GOLD PART 2

CURRENCY  TRADING.

 The London fix

In the previous chapter we discussed the various Gold contracts that are available on MCX. I’d like to begin this chapter by discussing how the prices of Gold in the spot market are arrived at internationally and in India.  However, I have to mention this – this method to ‘fix’ gold prices is merely symbolic and holds very little relevance to trading gold futures at MCX. I’m discussing this simply because it is an interesting thing to know. J

Internationally, the price of Gold is fixed in London on a daily basis, twice a day in two different sessions. The morning session at 10:30 AM is referred to as ‘AM Fix’ and the evening session at 3:00 PM is called the ‘PM Fix’. The prices are fixed by the gold dealers from London’s biggest bullion desk. The whole process is facilitated by Nathan Mayer Rothschild & Sons.

There are about 10-11 participating banks, which include names like JP Morgan, Standard Chartered, ScotiaMocatta (Scotiabank), Société Générale etc.  Do note, the general public and other banks are not permitted to participate in this process. The dealers from these banks call the dedicated conference line at the designated time and submit their bids to buy and sell gold. From all the bids and offers an average price is arrived at, and the same price is relayed to the market which then becomes the benchmark for gold trading. The whole process lasts for about 10-15 minutes. The process is again repeated in the ‘PM session’ and the gold prices are again discovered and relayed to the markets.

The gold price that is fixed by the AM and PM sessions is very close to the actual price of gold that is traded in London and other international markets. So in a sense, the price that is relayed holds no surprise to traders or bullion dealers, in fact some participants even believe that like many things in England, even this is conducted more to keep up with tradition.

India too follows a somewhat similar practice, but less elaborate. India, being one of the biggest consumers of Gold, imports the yellow metal. The gold is imported by designated banks and the banks in turn supply this gold to bullion dealers (after adding the necessary charges; more on this a little later). The Indian Bullion Association then bids for the gold through its network of bullion dealers. These dealers mainly base their quotes on how much gold they would like to buy or sell at a given price, the rates are averaged out, and this roughly sets the floor for the Gold prices in India. In fact there is some sort of circularity here because dealers tend to look at the Gold futures price traded on MCX before placing their bids with the Indian bullion association. Anyway, this price is relayed to the dealers’ and jewelers’ network and the price for the day is set.

Gold price disparity

Traders tend to compare the Gold futures rate in Chicago Mercantile Exchange (CME) and the Gold Futures rate on MCX and assume there is an arbitrage opportunity lurking around. The rationale for this is that Gold being an international commodity should often trade at around the same price, in the absence of which an arbitrage opportunity arises. So for example if 10 grams of 995 purity Gold in CME is quoted at $430, then on MCX the price of 10 grams of 995 purity should be in and around $ 430.

But this is often not the case, they trade at a significantly different price and due to this a disparity between gold futures in CME and MCX always exists. The question however is, why does this disparity between the two gold future contracts exist?

Let us figure this out –

To understand the disparity between the two future contracts, one should understand how the Gold spot rate evolves in India.

Remember, India is a net importer of gold. In the international markets, US especially, Gold is quoted on a per troy ounce basis. One troy ounce is approximately 31.1035 grams. Assume Gold in the US spot market is traded at $1320 per troy ounce – given this, what do you think should be the spot price of gold in India. Assume $ 1 = Rs 65.

The general tendency is to identify the cost for 10 gram of gold in USD and multiply the same with the current USD INR rate and figure out the price. Let us do this math quickly –

31.1 Grams = $1320, therefore 10 grams = $424.43. Since USD INR is at 65, the price of Gold in India should be approximately = Rs.27,588/-.

Unfortunately, in reality this is not so straightforward. Gold when imported (remember it is the banks which import gold) attracts duties and taxes. The spot price of Gold in India should include all these charges. In fact, let me list down all the costs that are applicable when a bank imports gold –

1. CIF applicable in Dollars (CIF stands for cost, insurance, and freight)
2. Custom duty
3. Cess
4. Bank cost

With all these charges, the landed price of Gold tends to increase. In fact, this post on TradingQ&Abeautifully illustrates how the cost adds up.

So for example if the rate of spot Gold in US is $420 per 10 grams, then in India after adding all the additional costs, the spot rate will be much higher. For the sake of this discussion, let us assume the rate in India is $435 – leading to a $15 disparity in spot rates.

Now, this explains the disparity in spot rates, but what about the futures price? Remember the futures prices is a derived from spot rates, the formula linking futures price with spot price is –

F = S*e(rt)

You can read more on futures pricing.

So in the US markets, the basis for the future pricing will be the spot price of Gold in the US, i.e. $420, while at the same time the basis for the future price in India will be the spot price of gold in India i.e. $435. Given this, naturally the futures price of gold in CME and MCX will differ. This difference should not be mistaken for an arbitrage opportunity.

8.3 – What drives the gold price?

Investors across the world have this strange, but predictable behavior – at times of uncertainties, well at least economic uncertainties, they are all in a hurry to buy gold. Gold has always been considered a safe haven capable of safeguarding investments against any sort of economic meltdown.

Consider the Brexit (June 2016) event, the most recent event which kind of shook the world, and here is how Gold behaved before and after the event –

There was a clear run up in Gold before the event and post the event, in fact the big candle that you see during this period is on 24th June, the day after the Brexit verdict was out. Naturally, gold rallied owing to the outcome of Brexit. In fact, each and every time there is any sort of global/domestic uncertainty, investors flock to buy gold. This is mainly driven by the fact that Gold is considered a safe haven, capable of preserving your wealth.

Almost all the major events in the past has had an impact on Gold, think about it – Oil crisis, middle eastern uprising, Israel-Palestine, EU migrant crisis, Greek economy, Euro crisis, Lehman Brothers; the list is never ending. But the point to note is that every world event impacts the prices of gold.

This leads us to an important conclusion – Gold tends to increase in value in the backdrop of economic uncertainties. In fact, in the backdrop of economic uncertainties, demand for risky assets such as equities goes down, and the demand for safe haven assets such as Gold tends to increase.

Now besides the uncertain events, even on a day to day basis, investors tend to buy gold considering it a safe hedge against inflation. They believe, in the long run the value of gold will continue to rise. This perception is justified if you look at a very long term chart of gold –

Take a look at the chart above, in 1970 Gold was at roughly $35 and today in 2016, Gold is at $1360, translating to a 37x return. However, when you look at it from a CARG perspective, this translates to about 8% year on year growth. The world average inflation is roughly between 5-6%. This means if you are an investor in gold, on one hand you are expected to make 8% and on the other you lose about 6% (owing to inflation) netting you with an out performance of 2%. However, in countries such as India where inflation is high, investment in Gold does not really fetch much.

 Gold, Dollar, Rupee, and Interest rates

The movement in gold is also related to how the currencies and interest rate of the economy moves. So if you are a trader in Gold, then it is not only important to keep track of world economics, but also important to keep track of currencies and interest rates. The equations are simple; let us start with the dollar and build on it.

Have a look at this graph below –

This is the graph of USD versus Gold. The inverse relation between the two is quite evident. This inverse relation can broadly attributed to two reasons –

1. When the dollar decreases in values with respect to another currency, then the value of the other currency increases. With the increase in the currency value, the demand for commodities including Gold tends to increase. As the demand for gold increases, the prices too tend to increase.
2. A falling US dollar becomes less attractive to investors; the investors tend to look at parking their money in safer havens such as gold.

Having said this, one should be aware that this may not always be true. There could be instances when both gold and USD tends to increase. For example, think about a crisis in Saudi Arabia (declining oil prices), domestic investors may want to move away from investments in Saudi and park it in safer assets such as Gold and USD, thereby increasing the value of both these assets.

Either ways, it must be clear to you now that USD has a role to play in the directional movement of Gold. Having said, one must study the correlations between various variables and gold to see if any correlations actually exist. For example, increase in the US federal rates tends to strengthen the US Dollar, by virtue of this Gold price should reduce. But this does not necessarily happen all the time, and if I’m right the correlation between Gold and Federal rates is just under 0.3.

I understand the discussion above is kind of counter intuitive, as in earlier I mentioned a strong dollar tends to push gold prices down, but the factors that influence USD may not actually have a strong bearing on Gold itself.

Confusing? Yes it is, I agree.

So how would one actually trade gold? One of the best ways to trade gold is by studying its demand and supply. Demand and supply factors are many and complex, especially for an international commodity such as Gold. However, the demand and supply pressures reflect themselves in prices and in a sense manifest themselves in the form of charts, and charts can be read by means of ‘Technical Analysis’, and this is how you can develop trading insights in gold.

I’m a huge fan of Fundamental Analysis when it comes equities, but when it comes to commodities and currencies, I resort to charts.