Deriving the gold lease rate

1993
1,800

John Paul Koning

Financial Graph & Art www.financialgraphart.com

January 2012
2011

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1. Gold Price
1,000 Gold in $US 800 Gold in Euros 400

The gold forward offered rate (GOFO) is the rate at which the nine market making members of the London Bullion Market Association are willing to borrow cash in London, submitting gold as collateral. A gold forward transaction functions much like a swap, one bank exchanges cash for gold with another bank for some period of time before the transaction is reversed. Rates are quoted for terms of 1, 2, 3, 6, and 12 months. There is almost no correlation between the gold price in the top chart and GOFO in the second chart. The gold forward rate has almost always been above zero.This means that those who agree to temporarily accept gold in exchange for cash expect to be compensated for the inconvenience of bearing this transaction.This inconvenience relates to the higher cost of storing gold relative to cash and golds inferior liquidity. On those rare occasions when GOFO has gone negative - for instance October 1999 - banks have temporarily treated golds conveniences as superior to cash and, as a result, have been willing to pay a premium to own it. The London Interbank Offered Rate (LIBOR) is the rate at which sixteen major banks can borrow cash in London on an unsecured basis. As chart 3 shows, LIBOR and GOFO generally move together, although LIBOR has typically been quoted higher than GOFO.This is because a lender prefers to make loans on a secured basis than on an unsecured basis since the former is much safer. A gold forward transaction - essentially a cash loan secured by gold - is less risky for a lending bank to conduct than an unsecured loan. Thus, banks lending on gold collateral will usually be willing to set GOFO below LIBOR. The gold lease rate is the rate at which gold is lent out on an unsecured basis.While LIBOR and GOFO are generally available, lease rates are usually not publically quoted. Nevertheless, a hypothetical lease rate can be derived from LIBOR and GOFO. Say a major bank borrows gold and pays the lease rate, then swaps this gold for cash for six months with another major bank, paying GOFO. It invests this cash at LIBOR. The cost of this transaction - the sum of the lease rate and GOFO - cannot be less than the LIBOR return. For if it were less, banks would simply borrow the gold and sell it forward for cash, investing the proceeds at LIBOR thereby earning themselves risk-free profits. In a competitive market, this risk-free opportunity will be arbitraged away so that the following conditions always holds: lease rate + GOFO = LIBOR.Thus, knowing GOFO and LIBOR, the lease rate can be calculated. As chart four shows, the derived gold lease rate has typically been positive. Banks who lend gold expect to receive a return on the loan, and borrowing banks have been willing to provide that return. However, since 2009 derived lease rates have frequently fallen into negative territory, especially the three-month rate. Somewhat counter-intuitively, those borrowing gold for short periods now expect to receive a fee, and those lending are willing to pay this fee. One reason that lending banks might be willing to incur a negative lease rate is that storage costs have risen. By paying other banks to take on the burden of storing their gold, gold owners avoid these costs while continuing to enjoy the benefit of exposure to the gold price. Gold lease rates are almost always at a discount to LIBOR. It is more convenient to hold cash than gold due to golds high storage costs and inferior liquidity.Therefore, lenders require a higher interest rate to compensate them for foregoing the superior conveniences of cash. October 1999 was a rare exception, with lease rates rising above LIBOR.

200

8%

2. Gold Forward Offered Rate (GOFO)

6%

4%

2%

3 month 6 month 12 month

0%

-2%

-4%

3. London Interbank Offered Rate (LIBOR) and GOFO

8% The di erence between LIBOR and GOFO equals the derived lease rate 6%

4%

2%

6 month GOFO

LIBOR
0%

6-month

-2%

10%

4. Derived Lease Rate

8%

6%

4%

LIBOR
2%

6-month

3 month 6 month 12 month

0%

-2%

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John Paul Koning, 2012

Gold price data from the World Gold Council. LIBOR and GOFO from the London Bullion Market Association