Friday, August 17, 2012

Interest rates and gold

Nick Rowe recently asked what the point of repoing an object was when you could just sell it, repurchasing it later. He could see three reasons. Firstly, you might repo a particluar thing because you hold it dear and want it back. It might not be available were you to simply try buying it back. Secondly, you might repo an asset because future liquidity might be an issue. Thirdly, you might repo an asset rather than sell it because future prices are uncertain. My comment used gold markets as an analogy:
Nick, I think for financial assets you are right about points 2 and 3. In gold markets, for instance, you'd rather lend or swap (ie. repo) your gold than sell it (upon the anticipation of buying it back at some future point) because you might fear that, come time to buy the gold back, the future price could be much higher, or that the gold market could be illiquid and you might not be able to buy.
Incidentally, you can also sell your gold and buy a futures contract. Selling spot and buying a futures contract is financially equivalent to swapping (repoing) gold - in both transactions you'll lock in a guaranteed price and will avoid the risk of illiquidity. So your question: why repo? is similar to the question: should I sell some asset and simultaneously buy a futures contract or sell it and take the risk of buying back at spot at some future point in time.
Some people might recognize these various gold transactions. A gold swap — a temporary exchange of gold for cash — is transacted at the GOFO (gold forward) rate. A gold loan, which is an unsecured and temporary exchange of gold for nothing but a promise to repay, is transacted at the gold lease rate.

You can actually conceptualize both transactions as swaps. In the first, gold is temporarily swapped for a liquid and safe financial promise (cash). In the second, gold is temporarily swapped for an illiquid and safe financial promise (a promise to repay the gold ie. "paper gold"). Lingo-wise a swap is no more than a repo.

The different rates at which these two swaps are conducted — GOFO and the lease rate — will be determined by the relative subjective value gold owners place on the swapped-for assets. Because liquid financial promises provide more services to their holders than illiquid promises, anyone swapping away gold will prefer the former to the latter. That's why the gold lease rate — the rate paid by the person taking the gold to the person foregoing that gold - has always been higher than GOFO. After all, the party swapping away gold needs some increased financial incentive to take the illiquid "paper gold" asset rather than the liquid cash.

Indeed, liquid and safe financial assets are so valued, and so easily storable, that in general, anyone swapping away their gold will not receive a fee for foregoing the metal. Rather, they will pay a fee for the advantages of getting cash. This fee is what GOFO represents.

These ideas can be tough to conceptualize. A while ago I caught the folks at FT Alphaville mixing them up. For instance, the author maintained that a dearth of cash in markets now meant that
since their cash had become more valuable to the market than their gold, they could now make a return from lending cash against gold, as opposed to gold against cash.
The above comment implies that the gold swap rate — cash for gold, or GOFO rate — has somehow switched. But in actuality, those swapping away cash for someone else's gold always earn a return (GOFO). This is because they are foregoing liquidity. The gold lease rate has switched, but that is a different rate, and a different story altogether.

On the topic of gold, David Glasner asks why gold markets are rising due to hyperinflation fears but bond markets aren't:
Now my question — and it’s primarily directed to all those believers in the efficient market hypothesis out there — is how does one explain the apparently inconsistent expectations underlying the bond markets and the gold markets. Should there not be a profitable trading strategy out there that would enable one to arbitrage the inconsistent expectations of the gold markets and the bond markets?
I don't think there is any discordance to explain:
I think gold prices and bond prices have been rising over the last three years for similar reasons. In general, the economy-wide expected rate of return has been falling (towards zero, perhaps below it) as investors grow fearful of the future. This pushes people into safe bonds. It also pushes them into assets like gold that have very low storage costs, since buying some easily-storable durable asset and holding it over time provides a 0% return, better than most risky alternatives which are expected to fall.
So I don’t think there are segmented expectations in these two markets, nor do I think it is worthwhile trying to arbitrage them.
Returning to the discussion of GOFO, if today's gold markets were actually dominated by those who believed in the inevitability of hyperinflation rather than (fairly) rational actors, then GOFO would be inverted... in essence, anyone who swapped away their gold for cash would expect to receive the GOFO rate rather than pay it. The current practice, as I pointed out above, is to pay that rate, not receive it. The reason for the inversion would be because the destiny of cash in a hyperinflation is demonetization and, as a result, it will lose all of its liquidity premium, whereas gold's destiny is to be remonetized and gain a relative liquidity premium. As a result, any gold-for-cash swap based on a universal expectation of hyperinflation would require whoever foregoes the benefits of gold's inevitable superior liquidity to be compensated by a return. Needless to say, GOFO has not inverted. Those foregoing  their gold still pay up to those foregoing cash.


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