Development Through Wage-Led Growth
Henry C.K. Liu
Part I:    Stagnant Worker Income Leads to Overcapacity
Part II:  Gold Keeps Rising as Other Commodities Fall
Part III: Labor Markets de-linked from the Gold Market
Part IV: Central Banks and Gold
Part V:  Central Banks and Gold Liquidity

Part VI: The London Gold Market
The average daily volume of gold cleared at the London Bullion Market Association (LBMA) in November 2008 was reported to be 18.3 million ounces (worth $13.9 billion at an average price of $759.56 per troy ounce, still substantially below the peak gold price of $850 per troy ounce set in January 1980, which was not breached for 28 years, an extraordinary long period for a bear market for gold. Gold price fell again to a historical low of $250 per troy ounce in July 1999 while inflation was rampant.) The November 2008 clearing volume meant that an amount equal to the annual production of all gold mines in the world was traded and cleared at the LBMA every 4.4 trading days.
As noted earlier in this series, the Gold Anti-Trust Action Committee (GATA) claims that net clearing data substantially understates the gross trade volume in gold, due to the fact that the calculation of clearing statistics shows only final net settlement of linked trades. The pre-net turnover may actually be four times greater than net clearing turnover. That means that the LBMA handles a pre-net turnover equal to the annual production of gold every trading day. Since all pre-existent gold has already been traded and owned, LBMA daily volume means that every ounce of gold produced by mines around the world is traded every trading day in London as soon as it is mined.
The day will not be far off when the increase in daily pre-net trading volume in gold trade at the LBMA will be larger than new gold produced by all the mines in the world. With the rise of gold derivatives, gold trading is no longer limited in volume by the available amount of unallocated physical gold. Gold is traded on a notional quantitative amount of gold as an underlying asset of gold derivatives. Gold trading is a transactional platform that expands or contracts with rising or falling trade velocity regardless of price, which is one of the structural components in the logic of an asset bubble.
Gold Different from Oil
Gold, unlike oil which is sometimes referred to as Black Gold, is not consumed by combustion for the production of energy. Oil trading is based on the prospect of an eventual final delivery for non-renewalble consumption, no matter how remote; but such a fate of final delivery for non-renewable consumption does not exist for gold trading. Gold is consumed in the market mostly by owning which does not deplete quantitatively in the world. Unlike oil, which is a transitional asset, gold is a final asset.
There is no such phenomenon as “Peak Gold”, as the term “Peak Oil” is bantered about in the socio-technical discourse on non-renewable energy. Physical gold will continue to increase in quantity as long as gold mines continue to produce gold. But if and when all the gold in the ground has been mined, including those under deep sea beds, physical gold will still only stay constant in quantity without quantitative decline. Gold consumption involves only a transfer of ownership, not a physical depletion of gold. This is why referring to oil as Black Gold is problematic. And this is why oil is only a commodity, albeit a prime commodity, and why oil cannot perform as a reserve monetary asset.
London Gold Market not for Individual Traders
The London gold market is not accessible to individual traders because of two big barriers:
1. Large transaction size
The standard physical bullion accepted in trade is the London Good Delivery Bar, which weighs 400 troy ounces each (12.4 kilograms). At a price of $1,400 per troy ounce, each Good Delivery Bar is worth $560,000. This standard per trade module is too high in price for most individual traders. Even if gold price falls to $400, and one London Good Delivery Bar being worth $160,000, individual accounts are not large enough to attract the attention of dealers, the business economics of which prefers trades of $500,000 as a transactional minimum. And that minimum is expected to increase over time due to rising overhead cost. The day will come when the trading unit of gold is 10 Good Delivery Bars.  This high entrance threshold for individual investors is what drives the emergence of gold exchange traded funds (ETFs).
2. High regulatory qualification for opening gold trading accounts
Even if an individual is able and willing to trade sufficient amount of gold, most dealers will not accept an individual account except for extremely high-net-worth individuals. Logistical, regulatory and business considerations add to the high threshold of entrance to the gold trading game. Logistically, storing and delivering gold are costly undertakings that continually discount the monetary value of gold held. Regulatory requirements also place strict legal obligations on firms that deal with the retail public, These facts make individual accounts not a cost-effective business for profit-minded gold dealers.
Gold Trading Account Types
There are two types of gold trading accounts:
Allocated Gold Accounts
Allocated Gold Accounts are accounts held by gold dealers in each clients name on which are maintained balances of specifically identifiable bars, plates or ingots of metal ‘allocated’ to a specific customer and segregated from other gold held in the dealer’s vault. A client with an allocated account has full title to the specific physical gold in it, with the dealer acting as custodian holding the “allocated” gold on the clients behalf. To avoid confusion, gold in a client’s allocated account is separated from a gold dealer’s assets.
Unallocated Gold Accounts
Unallocated Gold Accounts are the most common vehicle for trading, settling and holding gold, as well as other precious metals such as silver, platinum and palladium. Transactions may be settled by credits or debits to an unallocated account without specific direct allocation in a general pool of gold. The balance in an unallocated account represents the indebtedness or financial obligations between the client and the dealer based on an underlying notional amount of gold that is not expected to be delivered physically. Credit balances on an unallocated account do not entitle the creditor to specific bars of gold, but are backed by the general stock of the gold dealer with whom the unallocated account is held. A client with an unallocated account is an unsecured creditor to the gold dealer for the monetary value of a notional amount of gold the client bought or sold at a specific price. Profit and loss in an unallocated gold account is calculated from the difference between the transaction price and the spot price of gold. Unallocated gold trading is a transactional platform that creates profit opportunities by price volatility, which is one of the conceptual components behind the logic of an asset price bubble and also behind the logic of the bubble’s eventual burst.
Unallocated Gold Account Risks
The total quantity of unallocated gold in the gold market is estimated to be around 15,000 tonnes at the end of 2008. The 2,134 tonnes on a daily average of spot gold traded through London represent 14.2% of the unallocated gold pool. This amount of daily gold turnover is high compared to the average daily turnover in UK equities of between 0.34% and 0.63% for the 12 months ending September 2009.
While LBMA members are not required to provide information on the amount of unallocated gold held in their books, the relatively high turnover in gold trade suggests that gold dealers operate at a low fractional reserve system where unallocated gold accounts are only fractionally backed by physical gold. When gold is bought and sold by clients of LBMA member dealers with no intention of taking delivery of physical gold, the amount of gold reserve needed to back the volume of unallocated gold trade remains unaffected by the volume of trade because a buy must be balanced with a sale simultaneously in a trade. Unallocated gold trades require gold reserve only as a notional value that provides adequate backup for net balances, and not a physical reality because the same non-delivery gold can be traded many times in the course of a trading day. The gold market expands by increasing transactional velocity, unrelated to the size of the pool of unallocated physical gold.  Transactions that depends on the velocity of trades generally contributes to the forming of price bubbles.
Since there is no minimum gold reserve requirement set by the LABMA for member gold dealers, unallocated gold trading accounts are in fact fractionally backed only by a  notional amount of gold made credible by the collective credit standing of the gold dealers, unrelated to the amount of physical gold actually held collectively or individually by LBMA members.
Gold dealers can always meet requests for physical delivery of the gold they sell by buying it in the gold spot market. The uncertainty involves only the spot price at which dealers can acquire the gold for delivery, physical or virtual. This spot price is a function of the balance between buyers and selling. When the number of buyer exceeds the number of sellers, the spot price of gold rises and vice versa. Since gold trade is mostly non-delivery trades, the spot price of gold is determined by imbalance between buys and sells, unrelated directly to the supply and demand for physical gold. This makes the gold market highly susceptible to market trend imbalances.
Gold trading is a transactional platform on which price is determined by the directional flow toward equilibrium between buying and selling, which is one component way to define the logic of a trade bubble. Ironically, the directional flow towards equilibrium in a reverse-resistent imbalance between buying and selling will also lead to market failures when no seller can be found at any price (inflationary bubble) or no buyer can be found at any price (deflationary bubble). The gold market’s detachment from physical gold substantially increases the probability of such scenarios of market failure.
Trades in unallocated gold are basically monetary loans (derived from the transactional price of gold) from buyers to the gold dealer since physical gold delivery is not required or expected in gold trades. Sellers in unallocated gold accounts are merely calling back monetary loans (derived from the transactional price of gold) previously extended to the gold dealer. The gold dealer uses unallocated gold that its clients bought from it as part of the dealer’s liquid reserve, while paying off the monetary loan previously extended by some sellers derived from the price of gold, as a seller must have been a buyer previously in order to have the gold to sell currently. 
When gold price rises after a buyer bought the gold, the buyer makes a profit on paper until he sells; when gold price falls after a buyer bought the gold, the buyer suffers a loss if he needs to sell. Theoretically, the gold dealer’s solvency is not affected by volatility in gold price, provided the dealer does not operate a proprietary gold trading desk, and provided its clients do not default in their financial obligations to it.
A gold dealer can fail financially if it suffers unsustainable loss from its own proprietary trading account, or the market value of its gold reserve falls below what the dealer paid  earlier on credit and the dealer is unable to meet margin calls, or because new buyers are paying a lower price than old buyers previous paid to buy the gold and the dealer does not have enough money to pay new sellers because there are more sellers than buyers.
A dealer caught in a work-out resolution must pay first, from its allocated holdings, the allocated account clients as secured creditors. The unallocated account clients, being unsecured creditors with only unsecured claim on the unallocated gold pool held by the gold dealer, will get paid last, provided there is enough unallocated gold left in the dealer’s reserve to pay all of them. If not, under a bankruptcy regime, all unallocated accounts will only receive a pro-rated amount among other unallocated accounts.
Similarly to a bank run on fiat money that can quickly deplete a bank’s fractional reserve, LBMA unallocated gold account holders are susceptible to financial loss caused by the depletion of unallocated gold reserve if a sufficiently large number of market participants with unallocated accounts suddenly request delivery of physical bullions they own. In normal times, this is considered unlikely as much gold trading is part of hedging strategies that place claims and counter-claims on the same physical gold many times over without demanding actual delivery. But the operative emphasis of this logic is on “normal times”.
The London Over-the-Counter (OTC) Gold Market
The London gold market is an Over-the-Counter (OTC) market - which means that buyers and sellers trade directly with each other bilaterally, arranged by the gold dealer, and not on an exchange floor through open price competition among all other market participants operating under the same exchange rules and governmental regulatory regimes. The surviving one of the two bilateral parties in an OTC bilateral trade carries the entire risk burden of counterparty default, unlike trades in an central exchange where the counterparty risk of default is assumed by the exchange as a financial intermediary. Bilateral counterparty risk include the effects of other counterparty risks knowingly or unknowingly assumed separately by the initial bilateral counter parties in a daisy chain of risks. A central exchange mitigates counterparty risk by enforcing strict membership and trading rules and by requiring solid financial qualifications for membership. The rules and practices of the central exchange offer more protection to exchange trading members than OTC traders enjoy bilaterally. 
Outside of London, only a small limited amount of gold trading takes place on the New York Mercantile Exchange (NYMEX) or the Tokyo Commodity Exchange (TOCOM). Gold forward contracts, known also as gold futures contracts, are non-standardized contracts between two parties to buy or sell gold at a specified future time at a price agreed to on the trade day. A gold forward contract is a transaction in which two parties bilaterally agree on the purchase and sale of gold at a future date, commonly 1 month, 3 months, 6 months or 1 year hence, but any specifically structured dates may be traded by any two parties in the OTC market. These bilateral forward contracts often contain terms that are party specific, that are difficult to transfer readily to other third parties, making them less liquid in the open market. Such illiquidity is compensated by a larger premium on the transaction.
Gold Option Premiums
The premium on a gold forward transaction in US dollars will reflect current Euro-dollar interest rates less an allowance for current gold leasing rates. Gold forward contracts are the basic modules of many gold-related swap arrangements. For example, a central bank would sell gold at spot price while simultaneously entering into a forward contract to buy the gold back at the same price or a lower price by a future date if such contract are available at a reasonable premium.
Gold mining companies have also made extensive use of the gold forward market in recent years as part of their more sophisticated hedging programs designed to mitigate gold price volatility over specific periods. Gold miners would pay a premium to enter into forward contract at a strike price to ensure them a desired profit margin over the current or estimated future cost of production.
In the options market, the right, but not the obligation, to buy is referred to as a call option (‘call’); and the right, but not the obligation, to sell is referred to as a put option (‘put’). The pre-agreed price of the transaction is known as the strike price or exercise price. The pre-agreed strike price is not the price of the option because the transaction is designed to be self neutralizing in value. The price of an option is the premium on the price-neutral transaction based on currently known market implications.
Options have become the third dimension of the gold market, beside physical gold and gold futures transactions. The gold option market has expanded at a fast pace since the 1980s, along with other structured finance markets such as debt securitization and derivatives markets. The options market has generated a lexicon of specialized terminology that forms its own nomenclature to accommodate the great variety of trading and hedging strategies with increasing esoteric complexity.
A premium (basic price of the option) is the compensation the grantor of the option receives from the buyer for providing the opportunity of meeting the buyer’s expected transaction aims. The premium for an option is calculated based on a combination of the current gold price, the strike price, current interest rates, the time to expiration and the anticipated gold price volatility during the period of the option contract.
The premium in an option is the logical mathematical product of market implications. It is not based on the hunch of a gambler. The risk in option transaction lies in paradigm shifts in the market that renders the logic behind market implications inoperative, such as an unexpected external perturbation, as the Russian sovereign debt default in 1998 and its adverse impact on the high-leveraged trading strategies of Long Term Capital Management (LTCM), a spectacularly successful hedge fund before its sudden demise from an unexpected shift in market paradigm, causing its over-leveraged positions to turn bad, after losing $4.6 billion in less than four months, 
Black-Scholes Formula for Pricing Options and the Emergence of CDS
In pricing options, the premium is the amount required to compensate for the specific amount at risk to the issuer. The premium can be precisely calculated electronically using the Black-Scholes model.
In their 1973 paper, “The Pricing of Options and Corporate Liabilities”, Fischer Black (1938-95) at the University of Chicago and MIT, and later a partner in Goldman Sachs before falling victim to cancer, and Myron Scholes, (1941-Present) at MIT and later in 1994 was one of the founding partners of LTCM, published an option valuation formula which has since come to be accepted by the market as the standard method of pricing options. Black and Scholes derived a stochastic partial differential equation governing the price of an asset on which an option is based, and then solved it to obtain their formula for the price of the option. Robert C. Merton, (1944-Present), also of MIT, published a paper expanding the mathematical understanding of the options pricing model and coined the term “Black-Scholes” option pricing model. Merton and Scholes received the 1997 Noble Prize for Economics for this and related work.

Black and Scholes made path-breaking contribution to the growth of the option market by providing a mathematical calculation for precise pricing of an option, changing it from mysterious intuitive guesses to measurable rational market implications. The formula was the intellectual godfather of the conceptual logic behind credit default swaps (CDS), a pivotal financial product that helped enable the spectacular growth of structured finance, and as it turned out, one of the prime causes of the global financial crisis in deregulated globalized markets that broke out in mid 2007. (Please see my December 3, 2009 AToL article: DERIVATIVE MARKET REFORM, Part 1: The Folly of Deregulation; or on my web site)
As pointed out in my May 25, 2009 article: Mark-to-Market vs Mark-to-Model, a $10,000 bet on a CDS failure could stand to win $100,000,000 in insurance payments within a year. That was exactly what many hedge funds did because they could recoup all their lost bets even if they only won once in 10,000 years. 
As it turned out, many only had to wait a couple of years before winning a huge windfall. But until AIG was bailed out by the Fed, these hedge funds were not sure they could collect their winnings from AIG, their insurer of choice.
And, as it turned out, AIG was bailed out by the Treasury and the Fed so that its CDS contracts to cover Goldman Sachs were paid in full by AIG. A search for key words: “Geithner AIG hearings” on Youtube will lead to video clips on Congressional and Commission hearings on the scandalous AIG bailout and the unseemly relationship between AIG, Goldman Sachs, the Fed and the Treassury.
Gold Option Premiums
Among the parameters that determine the premium of a gold option: the current gold price, the strike price, the current interest rates, the time to expiration and the anticipated gold price volatility, only the anticipated gold price volatility is not known. Therefore, most option market-makers quote premiums based on identical calculations, with variance only in their expectations of gold price volatility. Accordingly, only the position in the market-maker’s book will vary from those of other market-markers.
Premiums of gold options predictably can fluctuate considerably, but as a general rule, they are usually in the range of $15 to $25 per troy ounce in a calm market. On occasion, premium can fluctuate much higher in volatile markets, specially when gold prices are higher or lower than fundamentals. That is both the attraction and consequent importance of options to market participants: options offer affordable yet immense leverage because the buyer only has to pay the premium to build up large positions with relatively small capital outlay.
The premium in an option is the only amount at risk for the buyer, whether call or put, because the option is itself value neutral. If the buyer paid a premium of $20 for an option contract, that would be all the buyer stands to lose. For the grantor on the other side of the options transaction, the attraction is the premium income, but the grantor stands exposed if the underlying price moves against the option grantor who must normally hedge this exposure at a cost below the premium income.
All options strategies, no matter how complex, are made up of a combination of the two basic transactions – a call and a put. A call option is “in-the-money” when the strike price is lower than the current price; and is “out-of-the-money” if its strike price is higher than the current price. A put option is “in-the-money” if the strike price is higher than the current price and is “out-of-the-money” if its strike price is lower than the current price. The amount by which an option is in-the-money is called its intrinsic value.
For example, say spot gold is $975 per troy ounce and a call option is bought at a strike price of $1,000 for 6 months. If the price then rises to $1,000 during the life of the option (within 6 months), it is described as ‘at market’. The holder could either exercise the call option to buy gold at that price, or hold on to it since the option has no intrinsic value even to cover transaction cost in fees.
If gold price then rises to $1,100, the call option would be “in-the-money”, and it could be exercised to buy gold at the strike price of $1,000, resulting in an immediate profit of $100 per troy ounce for the holder of the option, at the expense of the issuer of the option.
The issuer of the call option then suffers at least an immediate opportunity cost, as he/she may or may not suffer a real loss, depending on the price at which he/she acquired the gold earlier. Most likely the issuer already hedged his/her risk with positions in another option. The premium of the call option is the price charged by the issuer reflecting on the issuer’s judgment of the market implications on the probability of  of gold price rising above the strike price of $1,000 per troy ounce
Similarly, a put option is purchased when gold spot price is $1,000 per troy ounce at a strike price of $975. If gold falls to $$975, the option is “at market”. If gold falls to $875 before the expiration date, or expiry, the holder can exercise the right to sell at $975 and make a profit of $100 per troy ounce at the expense of the issuer either as opportunity cost or a real loss depending the price at which he/she can sell the gold at a later date.
Some hedge funds manage to achieve extraordinarily high performance with a strategy of Options Statistical Arbitrage (“OSA”) that targets 30%+ net annual returns with a Sharpe ratio of 3+.
Sharpe Ratio
The Sharpe ratio (or reward-to-variability ratio), developed by William Forsyth Sharpe, is a measure of the excess return, or risk premium, per unit of risk in an investment asset or a trading strategy. The return on a benchmark asset, such as the risk-free rate of return, is the expected value of the excess of the asset return over the benchmark return. The standard deviation of the asset excess return is a constant risk-free return throughout the period.
The Sharpe ratio is used to characterize how well the return of an risky asset compensates the investor for the risk taken. When comparing two assets each with the expected return against the same benchmark risk free return, the asset with the higher Sharpe ratio gives more return for the same risk.
Investors are often advised to pick investments with high Sharpe ratios. However, like any other mathematical model, it relies on the data being correct. Pyramid schemes with a long duration of operation would typically provide a high Sharpe ratio when derived from reported returns, but the inputs are false because the true risk is masked by the continuation of the fraud.
When examining the investment performance of assets with smoothing of returns, the Sharpe ratio should be derived from the performance of the underlying assets rather than the fund’s returns. Sharpe ratios are often used to rank the performance of portfolio managers or mutual fund managers.
The principal advantage of the Sharpe ratio is that it is directly computable from any observed series of returns without need for additional information surrounding the source of profitability. Unfortunately, some users are carelessly drawn to refer to the ratio as giving the level of “risk-adjusted returns” when the ratio gives only the volatility of adjusted returns when interpreted properly.
Given that a hedge fund manager typically aims for a Sharpe ratio of greater than 1.0, a commodity trading advisor (CTA) manager with a Sharpe ratio of 0.19 would do poorly under this criterion. A Sharpe ratio of 1.0 would suggest that the relevant percentage of return and risk is about even. A Sharpe ration of 2.0 is excellent but probably cannot be sustained for long.
But the Sharpe ratio has its own set of difficulties as a performance measure. In September 1996, after 31 months of operation, LTCM reportedly had a Sharpe ratio of 4.35 (after fees). With the benefit of hindsight, one can say that LTCM’s realized Sharpe ratio after two-and-a-half years of operation did not give a meaningful indication of how to evaluate its investments.
LTCM started with $1.3 billion in initial assets and a strategy focused on bond trading. The trading strategy of the fund was to make convergence trades, which involve taking advantage of arbitrage between securities that are temporarily incorrectly priced relative to each other. Due to the small spread in arbitrage opportunities, the fund had to leverage itself highly to transform its conceptual advantage to make money. At its height in 1998, the fund had $5 billion in capital, controlled over $100 billion of assets and had positions whose total worth was over $1 trillion in notional value. Soon, it had to cut its capital down by more than half ($2.7 billion) without correspondingly reducing to risk exposure in an increasingly risk adverse market in order to maintain accustomed high return. All it did was to increase its Sharpe ratio.
Due to its highly leveraged nature and a financial crisis in Russia related to the default of sovereign bonds which led to a abrupt flight to quality, LTCM sustained massive losses and was in danger of defaulting on its extensive financial commitments. The large size and wide breath of its positions made it difficult for LTCM to cut its losses in its bad positions without also wiping out still profitable positions. LTCM held huge positions in the market, totaling roughly 5% of the total global fixed-income market.
LTCM had borrowed massive amounts of money to finance its leveraged trades. Had LTCM gone into default, it would have triggered a global market seizure and financial crisis, caused by the massive write-offs its creditors would have had to make. In September 1998, Fed-assisted bailout of LTCM, a classic model of too-big-to-fail, prevented a systematic meltdown of the market at the last moment.
Volatility tends to come in lumps, as volatility tends to breed more volatility. The LTCM near collapse and the Russian sovereign debt crisis showed that high volatility would stay with the markets for extended time periods even after the precipitating events had subsided. Some market observers believe major volatility events tend to occur every four years, inherent in the structural dynamics of deregulated financial markets.
(Please see again my December 3, 2009 AToL article: DERIVATIVE MARKET REFORM, Part 1: The Folly of Deregulation; or on my web site)
Gold Mining Companies and Options
Gold mining companies in particular can buy this kind of put option for price protection. Of course, with either the call or the put, if the strike price of $1,000 per troy ounce is not reached, the option expires with no intrinsic value or even “out-of-the-money”, the holder loses only the premium.
The mining company, to continue that example, will not mind if a put option with a strike price at $1,000 expires unexercised by the holder to avoid loss (extrinsic value) of $25 per troy ounce, because with spot gold actually up at $975 per troy ounce within the option period, the put provides price insurance to the mining company if the price should fall below $975 per troy ounce, while the company could still participate in the higher price during and after the option period.
Much more complex option strategies have been devised to meet the specific hedging needs of buyers with different appetite for risk against protection or for profit from market volatility, but the basic principle remains.
Normally a grantor of options would seek insurance using what is known as delta hedging, a formula measuring the amount of gold to be bought or sold to cover the exposure. The formula is a by-product of the Black-Scholes model used in precise option pricing. The variable factor in delta hedging is the measure of probability of an option being exercised against a grantor.
If, for example, the strike price is $1,000 per troy ounce of gold, the closer gold gets to that price the more the grantor must buy or sell to become ‘delta neutral’. Delta hedging can have considerable impact on the market price if large options positions of 100,000 ounces or more have to be covered by the equivalent purchase or sale of part or all of that gold.
Delta hedging is a strategy undertaken by grantors of options to manage their price exposure. The delta is the mathematical differential used by gold options market participants to measure the amount of gold to be bought or sold in order to hedge price exposure. The ‘delta variable’ is a measure of the probability of an option being exercised against the grantor and therefore dictates how much an option grantor must hedge to be covered or ‘delta neutral’.
The delta hedge is calculated on a basic model taking into account changes in the spot price, the time to expiration and the difference between the strike and spot prices. As the delta changes, the option grantor will either buy or sell the metal.
The term delta describes how the value of an option changes as a result of small changes in the underlying asset, assuming ceteris paribus (all the other factors influencing option pricing being constant). The delta of an option can also be viewed as the required hedge for the option against changes in the underlying stock, i.e. the position in the stock which ensures that the Profit/Loss on the option is offset by the Profit/Loss on the stock position.
The term gamma describes how the delta of the option changes when the underlying asset changes. Hence, the gamma also describes how one should change one’s hedge to remain delta neutral when the spot price moves. All purchased standard options, calls and puts, have positive gamma.
The gamma position also provides insight into the investor's view on the volatility of the underlying asset, as a long position shows expectations of a volatile market while a short position indicates that the investor expects a calm market.
The term theta describes the change in the value of the option when time passes and everything else remains constant. This change stems from the fact that the passage of time shortens an option’s remaining expiration period. This reduction in an option’s contract life is also commonly referred to as how much the option “bleeds” the speculator. The theta (sensitivity) is often noted in pips lost in value per day that passes. A pip is the smallest price change that a given exchange rate can make. Since most major currency pairs are priced to four decimal places, the smallest change is that of the last decimal point - for most pairs this is the equivalent of 1/100 of one percent, or one basis point
The term vega describes the change in the value of the option when the volatility changes. The volatility represents how large the swings are in the underlying asset and is the cornerstone in option pricing. Larger swings imply that the underlying asset is more likely to take on more extreme values. While the option holder’s risk is limited to the premium, the upside is unlimited for vanilla options. Hence, an increase in the volatility of the underlying asset increases the value of the option.
The term rho describes the sensitivity of the option price, based on the Black-Scholes model, with regards to changes in the interest rate.
For the grantor, or writer, of options, the objective is premium income while price risks are hedged. But the term premium has a additional meaning in gold trading.
In the gold market, a premium is normally charged for extra quality on bars over 995 fine. A premium is also normally charged on the manufacturing costs of bars smaller than the standard 400-troy-ounce (12.5 kilogram) good delivery bars, such bars as kilobars and ten-tola bars. 
The tola bar is a unit of weight for gold popular on gold markets in the Indian sub-continent. One tola = 0.375 ounces (11.1 grams) of 999 fineness usually marketed as 10-tola bars and also 5-tola bars. The 999 ten-tola bars mainly go to India but also circulate widely in the Gulf States; 999.9 ten-tola bars are sold in Saudi Arabia. Swiss refineries account for around 50% of 999.9 ten-tola bars output, supported by UK, South African and Australian production.
A premium over loco London may also be charged for bars c.i.f. certain locations, such as regional markets like Dubai or Singapore.
A premium is also percentage mark-up over the actual gold content of a coin or small bar. Bullion coins were conceived to keep this premium as low as possible.
Gold Swaps
The term ‘swap’ has come to have several meanings in the physical gold market.
It can simply mean the exchange of metal in one location for metal in another to avoid the costly and risky movement of gold. For example, gold held in New York with the Federal Reserve Bank may be swapped for gold held in London with the Bank of England with no actual movement of physical gold.
A ‘swap’ has increasingly come to describe the simultaneous spot sale of gold with a forward transaction to buy the same amount back at a later date. For governments and central banks, swaps have become a way either of raising cash to meet short-term contingencies or simply to invest the money on an interest-bearing basis. Gold swaps have become an important source of liquidity to the market.
Swaps have been used in particular by gold mining nations such as South Africa, Brazil and the Philippines, which market their local production. Instead of selling the gold outright, they can swap it to provide immediate liquidity.
South Africa, for example, entered into extensive swap programs from the 1970s onwards, often using part of her reserves in addition to the regular gold production that she was marketing. Swaps, usually for six months, were either rolled over on maturity or, on occasion if the price was high, the gold was partly sold and partly taken back into reserves. At the peak in the mid-1980s South Africa was estimated to have as much as four hundred tonnes of gold out on swaps.
The Reserve Bank of India also swapped gold for a stand-by loan from the Bank of Japan in 1991 to tide it over a short-term foreign exchange crisis. Central banks usually, though not always, indicate when they have swapped gold by showing a drop in their published reserve figures in the International Financial Statistics publication of the IMF; this is sometimes taken as an outright sale; often it is not.
In futures markets, swaps can be used for rolling over or rolling forward contracts. In practice, the mechanism of a gold forward contract incolves a central bank lending gold to a bullion bank for a specific period at a gold lending rate. The bullion bank then sells the gold at spot price and deposits the cash proceeds in an interest-bearing account. At the expiration date of the central bank lease contract, the bullion bank closes the cash account, then pays a gold mining company the cash including interest earned from the interest-bearing account, less the LIBOR rate and the bullion bank fees. The mining company then delivers the gold back to the central bank to unwound and complete the forward transaction.  
Spot gold is traded for settlement two business days following the trade date (T+2), with a business day defined as a day when both the New York and London markets are open for business.
The Gold Spot and Forward Markets
Unlike many other commodity markets, the gold forward market is driven by spot prices and interest rate differentials, similar to foreign exchange markets, rather than underlying supply and demand dynamics. This is because gold, like fiat currencies, is borrowed and lent by central banks and in the interbank market.
Because interest rates for gold tend to be lower than US domestic interest rates because cash is more liquid than gold -- it encourages gold borrowings so that central banks can earn interest on their large gold holdings -- in normal circumstances the gold market tends to be in contango, meaning the forward price of gold is higher than the spot price. Historically, this has made it an attractive market for forward sales by gold producers and contributed to an active and relatively liquid gold derivatives market.
Gold trading historically has taken place in an exclusive membership club apart from open trading practices in exchanges in the modern financial marketplace. In the gold market, a market-making gold dealer quotes a price for the buyer or seller who does not have the benefit of immediate direct comparison with prices offered by other market participants, which is a market dynamic buyers or sellers normally find on an exchange floor.
Gold Derivatives and ETFs
Gold market-making dealers, working closely with central bank gold desks, exercise near monopolistic control of gold prices on behalf of central banks. OTC counterparty default risk is bilateral and not assumed by exhanges that stand behind transactions on their  trading floors by regulating the performance and credit-worthiness of exchange members of good standing.  In recent decades, the spectacular growth of the largely self-regulated market for gold derivatives and gold exchange traded funds (ETFs) has resulted in increased systemic risk in the OTC gold market.
The global financial crisis that began in mid 2007 has provided impetus to move the self-regulated trading of OTC derivative contracts to Central Counterparties (CCPs), rather than the bilateral clearing that has been the practice to date. Financial regulatory reform proposals to mitigate the falling-domino chain effects of systemic risk associated with OTC derivative trading by large complex financial institutions (LCFIs) require various degrees of offloading of standardized OTC derivatives. This means either the users of derivative contracts will have to provide and hold more collateral against contracts traded bilaterally, or margin will have to be posted to CCPs to cover potential losses from counterparty defaults.
January 14, 2011
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