or hold physical gold.

Dealers developed derivatives to provide a better service for their customers while, at the same time, increasing their own revenues, thereby minimizing (as much as possible) their own risk. Gold dealers can now offer a much broader range of transactions to their customers.

Derivatives reduce the risk of loss for end-users and are a source of strength for financial institutions because they reinforce existing activities with clients and help build diversified credit portfolios. What makes derivatives important is not so much the size of the activity as the role they play in developing new ways to understand, measure and manage financial risk. Derivatives have become the prime tool of the risk management business, which is the fastest-growing segment of the financial services industry.

Derivative transactions, from the point of view of both the dealing community and the end-user, represent gold with added value.

Derivatives broaden the appeal of the gold market by making it accessible to a wider potential clientele. This adds to trading volumes and, therefore, brings a greater depth of liquidity. Beyond that, hedging associated with derivative transactions also adds to liquidity.

Most end-users enter into derivative transactions specifically for hedging purposes and they are provided with tailor-made transactions that do not require continuing hedge adjustments on their part.

As for dealers, most portfolios of derivatives require only limited amounts of hedging relative to their overall size because, to some extent, positions can be matched. However, by their very nature, derivatives add to the risks assumed by the dealing community — it is this transfer of risk that essentially brought derivatives into being — and these extra risks also have to be hedged. This additional dealer-hedging associated with derivative transactions adds further to trading volumes, and hence liquidity, in the gold market . . .

— From an article in “The Australian Nugget Journal,” based on a paper delivered by the author at the 1994 Australian Gold Conference. The author works for Lehman Brothers of New York City.