Commentary courtesy of www.fmxconnect.com
On Wednesday, gold opened at $1194.0 per 100 troy ounces and wavered around 1200 before settling just below at 1198.9, marking another new 6 week low. However a boost in confidence has seen a rise in this mornings prices, with gold now holding above 1200.
Yesterdays’ activity was constructive, even if measured in dead cat bounce terms. Gold opened very weakly and chopped around gradually working its way up to 1198. Big buying came in and pushed the market through 1200 relatively easily however after Comex closed and the DX weakened. It might be safe to say, that the Euro crisis premium is out of the market now, considering the inverted dollar relationship seems to be reasserting itself. But we will see. Translation: gold would then be priced like a commodity, not an alternative to fiat again.
If this is true, expect smaller ranges, false breakouts and choppy prices. Also if it is true, then we will see the market begin to price in QE2. How that affects Gold is anyone’s guess. My own would be to go long Oil and short Gold until some other Euro based headline gets traction.
Bullion Dealers and the Comex/OTC Arb
Let’s get right to it.
Bullion dealers provide liquidity for clients seeking to add or subtract risk from their own portfolios. They operate as brokers, advisors, and counterparties to their clients at various times during dealings. For our example today, we are focusing on the counterparty aspect of a dealer/ client relationship.
1. A miner calls his bullion banker to do a trade to lock in some cash flows and hedge flat price risk on his production 1 year from now.
2. The Dealer makes him a market based on many things, but for our purposes, let’s just say he makes a flat market at true value of the gold price. This will be a profitless trade in a 100% efficient marketplace for price. His price is for physical gold priced forward 1 year. Call it August 2011
3. The miner enters into a contract agreeing to sell him the metal at the agreed on price in Aug 2010, or the contract is cash settled at that time, depending on the terms they work out. For our example, we will assume the trade will be physically settled. The 2 entities use ISDAs to settle the capital requirements. Essentially, the Dealer’s firm clears the trade bilaterally, OTC.
4. The Dealer has unhedged price risk. He has several major choices if he wishes to remain as market neutral as possible.
a. Call another OTC Dealer and sell to that dealer what was sold to him (August2011). In effect doubling counterparty credit risk and removing flat price risk.
b. Call another OTC Dealer and sell a Spot contract to him. In effect doing the same as in “a” but adding the extra wrinkle of term risk (spot to Aug 2011)
c. Hedge the Aug 2011 forward risk on Comex using the Aug2011 future. The effect is creating a forward to future basis trade. Common in currency arbs as well as cash versus futures arb in equities.
d. Hedge the Aug 2011 forward risk on Comex front month futures. This is the risk of “c” above with the added dimension of term risk being layered on.
Tomorrow: What factors influence the Bullion Dealer’s choice in making his hedging decision.; or weighing Execution, Counterparty, and Exit Risk
August gold was up 2.1 to $1201.0 per 100 troy ounces as of 7:16 AM EST, this morning. The September U.S. dollar index was up .042 to 84.080. October platinum was up 6.1 to $1532.5 per 50 troy ounces. Silver was up 6.0 cents to 18.060.