The gold lease rate is the same as an interest rate in a currency. So if the lease rate is .75% for one month that means you can borrow or lend gold for one month at .75% with the interest payable in gold i.e if you borrow 100,000 ounces you will need to repay 100,062.5 ounces. Think of the lease rate as being applicable to all metal (single currency) dealing.
The forward rate is a derivative of two interest rates or in the case of a metal an interest rate and a lease rate. It is used when there is an exchange of currency and expresses the amount of a discount or premium to spot at which a forward transaction will occur. This discount or premium is roughly equivalent to the difference between the two interest rates. So if the one month gold forward rate is 5.05% and the one month lease rate is .75% that implies that one month US dollar rates are 5.80%. Any wide variance is arbitrageable.
The following example might clarify it.
Take an equivalent amount of two instruments and invest them for a period of time and then determine and forward exchange rate based on the future value. Lets say gold is $300, 1 year gold lease rates are 1% and 1 year dollar interest rates are 6%. The theory says the forward rate should be @5%.
Take 100,000 ounces of gold. Leased for one year at 1% generates a future principal and interest of 101,000 ounces. The spot dollar equivalent is $30,000,000. Invested for a year at 6% generates a future principal and interest of $31,800,000. $31,800,000/101,000 ounces = 314.8515 per ounce, a premium of 4.95%.
Given this it is easy to see how the arbitrage would enforce the relationship. For example, what would happen if spot and all the interest rates remained the same and forward rates started trading at a 10% premium? Using the above example an arbitrageur would buy 100,000 ounces of gold and lease it out for 1 year at 1% generating 101,000 ounces. He funds this purchase buy borrowing $30,000,000 for 1 year at 6 and will need to repay $31,800,000. If the forward market is a 10% premium that implies a forward rate of $330/ounce. This would allow the 101,000 ounces to be sold forward $33,330,000. The loan can then be paid off leaving a risk free profit of $1,530,000. As long as this risk free profit remains available arbitrageurs will execute this transaction until the additional forward selling pressure brings the premium down.
It works the same for currency pairs.
Henry |
