W O R L D G O L D C O U NC IL

Gold Derivatives: The market impact

A PROJECT REPORT ON A Comparative Study of Gold Price Movement in Indian and Global Market Submitted To: SIGMA INSTITUTE OF ENGINEERING STUDIES (Vadodara)

Affiliated to Gujarat Technological University, Ahmedabad IN PARTIAL FULLFILLMENT FOR THE DEGREE OF MASTER OF BUSUINESS ADMINSTRATION (MBA) PREPARED BY: UNDER THE GUIDANCE OF

Chhaun patel & .Digvijaysinh Gohil

Mrs Ujjawal Jaiswal

DECLARATION

We, the undersigned, Chhaun Patel & Digvijaysinh Gohil student of MBA SEM IV hereby declare that Project titled A Comparative Study of Gold Price Movement In Indian and Global Market is an original work carried out under the guidance of Asst.Prof Ms. Ujjawal jaiswal faculty guide of sigma institute of Engineering, MBA department, Bakrol Baroda. The empirical findings in this report are based on the data collected.

DATE:

CHHAUN. A. PATEL & DIGVIJAYSINH GOHIL

PLACE:

Vadodara

STUDENT OF MBA-II SIGMA INSTITUTE OF ENGINEERING MBA DEPARTMENT BAKROL BARODA.

PREFACE Gold has maintained its value in terms of real purchasing power in the very long run in the US, Britain, France, Germany and Japan. Despite price fluctuations gold has consistently reverted to its historic purchasing power parity with other commodities and intermediate products. In all five countries the purchasing power of gold substantially increased after the abolition of dollar convertibility in 1971 but has since reverted to an historic mean. Gold has not necessarily held its value in terms of purchasing power in periods of social and economic instability. In times of war, for example, the prices of other commodities, more directly needed for the war effort, tend to rise faster. But over the period of Germanys massive inflation of 1918-24, when the value of bonds and stocks was severely diminished, gold maintained its purchasing power. Golds liquidity, acceptability and portability are particularly important in times of crisis and may well be more important than golds rate of exchange with paper money at such times. In the US since 1971 the purchasing power of gold has increased. In 1997, the average gold price was somewhat above the level indicated by the long-term average rate of exchange with other commodities and intermediate products, as represented by the wholesale price index. The 1997 gold price was, however, broadly in line with the historic rate of exchange against the basket of goods represented by the CPI. In Britain, France, Germany and Japan, gold in recent years has been close to its historic purchasing power parity with other commodities and intermediate products. A comparison of demand and supply fundamentals for gold, both before and after 1971, suggests the surge in golds purchasing power in the 1970s was at least in part a reaction to the prolonged period during which gold had been held at a fixed price. Other factors including inflation and spikes in the prices of most commodities also played a role in the rise of golds purchasing power. Post-1971, the increased worldwide demand for gold pushed up the rate of exchange between gold and other commodities and intermediate products. The more recent increase in the supply of gold has, however, pushed golds purchasing power back towards its historic mean. Among financial assets purchased in 1896 and sold in 1996, items of cumulative wealth, gold has under-performed stocks and government bonds in the US and Britain. However, in countries such as France, where inflation has been less controlled, gold has afforded a significantly higher increase in wealth than could be gained with government bonds. In Germany and Japan, bouts of hyperinflation wiped out the value of bonds and stocks but gold maintained its purchasing power and was thus a vital safe haven. This study considers the period 1968-96 and finds that, as the real returns from holding gold were not positively correlated with those on other assets, gold would have had a useful place in a diversified portfolio. Compared to buying and selling out of a purely

equity portfolio, buying and selling out of an equity portfolio that contained gold would have afforded, on average, a higher return with decreased risk. THE AUTHOR

ACKNOWLEDGEMENT

The satisfaction and happiness that accompany the successful completion of any task would be incomplete without mentioning the people who made it possible, whose consistent guidance and encouragement crowned the efforts with success. It gives us great contentment in submitting our Grand Project report on the subject matter A Comparative Study of Gold Price Movement In Indian and Global Market, which is carried out as a partial fulfillment for the degree of Masters of Business Administration in Finance at Sigma Institute of Engineering , affiliated to Gujarat Technological University. We owe a great many thanks to a great many people who helped and supported us in completing this project. We express our thanks to the Director Dr. Y. B. Joshi for extending his support. We deeply thanks to Mrs. Ujjawal Jaiswal the Guide of the project for guiding and correcting various documents of our with attention and care. She has taken pain to go through the project and make necessary correction as and when needed.

We would also thanks to our Institution and our other faculty members without whom this project would have been a distant reality.

EXECUTIVE SUMMARY OBJECTIVES OF THE STUDY: The main objectives of present research are:

1) To study the trend of gold price movements in the post liberalization period and its relationship with international prices. 2) To find out the correlation between gold prices in both the markets. 3) To study the impact of changes in foreign exchange rates on the gold prices in Indian as well as in the international market.

RESEARCH METHODOLOGY:
STATISTICAL HYPOTHESIS:

1. To test the significance of seasonal variability of Gold prices in Indian Gold Market and International Gold Market.

2. To test the significance of the value of Karl Pearson co-efficient of

correlation between gold prices in Indian Gold Market and International Gold market.

3. To study the impact of changes in foreign exchange rates on the gold prices in Indian as well as in the international market.

PERIOD OF STUDY :

The present study is a time series study covering period from 1991-2010.This period was chosen because before 1991, the government controlled the economy of the country. The prices were not determined by the market forces but rather fixed by the government .From time to time .From 1990 onwards; the government of India started the process for globalization and liberalization. It allowed the companies to enter the Indian market and a number of other steps were also taken to make India an active member of the world region. SAMPLE STUDY: The research is mainly based on secondary data, which has been collected from various RBI Bulletins,IMF publications,Govt of india Publications and web sites of moneycontrol.com.

 STATISTICAL TECHNIQUES USED: Different statistical techniques have been used for data presentations, analysis & interpretations of results. For data presentations, trend line graphs have been used while for analysis of data; the techniques used were measures of variatioin, correlation and time series analysis. For interpreting the results of hypothesis testing, students t-test has been used.

FINDINGS:

The price of the gold is increasing these days and investment in gold bullion coins is really a worthy venture. As there is limited supply of the precious metal, the price of the gold goes high. The popularity of investment in gold bars exceeded the demand for jewellery as these days gold investment is considered to be wise compared to real estate and stock investments. Even in the days of inflation, the fundamental price for the metal remains constant. Purchasing this metal in the forms of bars is cost effective compared with jewellery. Here the prices are dependent mainly on prices in international gold market and then the exchange rate. No definite increasing or decreasing trend was observed regarding variation in monthly average gold prices during a year for both the Indian gold market and international gold market. Prices are mainly dependent on international gold market.

CONCLUSIONS: It can be concluded that in international markets, exchange rate might be the most important factor. When rates in general decrease and gold prices increases, people may go for gold purchases in case of currency depreciation. But in the Indian gold market, exchange rate variation has an effect on price. Here, the prices are dependent mainly on prices in international gold market and then the exchange rate. No definite increasing or decreasing trend observed regarding variation in monthly average gold prices during a year for both the Indian gold market & International market. After 2001, it shows an increasing trend. If monthly variations are considered, Indian

gold market has greater variability than the internal gold market. While taking into account the yearly variations in gold prices in the two markets, it was found that the Indian gold market has lesser variability than the international gold market.

SUGGESTIONS: Gold policy should be reviewed because of the following reasons: (a) We should not waste scarce foreign exchange on unproductive purposes. The recent liberalization of imports through NRI and SIL route has shown that in reality , there is no adverse impact on liberalized gold import. (b) Import on use of gold should be discouraged since it affects domestic savings adversely and implies diversion of resources for unproductive purposes. Now, even depreciating luxury goods are produced and traded in our economy: still the question remains as to why gold is discriminated .So the main objective of the new gold policy should perhaps to: Recognize the importance of gold in the Indian Economic System and enable gold to play a transparent and positive role in the industrial development, employment and export sectors of the economy. Create and nurture appropriate official regulatory framework and self regulatory trade bodies. Exploit the scope for generating revenues to the central, state, and local governments. Ensure orderly development of gold related industry in India in terms of physical standards and consumer protection.

LIMITATIONS: 1) The data which has been taken for research is totally based on research work so it may be accurate or it may not be accurate.

TABLE OF CONTENTS Sr. No. 1. TOPIC INTRODUCTION 1.1 INDUSTRY PROFILE Page No.

1.1.1 MCX 1.1.2 NCDEX 2. GOLD 1) The physical Gold Market 1.1 1.2 1.3 Production Consumption Investment

2 ) The Paper Market 2.1 What Makes Gold Special ? 2.2 Gold Derivative Contracts 2.3 The Market 3) The Debate 3. RESEARCH METHODOLOGY 3.1 Title of the project 3.2 Research Objective 3.3 Statistical Hypothesis 3.4 Period of study 3.5 Sample Study 3.6 Statistical Techniques Used 4. 5. 6. FINDINGS SUGGESTIONS CONCLUSIONS Bibliography

CHAPTER I INTRODUCTION

1.1 INDUSTRY PROFILE Trading is basically done in Stock Exchange. There are two major Stock Exchange functioning in India there are as follows. 1.1.1 MULTICOMMODITY EXCHANGE IN INDIA.

Headquartered in Mumbai, Multi Commodity Exchange of India Ltd (MCX) The demutualised Exchange set up by Financial Technologies (India) Ltd (FTIL) permanent recognition from the Government of India to facilitate online trading, and clearing and settlement operations for commodity futures across the country. Started operations in November. Market share of over 80% of the Indian commodity futures market More than 2000 registered members Over 100,000 trader work stations, across India Sixth largest and amongst the fastest growing commodity futures exchange in the world, in terms of the number of contracts traded in 2009. MCX offers more than 40 commodities across various segments such as bullion, ferrous and non-ferrous metals, and a number of agri-commodities on its platform World's largest exchange in Silver Second largest in Gold, Copper and Natural Gas Third largest in Crude Oil futures Certified to three ISO standards:- ISO 9001:2000 Quality Management System standard, ISO 14001:2004

Equity partners: Equity partners NYSE Euronext State Bank of India and its associates (SBI), NABARD National Stock Exchange of India Ltd (NSE) SBI Life Insurance Co Ltd Bank of India (BOI) Bank of Baroda (BOB) Union Bank of India, Corporation Bank, Canara Bank, HDFC Bank, Fid Fund (Mauritius) Ltd. ICICI Ventures, IL&FS Kotak Group Citi Group and Merrill Lynch. Products:

Trading @ MCX : Trading @ MCX The Trader Work Station (TWS) is the application through which members access the trading platform, place orders and execute trades. TWS offers a multitude of user friendly trading features which include commodity price ticker, market watch screen displaying best buy, best sell, and last traded price, volume for the day, open interest etc., top gainer and loser contracts, net position, and on-line backup facility Trading System: Trading System Best five buy and sell orders for every contract available for trading are visible to the market and orders are matched based on price time priority logic Orders can be placed with time conditions and/ or price conditions:- Time related Conditions DAY order:- Valid for a day, if not matched, get cancelled GTC:- Good Till Cancelled (GTC) order is an order that remains in the system until the expiry of the respective contract in which it is entered or until when the same is cancelled by the member. GTD: - A Good Till Date (GTD) order is valid till the date specified by the member. After the specified date the unexecuted orders get automatically cancelled by the system. IOC - An Immediate or Cancel (IOC) order allows a member to execute the orders as soon as the same is placed in the market, failing which the order will get cancelled immediately. 2) Price Conditions:- Limit Order The order wherein the price is to be specified while placing the same. Market Order The order at the best available price at the time of placing the same.

Margins: - MCX follows a comprehensive and stringent margining system for all future contracts traded on the Exchange platform Actual margining and position monitoring is done on an on-line basis. For the purpose of computing and levying the margins, MCX uses SPAN (Standard Portfolio Analysis of Risk) system which follows a risk-based and portfolio-based approach. Trade Verification:-Clients/ Constituents can verify trades executed on the MCX platform on the next trading day by entering minimum

information. Trade Timings: Special Session: Monday to Saturday: 9:45 a.m. to 9:59 a.m. Special Session (order cancellation session) is held to cancel the pending orders prior to opening of market Normal Session: Monday through Friday: 10:00 a.m. to 11:30 p.m. (up to 11:55 p.m. on account of day light savings typically between every November and March of the following year) Saturdays: 10:00 a.m. to 2:00 p.m. Agriculture-commodities are available for futures trading up to 5:00 p.m. whereas non agriculture-commodities (bullions, metals, energy products) are available up to 11:30 pm / 11.55pm.

Trading Holidays List of holidays in the calendar year

1.1.2 NSDEX (National Commodity & Derivatives Exchange Ltd.)

National Commodity & Derivatives Exchange Limited (NCDEX) is an online commodity exchange based in India. It was incorporated as a private limited company incorporated on 23 April 2003 under the Companies Act, 1956. It obtained its Certificate for Commencement of Business on 9 May 2003. It has commenced its operations on 15 December 2003. NCDEX is a closely held private company which is promoted by national level institutions and has an independent Board of Directors and professionals not having vested interest in commodity markets.

Founded: 15th December 2003 Headquarters: Mumbai, Maharashtra, India Consortium of Shareholders:

Jaypee Capital[1] Renuka Sugars Life Insurance Corporation of India (LIC) National Bank for Agriculture and Rural Development (NABARD) National Stock Exchange of India (NSE) Punjab National Bank (PNB)

CRISIL Limited (formerly the Credit Rating Information Services of India Limited)

Indian Farmers Fertiliser Cooperative Limited (IFFCO) Canara Bank Goldman Sachs ICE

NCDEX is a public limited company incorporated on 23 April 2003 under the Companies Act, 1956. NCDEX is regulated by Forward Market Commission (FMC) in respect of futures trading in commodities. Besides, NCDEX is subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations, which impinge on its working. On 3 February 2006, the FMC found NCDEX guilty of violating settlement price norms and ordered the exchange to fire one of their executive. NCDEX is located in Mumbai and offers facilities in more than 550 centres in India Commodities traded: NCDEX currently facilitates trading of 57 commodities Agri-based commodities - Castor Seed Chana Chilli Coffee - Arabica, Coffee - Robusta Cotton Seed Oilcake Crude Palm Oil Expeller Mustard Oil Groundnut (in shell) Groundnut Expeller Oil Guar gum Guar Seeds Gur, Jeera Jute sacking bags Kidney Beans Indian 28 mm Cotton Indian 31 mm Cotton Masoor Grain Bold Medium Staple Cotton Mentha Oil Mulberry Green Cocoons Mulberry Raw Silk Rapeseed - Mustard Seed Pepper Raw Jute RBD Palmolein

Refined Soy Oil

Rubber Sesame Seeds Soy Bean Sugar - Small Sugar - Medium Turmeric Urad (Black Matpe) V-797 Kapas Yellow Peas Yellow Red Maize Yellow Soybean Meal. Bullion Gold 1 KG Gold 100gm Silver 30 KG Silver 5 KG

Facilities offered: NCDEX also offers as an information product, an agricultural commodity index. This is a composite index, called NCDEXAGRI that converse 20 commodities currently being offered for trading by NCDEX. This is a spot-price based index. NCDEX also offers as an information product, the index futures, called FUTEXAGRI. This is essentially a what-if index. It indicates that if futures on the index could be traded, then the current FUTEXAGRI value should be the no-arbitrage value for the index futures. However, indexes and index futures are not allowed to be traded under the current regulatory structure. Hence, these are only available for information

CHAPTER 2 GOLD

INDIA HEART OF GOLD

India is the worlds largest gold consumer market and in 2010, Indian gold demand is

likely to recover near to its pre-credit crunch level following the fall in demand in 2009. This should drive gold imports up from the relatively low levels experienced last year. In 2009, total Indian gold demand reached US$19bn, or Rs874bn, accounting for 15% of the global gold market. Over the past ten years, the value of gold demand in India has increased at an average rate of 13% per year, invested in gold. Continued rapid economic growth and urbanization will create greater wealth but also inflationary pressures stimulating gold demand. Asian demand for gold will be a key driver of the gold market for decades to come. Currently, India and China together account for approximately 25% of annual gold outpacing the countrys real GDP growth by almost 6%. In India, gold is seen as a symbol of security and as a sign of prosperity. Unlike other gold markets, the love for gold has not only spread across many generations but also across all social strata within the country. Indian consumers regard gold jewellery as an investment and are well aware of golds benefits as a store of value. Gold is also recognized as a form of money in India, a tradable liquid asset. It is one of the foundation assets for Indian households and a means to accumulate wealth. At the end of 2009, Indian consumers price expectations were strengthened by the Reserve Bank of Indias purchase of 200 tonnes of gold from the IMF and the transaction reinforced the perception among local consumers that gold is reliable and safe as a monetary asset. India will remain pivotal to the global gold market. In the Indian culture, gold is an integral part of daily life where purchases of gold jewellery are considered as a form of a liquid and tradable investment for the accumulation of wealth. It is important to highlight that in analyzing the gold market in India, traditional perceptions of the division between jewellery and investment demand and demand drivers do not apply. As consumers have adjusted their price expectations upwards, a further rise in gold jewellery and investment demand could be anticipated and this trend is projected to continue over the long-run as local investors are buying gold driven by wealth accumulation motives. The fact that Indian gold jewellery and investment demand remains robust, despite the rising price emphasizes the enduring desire among local consumers to purchase gold driven mainly by its allure as a jewellery and its properties as a hedge to offset the effects of depreciation and erosion of both savings and income. The country currently has one of the highest saving rates in the world; estimated at around 30% of total income, of which 10% is demand. They are likely to grow further as a proportion of demand in years to come

In the longer term, we are confident that Indias favourable demographic trends, the growing affluent middle classes and declining age profile, should ensure buoyant consumption growth. The investment sector exhibits great potential for further growth and will play an increasingly important role in the domestic gold market as it overlaps with gold jewellery consumption, boosted by increasing accessibility and opportunities

in new gold investment products. Despite being the largest global gold consumer, Indian jewellery consumption intensity is still relatively low. Its consumption of jewellery on a per capita basis of 0.4 grams in 2009 remains below countries such as Italy and the US. This is a reflection of both the countrys large population and low incomes. The strategic outlook for India will be the subject of a subsequent report in Q1 2011.

CONTEXT
Gold is a symbol of wealth and good fortune in India and is also used for daily consumption in the form of jewellery and ornaments. Since the start of 2010, Indian gold demand has recovered well from 2009 levels amidst the global economic uncertainty. India is the largest gold market in the world. In terms of jewellery consumption,

investment and industrial demand, it accounted for nearly 600 tonnes (15%) of total global demand for gold in 2009. Based on WGC estimates, the nation owns over 18,000. tonnes of above ground gold stocks2 worth approximately US$800bn at todays gold price and represents 11% of global stock. This is equivalent to nearly half an ounce of gold ownership per capita. In 2009, total Indian gold consumption reached US$19bn or Rs974bn equivalent at the end of 2009. Over the past decade, this has increased at an average rate of 13% per year, outpacing the countrys real GDP, inflation and population growth by 6%, 8% and 12% respectively.

Gold jewellery demand in India, the worlds largest gold jewellery market, rose 67% year-on-year to 272 tonnes in the first half of 2010. Over the same period, the average domestic gold price surged to almost Rs52,800/oz, before hitting a new high of Rs60,460/oz on 15 October 2010. Despite the higher gold price, market sentiment remains positive, especially with the local gold market also benefitting from the strengthening of the rupee against the US dollar. In India gold often represents a large percentage of the family assets and during the first six months of 2010 the Indian retail investment market was one of the strongest in the world. Demand increased substantially by 264% to 93 tonnes in this period (from 25 tonnes in H1 2009) and accounted for 25% of total domestic gold demand. The recovery in Indian demand for gold investment has stemmed from an increased appetite for capital preservation among local investors, as well as for golds properties as a US dollar hedge; heightened risk aversion; and higher inflation expectations. The main participants in the domestic gold industry, including State Reserve Bank of India and commercial banks such as HDFC, India Post Office, Muthoot Pappachan Group, and gold jewellers (such as Tanishq, GRT, TBZ to name a few) provide consumers and investors with a broad range of other channels and products. These products include the sale of gold coins and bars, gold saving schemes and Swarna Varsham microfinance gold link scheme.

Indias gold Exchange Traded Funds (ETFs) market has also enjoyed further growth in recent quarters. Total holdings amounted to 11 tonnes by the end of August 2010, up 77% from the same period last year, from 6 tonnes. Gold ETFs are structured to allow the inclusion of investments other than gold for up to 10% of their assets. However, currently all the Indian ETFs are backed by physical gold. The recent growth in holdings and the development of new products suggests the Indian gold ETF market may now be maturing after a relatively slow start. However, historic figures indicate that price corrections have not triggered significant redemptions, but in fact have encouraged Investors to increase their holdings. India is currently Asias third largest economy and its recent growth compared favorably with that of China. The domestic economy has grown at an average 8% over the past four years and is projected to grow at 8.5% in FY2010 according to Reserve Bank of India (RBI). Therefore India stands out as one of the worlds fastest growing economies and based on Consensus Economics forecasts, the countrys growth forecast will reach 8.3% in FY2011. The International Monetary Fund (IMF) also expects the outlook for Indias economy to remain strong and forecasts the countrys real GDP growth to remain in excess of 8% from 2010-15, an enviable rate of growth in comparison with most other economies and the second fastest in the BRICs.3 The countrys rapid economic growth, high savings rate and favorable demographics make India an important target destination for global foreign investment. Indias foreign direct investment (FDI) inflows rose 13% year-on-year to US$1.5bn in 2009. As a result of the FDI inflows, the rupee gained 5% against the US dollar in the same period and continues to exhibit an upward trend albeit with rising volatility. It is currently one of Asias best performing currencies and there is a strong consensus that the rupee will appreciate rather than depreciate over the longer term. While the likely scale and timing of this appreciation is unclear, the implications would be positive for the Indian gold market and for the global gold demand balance. India is the worlds largest consumer of gold in tonnage terms and an appreciating rupee in a country with a strong affinity to gold is likely to stimulate higher gold demand.

JEWELLERY CONSUMPTION Gold jewellery accounted for around 75% of total Indian gold demand in 2009, the remainder being investment (23%) and decorative and industrial (2%). Indian consumers also regard gold jewellery as an investment and are well aware of golds benefit as a store of value.

Gold plays a fundamental role in the marriage ceremony, and when it comes to Indian weddings, gold is said to be considered a necessity rather than a luxury. The gold (and other gifts) the bride receives are called her Streedhan (Stree meaning woman and dhan meaning wealth) and are a means of passing on some inheritance to daughters, as Hindu tradition dictates that the familys assets are only passed down. Gold is especially important in this respect as it remains directly under a wifes control, whereas she may not be privy to the familys other financial affairs. Wedding-related demand accounts for a substantial proportion of overall jewellery demand. This is particularly true in the south of India, where the most popular wedding jewellery sets tend to be the more traditional, intricate but bulky styles in heavier weights. In the northern cities there has been a trend towards more western styles, and lighter wedding sets, as well as diamond-set pieces, are becoming increasingly popular.

In 2010, Indian gold jewellery consumption is likely to recover to near pre-credit crisis level following the fall in demand in 2009. As consumers have adjusted their price expectations upwards, a further rise in demand is anticipated. Gold jewellery demand has picked up more forcefully as initiatives from gold jewellers such as save and buy schemes have proven effective in reviving local gold jewellery demand. The saving scheme provides consumers the opportunity to purchase gold jewellery, (and, in some cases gold coins or gift vouchers as well) through easy installments. At the time of maturity, the jeweller will also contribute a bonus amount as a scheme benefit to the consumers accumulated amount. These schemes are well aligned to the culture of Indian gold demand, where the purchase of gold jewellery is also considered as a form of investment. Despite being the largest source of global gold demand, Indian jewellery consumption intensity is still relatively low. National jewellery consumption on a per capita basis was 0.4 grams in 2009, well below countries such as Italy and the US.

This is a reflection of both Indias large population and its relative poverty compared to most other key gold markets. According to IHS Global Insight, only 356 million of the Indian population lived in cities in 2009. IHS Global Insight expects the urban population to reach 468 million (i.e. an additional 112 million) in 2020, hence providing more room for growth and improvement in the standards of living through urbanisation. It is also worth noting that a unique feature of the Indian market is that the average age of the population is younger than in Europe and the United States. In the longer term, Indias favourable demographic and age profile are likely to ensure buoyant consumption growth, especially given the existing strong affinity to gold in Indian Culture. The improving economic position of many domestic consumers will also play a part in determining demand for gold in coming years.

INVESTMENT DEMAND
In India, gold is one of the foundation assets for Indian households in the form of both jewellery and investment. It is viewed as a secure, liquid investment, a capital and value preserver and is the second preferred investment after bank deposits. Saving rates are estimated at around 30% of total income of which we believe around 10% is invested in gold. Whilst it is a fact that the traditional divisions between gold jewellery and investment overlap in India, during the first half of 2010, Indian net retail investment in gold has increased by 264% year-on-year to 93 tonnes. Net retail investment comprises individuals purchases of coins and bars and accounted for 25% of Indian gold demand in the same period. There is a growing domestic interest in gold investment, stimulated by a high savings ratio and the increasing gold investment opportunities available to Indian investors. 1. Golds characteristics inspires confidence to invest Diversification. Analysis of correlations between gold and key domestic financial assets over one-, three- and five-year periods suggests that there is no significant relationship between gold and Indian stocks, which makes it an ideal addition to achieve a diversified portfolio. US dollar hedge. Gold is traditionally a good hedge in the event of depreciation in the value of the US dollar against other currencies. Since the Indian rupee is also not fully convertible, gold is one of the limited ways in which Indian investors can diversify their currency exposure.

Volatility. In our analysis of gold and selected equity indices in India, gold has consistently moved independently from the factors that have driven the main equity markets and has exhibited lower volatility. BSE Sensex 30 Index, BSE500 Index and BSE Metal Index, for example, have had annualised volatilities of 27%, 30% and 46%, respectively, over the past five years (based on weekly returns ending September 2010). The volatility of gold over the same period was just 23% in rupee terms. As an asset class, gold has outperformed selected domestic equity indices and has provided an average annual rate of return of 37% over the five year period ending 30 September 2010 compared to returns for the BSE Sensex 30 Index of just 1% over the same period.

Inflationary pressures are expected to rise in India. Gold has the added virtue of being an acknowledged inflation hedge. Inflation is an ongoing concern in India as it erodes the valueof savings. The individuals purchasing power especially that of the lower middle class in India, reduces significantly as they have to pay more for necessary goods and services. According to IMF, inflation in India will average 13% and 6% in FY2010 and FY2011 respectively.

Real interest rates are also influencing household savings in India. Although the base rate has recently been raised to 8.5% by the Indian central bank, we believe that the yield on cash is still unattractive, since the real interest rate remains negative thanks to the high inflation rate.

The recent growth in holdings and the development of new products suggests that, after a slow start, banks and financial institutions are getting ready to launch new gold ETFs and gold schemes in the worlds largest gold consumer market. Most recently, State of Bank of India (SBI) and Religare. Innovated in the ETF space with the launch of the SBI Gold Exchange Traded Scheme and Religare Gold Exchange Traded Fund respectively. The WGC believes there is a strong case for growth in gold ETFs, given the appetite for gold

Although it is too early to tell whether holdings are sticky or long-term in nature, historic figures suggest that price corrections have not triggered significant redemptions, but in fact have encouraged investors to increase their holdings. An exception to this occurred in February 2009 when total Indian gold ETF redemptions reached 40% (a decrease of 2 tonnes in holdings) due to a 15% month-on-month spike in the local gold price during the global credit crisis. However, this event in turn highlights the liquidity aspect of holding gold in the form of an ETF.

Gold ETFs in India are structured to allow the inclusion of Investments other than gold for up to 10% of their assets. However, currently all the Indian ETFs are backed by physical gold.

3. INDIA POST GOLD RETAIL PROGRAMME In October 2008, India Post, the countrys national postal service, launched a pilot project with the WGC and Reliance Money to sell certified gold coins through its post office network in 100 outlets in four states (Delhi, Maharashtra, Tamil Nadu and Gujarat). Reliance Money acts as vendor for the project, which involves 99.99% pure gold coins in 0.5 gram, one gram, five gram and eight gram denominations. The India Post gold retail programme extended to 700 post offices across India due to ongoing strong demand. In May 2010, the WGC also launched the India Post branded gold medallion.

4. GOLD-LINKED MICROFINANCE SCHEME

The Gold-linked Microfinance scheme was initiated by the WGC in 2008 and is an effective savings instrument in the rural part of India, which is the largest proportion of the Indian population. According to Basic Statistical Returns (BSR) and RBI, only 21% of rural India has access to formal financial services due to lack of physical and social infrastructure in rural area.4 Currently, WGC is running projects in India in association with The Muthoot Pappachan Group under the Swarna Varsham Scheme and also with the Kshetriya Financial Services (KGFS) of IFMR Holdings Pvt. Ltd. and Mimo Finance of Mimoza Enterprise Finance Pvt Ltd. This scheme helps to make good quality gold accessible and, more importantly, affordable to the daily wage earners like agricultural labourers, vegetable vendors, fisherwomen, etc who comprise the Bottom of the Pyramid (BOP) in the Indian population segment. These individuals have the desire to save in gold, not only to preserve their wealth against unexpected calamities, but also to fulfil their future family obligations, such as a daughters Wedding, the purchase of a new housing shelter or funding their childrens education. .

We expect that increased accessibility and the availability of new gold investment products will act as a catalyst for further growth in Indian gold investment demand. We believe Indian investors are likely to save more and increasingly be more cautious in their investment decisions. We also believe that Indian investors will continue to move into gold as an insurance policy to protect their wealth in the aftermath of the global financial crisis since there are few assets that have the ability to hold their value during extreme conditions. Over the medium term, even as economic conditions improve, uncertainty is likely to remain high; not just economic uncertainty, but also currency and inflation uncertainty. That uncertainty is expected to be favourable for gold as an asset class amongst Indian investors

Decorative and industrial demand Since 1992, approximately 22 tonnes of gold per annum have been used in domestic decorative and industrial applications. This sector accounted for nearly 3% of Indian gold demand in 2009. Industrial and decorative demand for gold in the country is driven primarily by the use of jari, a gold thread used in clothing (particularly in the weaving of wedding saris

The rise in the price of gold over recent years has had a mixed impact on these two components of demand. Demand for jari has been steadily eroded by budget constraints as the rising price of gold has underpinned a trend for substitution to more affordable artificial jari. Demand for gold used in plating salts, however, has responded more positively to the rise in the gold price in recent years. Demand for costume jewellery has been boosted by the rising price of gold. Given the relatively low weights of gold that would be included in a plated jewellery set compared with a pure gold set of the same design, costume jewellery sets are much more affordable to the majority of budgetconscious Indian consumers. This is because the value of the gold contained in these

products is low compared to the value of the product, thus the use of gold in these applications is deemed price inelastic. However, the decision to move into imitation or plated jewellery is typically made by necessity, rather than choice. The imitation gold jewellery that is produced in India is not the equivalent of costume jewellery in the west it is a very close copy of 22k jewellery and the desire of the Indian consumer is to own the real thing, but affordability may dictate otherwise.

There is also growth in the electronics manufacturing sector in India, particularly in regions such as Bangalore and this may well provide an additional driver for gold demand in the coming years. This will be based on gold-bearing materials in electronic microchips, connectors and contacts. Indian consumer demand for products and devices like the iPhone, which contains these components will be supportive of this trend

We believe that there is room for recovery in this sector. The recent demand performance is seen as a trough, given the increasing acceptance of higher prices, the recovering global economic outlook and improving domestic living standards.

GOLD IMPORTS
Indian gold imports play an important role in the domestic gold market since India currently produces around 0.5% of its annual gold consumption. The value of annual gold imports increased by 1,015% between 1992 and 2009. In 1992, gold imports were approximately Rs88bn, this increased to Rs881bn by the end of 2009. The WGC believes that anecdotal evidence regarding current gold demand trends in India indicates a robust year-on- year recovery in imports from 2009 levels.

SEASONALITY AND MONSOON RAINS SEASONALITY

Aggregate Indian gold demand has an underlying seasonality. However, demand in each state seems to be dictated by its own marriage, monsoon and harvest season. The Hindu calendar is marked by a series of religious festivals and auspicious occasions for buying gold which are unique to each individual state. Similarly there are a number specific days that are considered inauspicious for gold purchases. Based on our observation of historic trends, the most active gold jewellery buying period is during the winter wedding season, from beginning of September to March. Although there is no perfect rule of thumb to seasonality, our analysis of five-year and ten-year average seasonality trends, to year-end 2009, shows that January, February, September and November have been the strongest months for the rupee gold price.

MONSOON RAINS
Historically, Indian gold demand has also been impacted by the monsoon rains. This is because they provide the main source of water for more than half of Indian farms and the return of the rains boosts rural incomes. During the first half of 2010, news of a good monsoon season and weak stock performance partly set the scene for the recent improvement in gold demand.

We expect local consumers and fabricators will now increasingly be purchasing or restocking on dips in the gold price rather than during the traditional auspicious period, weakening the influence of seasonal factors. In the past, local consumers have typically been reluctant to purchase gold during periods of high volatility for fear that they buy and then find that the price falls.

However, the ongoing strengthening in the local gold price seems to have increased price expectations among domestic consumers and may have encouraged buyers to accelerate their purchases in Anticipation of a further price appreciation. For example, local consumers have recently been buying gold even in inauspicious times such as the Hindus Pitrapaksha period in order to avoid the rush and potential rising price during the Navratri, Dhanteras, Diwali festivals and the Non-Resident Indian wedding season later in the year.

CENTRAL BANK THE RESERVE BANK OF INDIA

Recent developments have seen the Reserve Bank of India (RBI) purchasing 200 tonnes of gold from the IMF as a result of partially restoring a prior relationship within its reserves.The deal was completed in October 2009, when the gold price was trading around Rs 49,000/oz (or US$1,048), and was announced in early November 2009. The IMF had identified 403 tonnes of gold for sale to other members of the official sector community and the RBI was the first institution to take up the offer, buying almost half of the entire amount for sale. Since 1998, the RBIs holdings of gold had remained unchanged at 358 tonnes until the purchase in Q4 2009 when gold reserves rose by 56% to 558 tonnes5. The RBIs action has reinforced the perception among Indian consumers that gold is reliable and may have helped to reinforce the belief that prices are well supported at this level for the Long-term and, as a result, may underpin the continued positive sentiment of Indian consumers towards gold on behalf of Indian consumers. The RBIs gold reserves accounted for7% of RBIs total reserves of US$284bn as at the end of June 2010,

although this is still below the recent recorded peak of 9% in Q2 2000. For gold holdings to return to this level, we believe the RBI would need to purchase around 90 tonnes at todays gold price. The RBI like most other central banks has substantial holdings in US dollars and Euros. Over the past 2 years, the US dollar has depreciated against the Indian Rupee, as well as against other major currencies such as the Yen, Sterling and the Euro, and has not fared well as a preserver of capital. As illustrated earlier, gold has historically been an effective hedge against the depreciation of the US dollar. With ongoing uncertainties surrounding the worlds major currencies, the WGC believes the search for alternative international asset choices within the central bank sector should clearly involve a consideration of gold.

RECYCLED GOLD SUPPLY

Since 1992, Indians have recycled an average of 92 tonnes of gold per annum. In 2009, the supply of domestic recycled gold rose 29% to 116 tonnes while domestic gold demand fell by 19%. Historically, recycling activity has been sensitive to general economic conditions, the price of gold and price expectations. This is attributable to the fact that gold functions both as savings and as a form of money in India i.e. gold is a tradable, liquid asset. However, we believe that amidst the recovery in domestic gold demand, a considerably higher price will be required to stimulate another wave of recycling activity to flush out additional supplies of old gold.

In the long-term, we believe that recycling activity will continue to play an important role in the domestic gold market especially given the substantial estimated stock of over 18,000 tonnes owned in India. Sales of existing gold assets give consumers the benefit of liquidity and recycled gold is also expected to continue to provide flows of gold supply to meet demand.

CHAPTER 2

THE PAPER MARKET

The chapter describesthe nature and operation of the derivatives market in gold. The main conclusion from the chapte are set out below while the s r , subsequen section set out the reasoningin more detail: t s G oldsupportsa largeand active derivativesmarket. In part this is becauseof the very qualitie which made it so widely used as money its high value per s unit weight its indestructibility the ease with which its qualit can be , , y standardize and verified. But more important than this has been the d existenceof large stocksof gold, and the readinessof its owners largelyin the official sector to lend it. The availability of abundan stocks for t borrow in at low and generall stable rates, has made it possibleto design g y derivativ product which meet the requirement of producers fabricators, e s s , speculator and other market participant (2.1). s s The most important derivativ product is the forward contract A e . forward sale is equivalen to borrowin gold, selling it on the spot market, t g and depositin the sale proceedsin a bank account. The forward dollar g price of gold is determinedb y the spot price of gold, the cost of borrowin g dollar and the cost of borrowin gold (II.2.1). s g There is a wide variety of more comple derivative traded. Modern x s option pricing theoryshowshow such contractscan be replicatedor hedged by dynamic trading of forward contracts that is strategiesw here the number of forward contracts held depend on the level of the gold price s (2.2.2). The exchange traded market COMEX provides a good indication of sentiment. But most derivatives trading takes placeover-the-counter(OTC). The notional value of banks derivative position in gold, though large relativ e to their other commodity exposures, does look large relative to derivative not positions in other financial mar- kets. The evidenc is consisten with the e t estimate in the Cross Repor of the size of the gold lending market (2.3). s t For downstrea users and p roc esso r of gold (e.g. fabricators refiner and m s , s wholesalers) the benefits of being able to borrow gold are straightforward. Their profit mar- gins are low relative to the value of gold inventory they hold, and can easily be wiped out by adverse price movements Borrowin gold, or . g financin their inventor through gold linked borrowing, can largely remove g y exposureto gold price risk. The fact that lease rates are low and stable means that the co st and risks associated with carryinghigh level of inventory can be s kept small (2.4).

 For speculators, derivative market has made it cheap and easy to sell the gold short. One of the risks facing a short sellerof commoditiess a squeezein i the cash market which raises borrowin r a t e s for the commodit steeply and g y , thus force premature and costly liquidation of a potentially profitable s position. In the case of gold, the existenceof substantial stocks available for lending makes borrowing co sts fairly pre- dictabl and a squeez unlikel e e y (2.5). Comm ercialbanks perfor the standar economi function of a financial m d c s intermediary in any market. They manage the mismatch between lenders and borrowers mismatch of maturity, of lending rates and of credit. They also design and create comple structure which they hedge into the market. x s While they do take risk, they are not well set up to take market risk (e.g. on the level of the gold price) and are likely to hedge much market risk back into the market (2.6) . the derivative markets provide producers with a rich array of risk managementinstruments.Risk management a number of different objectives hedging has value, hedgin earning and hedging cash flow and the balance between g s them is a matter of judgement. The size of a producers hedgebook is likely to be influencedheavilyby managements view of the likely profitabilityof the transaction(2.7.1). accounting u l e s affect the size and compositionof hedge books. While the r newly IntroducedUS AccountingStandard (FAS133) will probablynot affect the amount of hedging it may well influence the instrument used. Cash , s flow and financing considerationswill limit the size of hedge books for more highly leveragedproducers (2.7.2-3). the complexit of individua produce hedge books and their long maturitie y l r s may give a misleadingidea of the economicimpact of producerhedgingas a whole. Much of the optionality nets out; over-simplifyingsomewhat, the options bought by one pro- ducer are effectivel written by anothe y r producer albeit with slightl differen terms. The long maturitiesof producer , y t hedge books are more of a reflection of an accounting decision to defer recognitionof the profits or lossesfrom particulartransactions yearsinto the future rather than of the transferof long-term forward price risk. From an economi perspective the main impact of the hedge book is fairly well c , reflecte by the effectiveshort positionor delta of the book (2.7.3). d

2.1 What makes gold special?

Gold supports a very active derivative market. In no other commodity s do pro- ducers routinely sell their output five years ahead or more. According to the Bank for International Settlements, gold derivatives account for 45% of the com- modity derivative exposure of banks in s the G10 countries. What features make gold so special? Gold has certain qualities which have made it synonymous with money for many generations, and these go some way to explaining the flourishing derivatives mar- ket. Gold is valuable 50,000 times as valuable tonne for tonne as oil for example and does not deteriorate over time. Quality is easy to verify, and it is cheap to transform one traded form into another. Costs of storage and transport are small when expressed as a percentage of value. This means that the gold market is a single integrated market, with price differentials for location or quality being far less significant and less variable than they are for most other commodities. A change in the price of London good delivery gold bars has a direct and

proportionate effect on the value of the inventory of a Far Eastern jeweler. Shocks in one part of the market are transmitted and absorbed throughout the world. Users and producers can all hedge or manage the same risk using the same con- tract; liquidity is pooled. But at least as important has been a second distinguishing feature of gold: the extent of above ground stocks, and the reasons for which they are held. In other commodities stocks are held either because they are necessary work in progress, or as a safeguard against a future shortage. The holders of these stocks place substantial value on having physical possessio of the commodity. As the likelihood of a shortage looms and n recedes, so does the value of the stock as a safeguard. When there is a glut, stocks become a nuisance. This means that the lease rate for most commodities is extremely volatile. Gold is different. For many holders of gold, physical possession of the metal is not important. The difference between possession of the gold and a warrant giving entitlement to delivery of the gold in a month or two is mainly a question of credit risk. The actual convenience yield the benefit they ascribe to holding physical gold is low or even slightly negative once storage costs are taken into account. For other holders of gold, both in the official sector and the private sector, physi- cal possession is central to the reason for holding gold. They want to hold gold precisely because it is an asset which is no one elses liability, and this advantage would be lost by lending the gold. The behavior of the gold lending market over the course of the 1990s suggests that once a central bank has put in place a policy of lending gold, the amount of gold it is prepared to lend within its predetermined policy limits is largely insensitive to the level of lease rates. But it does take time for a new policy to be put in place, or for an existing policy to be revised. Whether it is reasonable to expect gold interest rates to remain as low and stable in the future as they have been in the past is a matter we turn to later (in Chapter 5). But, as we will argue in the next section, it is the stability and predictability of gold interest rates that has underpinned the development of the paper market and the growth in particular of very long-dated contracts.

2.2 Gold derivative contracts The variety and complexity of derivative products and hedge books is consider- able. They are designed to achieve a variety of objectives economic, financial, accounting, and regulatory. In this section we focus particularly on the economic analysis of these products. We look at the types of risk which are transferred from the buyers of derivative to the s sellers. We show that, however complex the structure, the main gold specific risks which are transferred can be decomposed into spot gold price risk, gold interest rate risk and gold price volatility risk. In addition gold derivative often transfer currency interest rate and s exchange rate risks, but these risks are of less relevanc to this study. e The simplest derivative contract is the fixed price forward contract. After showing how it can be decomposed into a spot transaction and gold and cash borrowing and lending, we consider the nature and magnitude of the risks transferred be- tween the buyer and the seller. Then we extend the analysis to more complex products such as options, and examine the link between complex derivatives and trading strategies involving simple forward contracts.

2.2.1 F O R W A R D CONTRACTS The relation between forward markets and lending markets In a forward contract one party contract with another to deliver a fixed quantity of the commodity at some fixed price and date to a second party. The party who is delivering is short the contract and the one who is buying is long the contract. A forward sale is equivalent to borrowing the commodity, selling it on the spot market and investing the cash proceeds. So for example a producer who wants to sell 1 million ounces of gold forward one year, when the spot price is currently $300/oz, could instead search for an investor who has gold and is prepared to lend 1 million ounces for one year at a cash interest rate of 2%. The producer borrows the gold and sells it on the spot market. He invests the proceeds of $300m in a 1 year US Treasury bond, yielding say 7%. In one year the bond matures giving $321m. The producer then gives the investor 1 million ounces of gold and $6m interest to repay the loan. The net effect is that the gold producer hands over 1 million ounces of gold in one years time, and receives cash of $321 - 6 = $315 million. The producer has created a synthetic forward contract at $315/oz. The forward price is the spot price plus the dollar interest rate, less the gold interest rate.

The equivalence of the two transactions is important because it ties the forward market to the gold lending market. With a deep and liquid gold lending market

there is a deep and liquid forward market, going out at least as far as the gold lending market. Much of the lending of gold by central banks is short-term typically out to three months, though the average tenor has been increasing. The existence of a long-term gold forward market in the absence of a long-term gold lending market depends on the expectation that gold interest rates will remain low and stable. To see this, suppose the producer wants to sell gold five years forward, and the gold lending market only extends one year. He decides to create a synthetic forward contract by borrowing the gold for one year at a time, using the new gold loan to pay back the old. The final price he gets for the gold will equal the initial spot price plus the five year dollar interest rate less the cost of borrowing the gold for the five years. If the cost of borrowing is unpredictable, the price is very uncertain. But the uncertainty about the average level of the one year gold interest rate over the next five years is probably of the order of %, so the uncertainty in the realised forward price is around 2-3%. The gold producer can create a synthetic long-term forward contract using the short term lending market, and thereby get rid of the great bulk of the price risk he otherwise faces. The idea of a producer using a synthetic forward contract may seem unrealistic. In practice, the producer is more likely to seek to sell the gold forward to a bank. But the hedging issue does not disappear. In the absence of a counterparty who wants to buy the gold forward five years, the bank will hedge its risk by short term gold borrowing. The bank then takes on the risk that gold interest rates will rise. A producer who wants to sell production forward therefore faces a choice: he can pass the gold lease rate risk on to the bank and get a fixed price forward contract, or he can accept a forward contract where the price is adjusted in line with lease rates, and he bears the lease rate risk. The fixed price deal will probably prove more expensive since long-term lease rates are on average higher than short- term lease rates. Whether the bank writes a contract with a fixed lease rate, taking on the lease rate risk, or whether the producer agrees to keep the risk by accepting a floating lease rate, the point is the same. It is only because the risk is small, because gold interest rates are so stable, that it makes sense to do the transaction at all in the absence of a long-term forward buyer of gold. Were gold interest rates as volatile as oil interest rates, the final price on a long-term floating lease rate forward sale contract would be so uncertain that it would be quite ineffective in hedging fu- ture revenues. The premium a bank would charge to offer a fixed rate deal would tend to be so large as to make hedging unattractive. It follows that if the gold lending market were expected to become much more volatile, the long maturity derivative market would shrink s

The value of a forward contract A forward contract written at market prices has zero financial value initially. Some- one who has sold production forward, can negate the contract either by cancellation or by buying gold forward on the same terms. But as time passes, and the gold spot price and gold and dollar interest rates move, the forward price of gold changes and the contract becomes an asset to one side and a liability to the other. From the perspective of a producer who has sold known production forward this change in value may not seem significant. Any change in value of the forward contract is exactly offset by a change in the value of his future output. But there are at least three reasons why the change in the value of the forward contract is important. First, it represents the effect of hedging as opposed to not hedging. Second, it may create financing problems. Suppose the forward price has risen since the inception of the contract, so the hedge is loss-making from the producers perspective. From the banks perspective, the contract with the producer is now an asset, while the hedging transaction it has entered into to offset the risk is an equal and opposite liability. If the producer were to get into financial difficulties and be unable to honour the forward sale, the value of the contract is the amount which the bank stands to lose. To protect itself, the bank may demand margin (a financial payment on account), or collateral (the posting of some asset as security) or even the right to terminate the contract prematurely. The third reason that the value is important is that it can actually be realised. It is far easier and cheaper to buy gold forward and then sell it than it is to buy a gold mine and then sell it. It is the low level of transactions costs which allows producers to modify their hedges rapidly. The value of a forward sale contract can be realised by terminating it or by entering into an offsetting purchase contract. To get some idea of the sensitivity of a forward contract to changes in market conditions, consider the case of a producer who has sold gold forward five years at a fixed price when the spot price is $300/oz, and gold and dollar interest rates are 2% and 7% respectively The fair forward price is $381/oz. If . the spot gold price rises by $30/oz (a typical annual move) then the fair forward price in five years rises to 330x(1.07/1.02)5 = $419/oz. The producer is committed to selling his gold in five years at $381/oz when the fair forward price today is $419/oz. To cancel the hedge, the producer would have to agree today to buy the gold back at $419/oz, locking in a loss of $38/oz in five years time. Discounting the $38/ oz, the hedge has a negative value of $27/oz today. Of course, if the gold price had fallen $30/oz, the hedge contract would have a positive value of $27/oz to the producer.

But it is not only the gold price that can affect the value of the contract. If dollar interest rates go up 1% (again, a typical annual move) while spot gold stays at $300/oz, the fair forward price rises to $399/oz, and the hedge contracts value goes to +$12/oz. The mark-to-market value of a long-dated fixed dollar rate forward has a sensitivity to interest rates which is not much less than its sensitivity to the gold price. If the dollar rate is floating, the sensitivity of value to interest rates becomes virtually zero, in exactly the same way as the sensitivity of value of a bond to interest rates is large for long-dated fixed rate bonds, but small for float ing rate bonds. An increase in the long-term gold interest rate would have an effect similar in magnitude but opposite in sign to an increase in interest rates. The mark-tomarket value of a forward contract with a floating gold interest rate would have virtually no sensitivity to gold lease rates. Thus looking from the perspective of the value of the hedge book as opposed to the realised price at maturity, the floating rate forwards may be less risky than the fixed rate forwards. 2.2.2 Options In addition to simple forward contracts, there are many more complex products which are used by participants in the market. We have argued that long-dated forward contracts would not exist if they could not be hedged or synthesized reasonably accurately using the spot and short-term gold lending market. The same holds true of more complex products.

Hedging options Consider the case of a producer who wants to buy a put option, giving the right to sell gold in five years time at $300/oz. The bank writing the option will only be able to offer a good price if it can either find some other party who is prepared to sell the bank a similar option, or if the bank can hedge itself. Writing the option and taking the risk on its own books makes no economic sense; the bank has no advantages and some disadvantage relative to a gold producer in taking this risk on itself. s To hedge the risk, the bank will follow what is called a delta hedging strategy. The value of the put option depends on the level of the gold price. If the gold price is very low, the option is deep in the money, and very likely to be exercised so a $1 change in the gold price causes a $1 , change in the value of the put. As the gold price rises, the chance of the option being exercised falls, so the sensitivity to the gold price (or delta) is smaller. When the gold price is very high, the put option is nearly worthless and its price barely changes with the gold price; its delta goes to zero. If the bank sells gold forward, and varies the amount with the delta, then it can ensure that profits or losses on its option position occasioned by movements in the underlying gold price are offset by profits or losses on its gold forward Position. In an ideal world, if the hedge is executed properly, the bank should be perfectly hedged. All the risk that the producer is transferring to the bank is transferred into the forward market, and thence into the spot and lending market.

Another way of looking at the transaction is to observe that a producer who wants to create a floor on sale proceeds while remaining exposed to the upside could buy a put option from a bank. Alternativel he could y follow a suitable trading strategy in the forward market. He should sell some of his production forward; as the gold price rises, he should buy forward, and as it falls he should sell forward. If the gold price falls sufficiently, he should sell all his production forward, thus locking in a floor price for his production. If the gold price rises sufficientl he should y buy back all the forward contracts he had sold at the outset, and thus be fully exposed to the gold price. In this way the producer could create a synthetic put option. The producer then has the choice between this synthetic put option and buying a real put option from a bank which will then create a synthetic put to hedge itself. It is possible to see the producer, through the put option contract, in effect delegating the operation of the dynamic trading strategy to the bank. Whether it buys the put options or synthesise it, the s net effect on the forward market is the same. When the position is put on, the producer is directly or indirectly selling a quantity of gold forward equal to the product of the amount optioned and the delta. As the gold price rises or falls, the forward sale position declines or increases with the delta. Hedge error In theory, given certain assumptions1, the delta hedging strategy works perfectly. But in practice the assumptions do not hold perfectly, and there can be substan- tial hedge error. In particular, the efficacy of the strategy depends on the volatility in the gold price. If the price turns out to be very volatile, the synthetic strategy, which involves buying whenever the price rises, and selling whenever it falls, will be very expensive A bank . which writes a put option and hedges itself prices in a certain assumption about volatility. It makes a profit or loss on the hedge depending on whether the actual volatility is lower or higher than that factored into the original price (the implied volatility). For this reason, the writer of a put option is said to be selling volatility, and the buyer of the option is buying volatility. A similar analysis holds for call options, except that the buyer of a call option is long gold, whereas a buyer of a put is short gold. But both put and call option buyers are buying volatility, for in both cases the replicating strategy involves buying as prices rise and selling as they fall.

Volatility is not the only factor which gives rise to hedge error. The error is also affected by the detailed way the forward gold price behaves. Large jumps in the price for example can throw out the hedge. But volatility is the main determinant of how well the hedge works. Although we have looked at the particular example of a simple put strategy, the same is true of any option, whether a vanilla option like a put or call, or a more exotic structure such as one where the pay-out is conditioned by the price of gold hitting some critical level. To every option there corresponds a delta hedging strategy which replicates the option. The existence of the strategy makes it possible for the bank to offer the complex option, and also determines the price it must charge to cover its costs. If the bank is fully hedged into the spot gold market at all times then the existence of the option gives rise to a corresponding position on the spot market equal in size to the options delta. 2.3 THE MARKETS 2.3.1 Exchanges Trading in gold derivative takes place both over the counter and on s organised exchanges. The majority of exchange traded volume is on the New York Mercan- tile Exchange (NYMEX) in its COMEX division. Both futures and options are traded with maturities going out as far as five years for the futures and two years for the options. Actual delivery consists of the transfer of a COMEX warehouse receipt. The next largest exchange for gold derivative is the Tokyo Commodity Exchange which s has about one third the volume of COMEX. As is typical of futures markets the great majority of contracts are closed out before delivery. Virtually all trading takes place in the neardated contracts those with up to six months to maturity. Average daily futures volume on COMEX is some 35,000 contracts, corresponding to 100 tonnes per day or 25,000 tonnes per year. Average volume in the options market is around 20% of that in the futures in terms of numbers of contracts or quantity of underlying metal.

While this may sound large relative to annual new mined production of

just over 2,000 tonnes, very high volumes as a result of incessant shortterm trading are a feature of all derivative markets. A somewhat better s indicator of the economic significanc of the market is given by the open e interest the number of contracts in existence at any one point in time. This average around 150,000 contracts in the futures market, or 450 s tonnes. It should not be assumed that this means that there are longs who are collectivel long 450 tonnes of gold and shorts who are y collectively short 450 tonnes. Some traders will hold both long and short positions (in different maturities) to exploit movements in calendar spreads. Others will have an offsetting position in the options market or the over-the-counter market, or in one of the other commodity markets. The open interest in the options market is around twice as large as in the futures when measured in terms of numbers of contracts; in terms of delta of the underlying it is of the same order as the futures. A widely followed indicator is the net position of non-commercial traders in the options and futures market. This is often interpreted as being the aggregate position of individuals and hedge funds that are using the exchange to speculate on gold. The other side of the market, the commercial interest, is then assumed to be taken by hedgers who transmit the net demand to the spot market. If this interpretation is taken at face value then the change in the net non-commercial position represents a source of supply or demand for gold. Since annual swings in the net position rarely exceed 50 tonnes, the futures market can best be seen as an indicator of market sentiment rather than an important source of supply in its own right

. Speculative Positions and Gold Price Net positions on COMEX Contracts '000s 70 Long 50 30 10 -10 -30 -50 -70 -90 Sho rt Jan-97 Gold price Gold Price US$/oz 410 Contra cts 390 370 350 330 310 290 270 250 Jan-98 Jan-99 Jan-00

Source:CFTC/World Gold Council It is noteworthy that the volume of gold futures trading on COMEX, measured in contracts, has not changed significantl over the last y decade. It has not been affected by the large rise in producer hedging.

2.3.2 O v e r -the-counter market Much the greater part of derivative activity in gold takes place in the s over-the- counter market. The Bank for International Settlements produces a report on the Aggregate derivative position of the major banks in the G10 group of s countries at the end of each half year. Gold derivative are separatel s y identified. The report shows that the notional value of outstanding contracts in gold at end June 2000 was $262 billion. This corresponds to about 27,000 tonnes of gold. The notional value of outstanding contracts is a similar concept to the open inters- est in an exchange traded market. It gives no indication of the net long- or short- position of the banking sector. But it does highlight the important role of the OTC market relative to the exchange traded market. It is not possible to compare this notional value figure of 27,000 tonnes directly with the estimate in the Cross Report that 5,230 tonnes of gold were lent at the end of 1999. But the two figures do not appear inconsistent. Most of the deriva- tives market is intermediated by G10 banks. A forward sale of one tonne would count once; a strategy of buying a put option on one tonne and writing a call on one tonne would count twice. But then the bank writing the contract has to manage the position. This might well involve a forward contract with another bank, or a lease rate swap to manage the lease rate risk. Each of these would add to the notional value figure even though all that is happening is that risk is being transferred within the banking sector. The bank writing the original contract may well need to trade subsequently just to manage its changing risk over time. Thus a derivative contract between a bank and a customer may generate trades in the inter-bank market with a notional value which is several times the value of the original contract. Thus a ratio of 5:1 between gold lending and the notional value of banks derivative exposure is not at all implausible. Further insight into the magnitude can be obtained by comparing banks deriva- tive exposure in gold and in other markets:

Global Over-the-CounterDerivativesMarketsend-June 2000 Notional amount (US$ billion) Gold 262 0.32% Other commodities 323 0.39% Foreign exchange 15,494 18.92% Interest rate 64,125 78.32% Equity 1,671 2.04% 81,875 100% Total2 Source: BIS, November 2000 2 This excludes the BIS other category which is their estimate of the position in all markets of non- reporting institutions. This amounted to $12,163 billion. There is no reason to believe that gold figures more importantly in the positions of non-reporting institutions than in those which report to BIS.

Looking at gold as a commodity, it supports an unusually large and active deriva- tives market. Gold derivative comprise 45% of banks s commodity derivatives books. The reasons for this were discussed above. Gold in many ways resemble a financial asset rather than a commodity. s Comparing gold with currencies, the size of positions does not look unusually large.

The BIS data explicitly break out the exposure to the US dollar, euro, yen, Swiss franc, UK pound, Canadian dollar and Swedish krona. The krona is the smallest of them, yet the notional value of banks derivative position in foreign exchange contracts involving the Swedish Krona at the end of June 2000 was 70% higher than in gold3. To get some, very rough, insight into the size of the derivative market relative to the level of real activity underlying it, it is interesting to note that the notional value of banks krona derivatives book is equivalent to seven years of Swedish imports. The notional value of their gold derivative s book is equivalent to twelve years of gold production.

Another important source of information about the OTC derivative s

market is the Office for the Comptroller of the Currency which monitors the derivatives exposure of US commercial banks. The OCC shows that in the second quarter of 2000, the notional amount of US Commercial Banks exposure in gold derivatives was $92 billion, or 35% of the BIS figure, suggesting that the balance was due to non-US banks and to US investment banks. The OCC figures also show how concentrated the market is: over 80% of the notional value on the books of the commercial banks is due to just three (Chase, Morgan Guaranty and Citibank). In London, which is one of the main centres for these trades, the London Bullion Market Association has just eleven market-making members who include two of the three big US commercial banks, as well as a number of major international banks.

CHAPTER 3: THE DEBATE It is believedby many that the weaknessin the gold price over the last decadehas been due, at least in part, to the growth of the derivativesmarket. In this chapter,we review the arguments and the theoreticalevidence.The empirical evidenceis reviewed in the following chapter. The principa conclusion are: l s The fall in the price of gold over the last decade has coincided the growth of the paper with market. Short sellingby producersand others has added substantially the supplyof gold to from new production.But it doesnot necessarily follow that the fall in the gold price was causedby the paper market or that the acceleration supplyhas had a substantia impact on of l price The debate about the impact of paper markets on cash m arketsis neithernew nor confined to gold.Many studieshave been carriedout in both financial and commod markets.The ity empiricalevidencesuggests derivativemarketsfulfill a valuablerole in promotin the that g efficien sharing of risk; that while they could in theor destabilize price of the underlying t y the assets,it has not been a problem in other markets;and that they make the underlying market more liquid Gold demand has both consumption and an investmen a sp e c t The elasticit of t . y demand for financia a s s e t sis generall extrem el high; small change in price and expected l y y s returns causelarge shifts in portfoliocomposition.But investmentdemand for gold may be ratherl e s s elastic since the gold has particulara t t r i b u t e s(such as resilienceto financial and econom icshocks)which make it hard to substitute Assuming that supply of gold is inelastic and that demand is consumptionrather than investment demand and assumingdemand has a unit price elasticity,the accelerated supplyof gold from the derivativesmarket may have depressed price of gold over the last the decadeby 10-15%. But this model almostcertainlyover-estimates impact becauseit takes the no account either of supply elasticity,or the responseof holdersof gold to the expectedreturn from holding it The derivativesm arket has also increased the attractionsof holdinggold,m ade it le sscostly for fabricatorsand other downstream usersto hold large inventoriesof gold, and reducedthe cost of capitalfor producers. expandingboth supplyand demand, the impact on the gold price is In am biguous

CHAPTER III RESEARCH METHODOLOGY 3.1 RESEARCH TOPIC

3.2 RESEARCH OBJECTIVE

3.3 STATISTICAL HYPOTHESIS

3.4 PERIOD OF STUDY

3.5 SAMPLE STUDY

3.6 STATISTICAL TECHINICAL USED

3.7 LIMITATIONS OF STUDY

3.1 RESEARCH TOPIC: A Comparative Study of Gold Price Movement In Indian and Global Market 3.2 RESEARCH OBJECTIVES: The main objectives of present research are: 1) To study the trend of gold price movements in the post liberalization period and its relationship with international prices. 2) To find out the correlation between gold prices in both the markets. 3) To study the impact of changes in foreign exchange rates on the gold prices in Indian as well as in the international market.

3.3 STATISTICAL HYPOTHESIS: To test the significance of the value of karl pearson co-efficient of correlation between gold prices in Indian Gold Market and International Gold market To test the significance of seasonal variability of Gold prices in Indian Gold Market and International Gold Market.

3.4 PERIOD OF STUDY: The present study is a time series study covering period from 1991-2010.This period was chosen because before 1991, the govt controlled the economy of the country. The prices were not determined by the market forces but rather fixed by the govt.from time to time .From 1990 onwards ,the govt of india started the process for globalization and liberalization.It allowed the companies to enter the Indian market and a number of other steps were also taken to make india an active member of the world region. 3.5 SAMPLE STUDY: The research is mainly based on secondary data, which has been collected from various RBI Bulletins,IMF publications,Govt of india Publications and web sites of moneycontrol.com 3.6 STATISTICAL TECHNIQUES USED:

Different statistical techniques have been used for data presentations, analysis & interpretations of results. For data presentations, trend line graphs have been used while for analysis of data; the techniques used were measures of variatioin, correlation and time series analysis. For interpreting the results of hypothesis testing, students t-test has been used.

1) To study the trend of gold price movements in the post liberalization period and its relationship with international prices.

SEASONAL VARIATION OF GOLD PRICES MOVEMENT IN NATIONAL AND INTERNATIONAL TRADE Exhibition 1: Seasonal national gold price

M onth/ Year 2000 2001 2002 2003 2004 2005 2006

jan 4509 4404 4848 6096 6702 5984 7627

Exhibit 2: Seasonal International gold prices

M onth/year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

From EXHIBIT 1 & 2, it is clear that prices of gold in both the Indian market and international market do not show any seasonal affects. The values of seasonal indices in Indian market range from 93.4 to 108.38 while in the International market, the values vary from 95.03 to 107.68 . So in both the markets, there is only marginal difference in the values of monthly seasonal indices, which show that no seasonality is associated with gold price movements in the two markets.

jan 284.8 265.4 281.6 356.8 413.8 424.1 549.8 637.1 889. 858.6

2) Co-efficient of correlation between gold prices in both the markets.

We calculate r using YEAR 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 TOT AL x 4155 4560 5369 6030 6240 6222 8564 9044 12249 15228 77661 y 279 271 310 364 408 445 604 695 872 973 5221 x 17264025 20793600 28826161 36360900 38937600 38713284 73342096 81793936 150038001 231891984 717961587 y 77841 73441 96100 132496 166464 198025 364816 483025 760384 946729 329932 1 xy 1159245 1235760 1664390 2194920 2545920 2768790 5172656 6285580 1068112 8 1481684 4 4852523 3

Gold prices in Indian market (Rs/10gms) -X Gold prices in International market ($/oz)-Y

r=

r= r= r= r = 0.98

The value of r was found to be r=0.98. To test whether this value of r shows a significant relationship between two prices, Students t-test has been used. The hypothesis developed was:

t - Test: t - Test is one of the statistical tools for hypothesis which is used when the sample size is 10. Since, in this project study, we have taken past years data. 1. Define Null and Alternative Hypothesis

Null Hypothesis (Ho): There is no correlation between the gold prices in the Indian market and prices in the international market ( r = 0) Alternative Hypothesis (H1): There is significant correlation between the gold prices in the Indian market and prices in the international market ( r 0)

2. State Alpha: = 5% of significant level = 0.05% 3. Degree of Freedom: df = n-2 = 10-2 = 8 4: State Decision Rule Using our alpha level and degrees of freedom, we look up a critical value in the rtable .We find a critical r of 0.632.

If r is greater than 0.632, reject the null hypothesis 6: State Results

r= 0.98 7. State conclusion: There is relationship between the gold prices in the Indian market and prices in the international market, r (8) = 0.98

3) To find out whether changes in exchange rates of Indian rupee vis a vis US dollar

also affected the gold prices in the two markets, value of karl pearson coefficient was calculated between (1) Exchange rates and prices in Indian gold prices and (2) Exchange rates and prices in International gold market.

1) Value of r between gold prices in Indian market and exchange rate.

YEAR 2000 2001

r= (-0.165265631)

average pr indian ma

Interpretation: further value of r between the gold prices in international market and exchange rate was found to be (-0.165265631) which is statistically not significant. It means changes in gold prices in Indian gold market are dependent on changes in exchange rate of Indian rupee vis--vis US dollar.

2) Value of r between gold prices in International market and exchange rate.

YEAR 2000 2001 2002 2003 2004

averag e ($/0z) X

r= (-0.015557835)

Interpretation: further value of r between the gold prices in international market and exchange rate was found to be (-0.015557835) which is statistically not significant. It shows that changes in exchange rate significantly affect the gold price changes in international market. Though there might be other factors also which effect the gold price movements in international market, but changes in international exchange rate is also major factor.

3.7) LIMITATIONS OF STUDY: The data which has been taken for research is totally based on research work so it may be accurate or it may not be accurate.

CHAPTER IV FINDINGS

FINDINGS:

The price of the gold is increasing these days and investment in gold bullion coins is really a worthy venture. As there is limited supply of the precious metal, the price of the gold goes high. The popularity of investment in gold bars exceeded the demand for jewellery as these days gold investment is considered to be wise compared to real estate and stock investments. Even in the days of inflation, the fundamental price for the metal remains constant. Purchasing this metal in the forms of bars is cost effective compared with jewellery. Here the prices are dependent mainly on prices in international gold market and then the exchange rate. No definite increasing or decreasing trend was observed regarding variation in monthly average gold prices during a year for both the Indian gold market and international gold market. Prices are mainly dependent on international gold market.

CHAPTER V SUGGESTIONS

SUGGESTIONS

Gold policy should be reviewed because of the following reasons:

(c) We should not waste scarce foreign exchange on unproductive purposes. The recent liberalization of imports through NRI and SIL route has shown that in reality , there is no adverse impact on liberalized gold import. (d) Import on use of gold should be discouraged since it affects domestic savings adversely and implies diversion of resources for unproductive purposes. Now, even depreciating luxury goods are produced and traded in our economy: still the question remains as to why gold is discriminated .So the main objective of the new gold policy should perhaps to: Recognize the importance of gold in the Indian Economic System and enable gold to play a transparent and positive role in the industrial development, employment and export sectors of the economy.

Create and nurture appropriate official regulatory framework and self regulatory trade bodies.

Exploit the scope for generating revenues to the central, state, and local governments.

Ensure orderly development of gold related industry in India in terms of physical standards and consumer protection.

CHAPTER VI CONCLUSIONS

CONCLUSIONS It can be concluded that in international markets, exchange rate might be the most important factor. When rates in general decrease and gold prices increases, people may go for gold purchases in case of currency depreciation.

But in the Indian gold market, exchange rate variation has an effect on price. Here, the prices are dependent mainly on prices in international gold market and then the exchange rate.

No definite increasing or decreasing trend observed regarding variation in monthly average gold prices during a year for both the Indian gold market & International market.

After 2001, it shows an increasing trend. If monthly variations are considered, Indian gold market has greater variability than the internal gold market. While taking into account the yearly variations in gold prices in the two markets, it was found that the Indian gold market has lesser variability than the international gold market.

BIBLIOGRAPHY

BIBLIOGRAPHY

Internet Web sites visited: www.google.com www.wikipedia.com

www.goldprice.org www.worldgoldcouncil.com www.rbi.org www.kitco.com