Introduction There is very little, if any, effect on the economy from the price of gold. If anything, the opposite is usually true: perceptions about the economy can directly affect the price of gold. The usefulness of gold as an economic indicator is questioned by some, but it is still widely recognized as a hedge against the U. S. dollar and as some measure of inflation. Gold is used in most electronic devices such as computers and cell phones, but in such small quantities that fluctuations in the price of gold have very little impact on this sector of the economy.
Gold and Inflation Traditionally, the price of gold was seen to reflect monetary inflation, that is, inflation of the money supply. Because the fractional reserves banking system under the Federal Reserve is inherently inflationary, the total amount of money in circulation tends to expand, at times rather sharply. If monetary inflation exceeds real growth in products and services, then the result will be price inflation, which is what is measured by government measures of inflation such as the Consumer Price Index (CPI) and Producer Price Index (PPI).
The balance of supply and demand for gold tends to change relatively little from year to year, so, for decades; changes in the price were attributed to inflation. Because rising inflation often coincides with a booming economy, a rise in the gold price is sometimes coincident with a strong economy. Gold and the Dollar In a sense, the value of the dollar reflects the health of the US economy. However, in a floating currency system where the dollar is only priced relative to other floating currencies, it is increasingly difficult to use currency movements as a measure of the economy.
Still, gold is a very popular hedge for large institutions against devaluation in the US dollar. As the value of the dollar goes down relative to other major currencies, the price of gold tends to move higher, though the correlation is not always perfect. The movements in the dollar, however, can be more much attributable to changes in other national economies than in the US itself. When the dollar is seen to be on the rise, investors tend to flee from gold, causing the price to drop rather precipitously, without necessarily signaling a slowing of inflation. Gold and Mining
The only real direct effect gold has on the economy is in the mining sector, where individual companies may be highly sensitive to any fluctuation. Because gold miners make their profit from selling gold, their profit margins are largely determined by the prevailing market value of the commodity. In past decades, miners hedged their production in the futures market to create some stability and transparency, but that practice largely ended in the first decade of the twenty-first decade as the volatility of gold and its rising price made it unprofitable to do so. pic] This chart from the World Gold Council shows, global gold mining production has actually declined since 2000, despite the huge run-up in Gold prices. Now China leads the world in gold mining output, having upped its production in 2007 by 12% over 2006, producing 9. 7 million ounces or 276 metric tons, according to GFMS. GOLD OPTIONS Gold options are option contracts in which the underlying asset is a gold futures contract.
The holder of a gold option possesses the right (but not the obligation) to assume a long position (in the case of a call option) or a short position (in the case of a put option) in the underlying gold futures at the strike price. This right will cease to exist when the option expire after market close on expiration date. Call and Put Options Options are divided into two classes – calls and puts. Gold call options are purchased by traders who are bullish about gold prices. Traders who believe that gold prices will fall can buy gold put options instead.
Buying calls or puts is not the only way to trade options. Option selling is a popular strategy used by many professional option traders. More complex option trading strategies, also known as spreads, can also be constructed by simultaneously buying and selling options. Gold Options vs. Gold Futures Compared to the outright purchase of the underlying gold futures, gold options offer advantages such as additional leverage as well as the ability to limit potential losses. However, they are also wasting assets that have the potential to expire worthless. pic] Additional Leverage Compared to taking a position on the underlying gold futures outright, the buyer of a gold option gains additional leverage since the premium payable is typically lower than the margin requirement needed to open a position in the underlying gold futures. Limit Potential Losses As gold options only grant the right but not the obligation to assume the underlying gold futures position, potential losses are limited to only the premium paid to purchase the option. Flexibility
Using options alone, or in combination with futures, a wide range of strategies can be implemented to cater to specific risk profile, investment time horizon, cost consideration and outlook on underlying volatility. Time Decay Options have a limited lifespan and are subjected to the effects of time decay. The value of a gold option, specifically the time value, gets eroded away as time passes. However, since trading is a zero sum game, time decay can be turned into an ally if one choose to be a seller of options instead of buying them. pic] Determinants of the Price of Gold Assuming that the short-run price of gold is determined by supply and demand, it will fluctuate on a period-by-period basis in response to variables that alter the supply and/or demand for gold. We start by discussing factors that influence the short-run supply of gold. Central banks have been willing to lease gold since the early 1980’s . Gold producers (i. e. mines) can implicitly supply their customers by leasing gold from central bank gold reserves, through a bullion bank intermediary, as well as extracting it from their mines.
The quantity of gold supplied from extraction in any period is positively related to the gold price in an earlier period because there may be a substantial time lag before mines react to a price change. The quantity of gold supplied from extraction is also negatively related to the amount of extracted gold that is diverted to repay central banks for the gold leased in the previous period incremented by a physical interest rate in those cases where the central bank opts for interest to be repaid in gold.
Therefore the total supply of gold to the market in each period from extraction is positively related to the lagged gold price, negatively related to the amount of gold leased in the previous period and negatively related to the gold lease rate in the previous period. Central banks forgo convenience yield, which is the benefit associated with actually physically holding gold for one period on the gold they have leased out in return for the gold lease rate.
The amount of gold supplied by central banks for leasing is determined by central bank lenders adjusting their gold reserves to the point where the physical rate of interest they receive is equal to the convenience yield forgone to the central banks from holding gold plus a default risk. In equilibrium, the lease rate is equal to the convenience yield plus default risk. Therefore a fall in the physical interest rate, a rise in default risk or a rise in convenience yield caused by political or financial turmoil would reduce the quantity of gold leased to the industry from central banks in that period.
However, the repayment of gold leased in the previous period also impacts on the current period supply. The total supply of gold in any given period fluctuates in response to the current price, gold lease rate, convenience yield and default risk, and also the previous period quantity of leased gold to be repaid at the previous physical interest rate (when appropriate). The previous period quantity of leased gold to be repaid depends on the previous period convenience yield and default risk.
Therefore the total supply of gold depends on the current price of gold and the current and lagged values of the physical interest rate, the convenience yield, and the default risk premium. There are two components to the short-run demand for gold. The first category consists of the “use” demand for jewellery, medals, electrical components etc. The “use” demand for gold is a negative function of the price of gold. The demand for jewellery is also affected by price volatility but the impact of this variable may be too short-term to affect this analysis.
The second category is the “asset” demand for gold as an investment. This demand is based on a number of factors including dollar exchange rate expectations, inflationary expectations, “fear”, the returns on other assets and the lack of correlation with other assets. The effectiveness of gold in reducing portfolio risk is inversely related to beta which measures the extent to which the price of gold moves in the opposite direction from the stock market. Generally the empirical evidence shows that on average there is no correlation .
However, the correlation between the returns on holding gold and the returns on the stock market become negative for short periods when the stock markets under-perform very badly. If the beta for gold rises for a period of time, the portfolio demand for gold will fall during that period. Therefore the demand for gold as an investment is negatively related to the current beta and positively related to the lagged values of beta. Holding gold precludes earning interest on holding an alternative interest bearing asset. The real interest rate forgone is the cost of holding gold.
Therefore the asset demand for gold will fluctuate in response to changes in the real interest rate as well as gold’s beta. There have been occasions when the gold price has moved in line with interest rates, although the norm is for the price to move inversely with interest rates. For example, gold prices and interest rates both rise if the rising interest rates reflect concern over inflation or over the US dollar. The relationship between interest rates and the gold price depends on a clear distinction between real and nominal interest rates and the precise cause of the rise in interest rates. The market price of gold is etermined where supply is equal to demand. However, as explained above, the supply and demand for gold and therefore the equilibrium shortrun gold price will fluctuate in response to changes, inter alia, in the gold lease rate, convenience yield, default risk, the beta for gold and the real interest rate. The long-run price of gold is expected to rise in line with inflation and act as an inflation hedge essentially because the long-run price of gold is related to the marginal cost of extraction and if the cost of production rises at the rate of inflation, the price of gold will rise at the same rate.
This conclusion is not affected if gold producers implicitly supply their customers by leasing from central banks as well as by extracting gold from mines. Since this gold has to be repaid it only affects supply in the short term. Profit maximizing behaviour by gold producers ensures that the cost of gold from leasing is equal to the cost of gold from extraction. If this was not the case then the cost of gold from one source would not be equal to the cost of gold from the other source. In this situation, profit could be increased by sourcing a higher proportion from the less costly source.
The long-run price of gold will be equal to the marginal cost of gold extraction if the market is competitive or proportional to the marginal cost of gold extraction if gold producers have market power. In either case the long-run price of gold will rise at the general rate of inflation. The theoretical basis that enables the gold lease rate to be used as a proxy for world real interest rates in the empirical analysis requires that the marginal cost of extraction rises at the general rate of inflation over the sample period.
It is of course possible that technical progress may negate this assumption over longer time periods. Short-run and Long-run Determinants of the Price of Gold • There is a long-term one-for-one relationship between the price of gold and the general price level in the USA. More specifically, a one per cent rise in US inflation raises the long-term price of gold by an estimated one per cent. • A one percent increase in the long-term price of gold for a one percent rise in the general US price level lies within the 95 percent confidence interval. There are short-run deviations from the long run relationship between the price of gold caused by short-run changes in the US inflation rate, inflation volatility, credit risk, the US dollar trade-weighted exchange rate and the gold lease rate. • It takes about five years for the long-term relationship between the price of gold and the general price level to be restored following any shock that causes a deviation in this long-term relationship.
• There is no significant correlation between changes in the price of gold and the world’s inflation and inflation volatility as well as the world’s world income and gold’s ‘beta’ Gold is profitable as a long run inflation hedge for investors in countries whose currencies depreciate against the dollar by more than the difference between the country’s and the U. S. ’ inflation rate. The major gold consuming countries have been overrepresented (e. g. India, China, Turkey, Saudi Arabia, Indonesia). • U. S. wealth holders should profit from holding gold if the dollar deprecation will lower the price of gold to investors outside the U. S. , which will raise their demand for gold and thus raise the dollar price of gold or if dollar depreciation will raise U. S. nflation. Gold would then act as an inflation hedge. [pic] DEMAND AND SUPPLY OF GOLD Gold’s extensive appeal and functionality, including its characteristics as an investment vehicle, are underpinned by the supply and demand dynamics of the gold market. [pic] Demand Of Gold Demand for gold is widely spread around the world. East Asia, the Indian sub-continent and the Middle East accounted for 70% of world demand in 2008. 55% of demand is attributable to just five countries – India, Italy, Turkey, USA and China, each market driven by a different set of socio-economic and cultural factors.
Rapid demographic and other socio-economic changes in many of the key consuming nations are also likely to produce new patterns of demand. [pic] Supply Of Gold Supply of gold is being determined by various factors like: Mine production Gold is produced from mines on every continent except Antarctica, where mining is forbidden. Operations range from the tiny to the enormous and there are several hundred operating gold mines worldwide (excluding mining at the very small-scale, artisanal and often ‘unofficial’ level).
Today, the overall level of global mine production is relatively stable, averaging approximately 2,485 tonnes per year over the last five years. New mines that are being developed are serving to replace current production, rather than to cause any significant expansion in the global total. Recycled gold (scrap) Although gold mine production is relatively inelastic, recycled gold (or scrap) ensures there is a potential source of easily traded supply when needed, and this helps to stabilise the gold price.
The value of gold means that it is economically viable to recover it from most of its uses; at least, that is, where it is in a form that is capable of being, if need be, extracted, then melted down, re-refined and reused. Between 2004 and 2008, recycled gold contributed an average 28% to annual supply flows. Central banks Central banks and supranational organisations (such as the International Monetary Fund) currently hold just under one-fifth of global above-ground stocks of gold as reserve assets (amounting to around 29,600 tonnes, dispersed across 110 organisations).
On average, governments hold around 10% of their official reserves as gold, although the proportion varies country-by-country. Although a number of central banks have increased their gold reserves in the past decade, the sector as a whole has typically been a net seller since 1989, contributing an average of 447 tonnes to annual supply flows between 2004 and 2008. Since 1999, the bulk of these sales have been regulated by the Central Bank Gold Agreement/CBGAs (which have stabilised sales from 15 of the world’s biggest holders of gold).
Significantly, gold sales from official sector sources have been diminishing in recent years. Net central bank sales amounted to just 246 tonnes in 2008. [pic] WORLD GOLD COUNCIL WORLD OFFICIAL GOLD HOLDINGS |SNO. |COUNTRY |TONNES |% OF RESERVE | | 1. |USA |8133. 5 |77. 4 | |2. |GERMANY |3408. 3 |69. 2 | |3. |IMF |3017. | | |4. |ITALY |2451. 8 |66. 9 | |5. |FRANCE |2445. 1 |70. 6 | |6. |CHINA |1054. 1 |1. 9 | |7. |SWITZERLAND |1041. 9 |29. 1 | |8. |JAPAN |765. |2. 3 | |9. |NEITHERLAND |612. 5 |59. 6 | |10. |RUSSIA |568. 5 |4. 3 | |11. |INDIA |557. 7 |6. 2 | Current Position Of Gold Effect of gold on the Indian economy India is the world’s largest consumer of gold in jewellery, with an annual demand estimated at about 800 tonnes.
While the country exports about 60 tonnes of the metal annually, it imports about 600 tonnes. According to figures with the Multi Commodity Exchange of India, the total stock of gold in the country is about 13,000 tonnes, which is about 9 percent of the world stock As the price of gold scales an almost two-decade high, local banks are moving in to take advantage. Their target this time is the gold coin retail segment. Corporation Bank, HDFC Bank, and IndusInd Bank are now jostling for a slice of the pie in this segment of the market.
A small gold coin weighing just 2 gm is being retailed for close to Rs 1,500 by some of the market players keeping in mind the upcoming Diwali and Eid festivals. The banking regulator has now ensured that customers have the choice of buying these coins from either banks or traditional retail gold outlets like Zaveri Bazar in Mumbai. The Indian Government has decided to sell surplus gold and silver lying in its mints. There are about five tonnes of surplus gold and 1670 tonnes of silver lying in Indian Government mints.
Gold traders said many gold jewellers were maintaining below average gold inventory as they considered current gold prices too high. ” People thought gold prices will also fall the way silver price has dropped, but that has not happened so far,” EFFECT OF GOLD ON WORLD ECONOMY • Erosion in precious metals values continued overnight as gold was headed for its largest weekly fall in 15 months. • Copper which lost 4. 3% on Chinese slowdown concerns. The country imported 8. 1% less of the red metal, albeit the very latest in import tallies give reason for some optimism. Global economics is afoot among investors. • The Lower House of Parliament in Germany approved the $1T rescue bill after having come to the realization that there really were no other alternatives handy. • Crude oil was down 117 cents at $69. 63 while Dow futures once again pointed lower for the day. Platinum’s near 17% loss since then pales in comparison to palladium’s 36% drop from a $571. 00 Fix since that same time. Rhodium was quoted unchanged at $2690. 00 per ounce. • Crude oil prices declining around $20. 0 a barrel in a short time and with copper and lumber futures prices in a steep price downtrend, combined with world stock markets that are sputtering, a double-dip world economic recession that could be accompanied by commodity price deflation can take place.
Price deflation is the archenemy of all raw commodity market bulls. ” • Gold bullion extended its losses, easing back under the $1180 mark as general commodity sector weakness and further damage in Asian equity markets (Japan’s Nikkei Index was off 245 points last night) conspired to elicit more selling among weak longs. Gold retreated for the third consecutive session, after closing at a record high on Tuesday, as a flow of upbeat U. S. jobs and trade data released this week fueled investors’ appetite for risky assets and eroded gold’s appeal as a safe-haven. Japan’s economy also slowed less than initially estimated in the second quarter, which helped investors remain optimistic about the global economic recovery. Gold lost 0. 4% this week, ending a five-week winning streak. Investors were drawn to equities and other investments seen most likely to benefit from global growth after Chinese trade data and an oil demand forecast burnished the outlook for the international economy. October oil futures added nearly 3% after the International Energy Agency raised its forecast for oil demand this year and China data showing a surge in imports lifted hopes for global growth.
The S;P 500 Index rose 0. 4%. • The market got another dose of positive news when the Commerce Department reported that wholesale inventories and sales increased sharply in July, well ahead of expectations. Analysts said that interest in bullion from Asian central banks is another factor that could support prices in the long-term. The IMF said it sold 10 tonnes of gold to the central bank of Bangladesh this week and industry experts expect more central banks to follow. FUTURE ASPECT OF GOLD Recommendations: REFRENCES: 1. http://www. bloomberg. com/news/2010-08-30/gold-rallying-to-1-500-for-analysts-as-soros-s-bubble-inflates. html 2. http://www. ehow. com/how-does_4587678_price-gold-affect-economy. html 3. http://www. nuwireinvestor. com/articles/gold-demand-expected-to-rise-regardless-of-the-direction-of-55972. aspx