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(angl) Why Does The "Paper Gold" Price Track The Physical Gold Price ?

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Published : February 07th, 2013
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Category : Editorials

It's curious, isn't it? So-called "paper gold" (a futures contract) has a price that is not only very close to physical gold, but it remains locked to it. This is despite the fact that "paper gold" is reviled in the gold community.

I am writing this on Sunday evening with little liquidity in the market, and yet spot gold (XAU) is 1665.80 and the December future (GC Z3) is 1674.40. There is a small positive spread, about 0.5%, between spot and future. This spread is remarkably consistent from day to day. If spot gold goes down 1.2% then the December future,and the other months as well, go down by almost exactly 1.2%.

It's worth underscoring that these are different prices for different things in different markets. "Paper gold" is not physical metal! If there weren't some force that kept their prices locked together, they would detach and one could rise while the other falls, or vice versa. This is not, in fact, how they behave. They remain locked (at least for the time being). Why? What is this mysterious force that binds them tightly together?

Let's take a step back for a moment. The futures market exists to serve the needs of producers and consumers. Producers -- miners in this case -- need to have predictable and consistent cash flow so they sell some of their production forward. Consumers, such as electronics manufacturers, and jewelers, have the same need so they buy some of their raw materials forward. Both can sign a contract now that locks in a price at some date in the future.

Of course, in the gold standard, there would be no such thing as a gold futures market. Futures for all other goods would be priced in terms of gold. Gold itself would not be available at a discount, nor would one ever need to pay a premium to get it. One could borrow it at interest, but that is in the bond market not in the futures market.

Once a futures market is established, speculators come in to bet on the direction of the price. They do not produce the good -- gold in this case -- nor use it. They cannot deliver gold to a buyer, nor do they wish to be delivered gold. They want to profit from a change in the price. They believe they have superior knowledge compared to the other market participants, and so use the futures market as an easier and more convenient way to bet than the physical metal market. And besides, the futures market offers leverage.

This is the basic theory of the futures markets, in a nutshell. Producers and consumers are trying to reduce risk. Speculators are making bets, pushing prices around, sometimes annoying the producers and sometimes annoying the consumers.

We still have not explained the fact that the price of "paper gold" tracks the price of gold metal. To do that, we need to introduce a third type of actor in the futures markets. The arbitrageur does not care about price; he is focused on spread. The arbitrageur can buy physical metal and at the same time sell a futures contract. This will earn him a little over $8 per ounce based on the prices I quoted at the top, or a bit more than 0.5% annualized. Compared to the yield on a 1-year Treasury, about 0.15%, this isn't bad.

So long as the price of the futures contract is higher than the price of the physical metal, then the arbitrageur can buy metal and sell a contract to pocket this spread. This will obviously lift the price of the metal and depress the price of the paper, compressing the spread. The arbitrageur will stop when the spread becomes too small to be worth his time, effort, and risk.

If the futures contract ever became cheaper than the physical metal (called "backwardation") then anyone who owns a gold bar can sell it and simultaneously buy a future with the intent to stand for delivery. In this case, the arbitrageur sells physical metal and buys a future, thus depressing the price of metal and lifting the price of the future. As in the previous case, the spread is compressed.

This is not merely academic theory. Analysis of this spread (called the "basis") can shed light on what's really happening in the markets. Sometimes (as now) there is a simple trade that is obvious, but only to someone looking at this spread.

In Part II of this article (free enrollment required for full access), we walk through the analysis and propose a contrarian precious metals trade.

Companies Mentionned : Gold | Metals X |
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Keith Weiner is a technology entrepreneur and president of the Gold Standard Institute USA. He was the founder of DiamondWare, a Voice Over Internet Protocol software company, which he sold to Nortel in 2008. He is an Objectivist who has his PhD from the New Austrian School of Economics, with a focus on monetary science. Keith, who currently trades and analyzes precious metals and commodities, advocates a return to a proper gold standard and laissez-faire capitalism. He lives with his wife near Phoenix, Arizona.
Latest comment posted for this article
All games come to an end, and so does this one. Its demise was, indeed, encoded at the very time of the inception of the paper gold charade. Those worthless paper, never-to-exist ounces will be priced at their true value= $0; Physical Gold is re-set to i  Read more
Goldgirlme - 2/9/2013 at 12:49 PM GMT
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Why Does The "Paper Gold" Price Track The Physical Gold Price ?

It would be far more appropriate to switch this around. Why does the "Physical Gold" price track the Paper Gold price.

Now the answer is simple. The market is legalized gambling. There is little buying and holding physical compared to paper. Paper is far more convenient when it comes to trading, but we can make it easier still. It is all on the computer so no need to look for the paper either. There are vastly far more gamblers than producers and end users combined. HST ring a bell? Perhaps the house gets its bite?

If you don't know who the sucker is, it is you.

Rate :   1  2Rating :   -1
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Yes, many are those buyers of never-to-exist "gold" (the paper,highly flammable variety) who are stunned that their purchase does not see the Comex 'gold' price advance!!! When supply can be made available at the tap of a few keys, shouldn't it be obvious to all but the most lumpen that they are missing something?!

Is it so hard to decipher that an endless supply of paper gold promises which can never be met -again produced with all the sweat of a tap here and a tap there- is a price CREATION tool. This stuff aint hard, is it? The Comex paper gold price, engineered by a limitless supply of BB paper gold, bears NO relation to the Physical Gold price. None. Behind the scenes, away from public view, the BIS shifts Physical to where its owners (of the BIS) have decided it will go. And the TRUE VALUE price is paid in these inter CB trades. There are people inside this machine, inside the dome. Preciousmetalspete has been there since 1978, and knows all the architects of the game. Check out his blogspot if you want to know how Gold works.

And the clues are blatant, smack in the face! The revelations are brazen if you have your eyes open.... e.g a 7 yr timescale required for the repatriation of a few measly tonnes from FRBNY to Buba?!... How come 7 years? How is that possible? Eyes-opening time!
Rate :   2  1Rating :   1
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They have been playing with it for so many years that they wouldn't know how to get serious.
All games come to an end, and so does this one. Its demise was, indeed, encoded at the very time of the inception of the paper gold charade. Those worthless paper, never-to-exist ounces will be priced at their true value= $0; Physical Gold is re-set to its TRUE VALUE (a price which exists even today in inter CB Phys Gold trade).... The script unfolds precisely as described by preciousmetalspete in his blogspot article "How Oil is set to Reveal the ...True Value of Physical (and paper) Gold"... Using Iran's exclusion from the thieving USD as the kind of trigger which releases the encoded outcome, this is a seminal, much-read and highly-acclaimed article, which details the PROCESS of paper gold's burning and the PUBLIC revaluation of Phys Gold's true worth.
It includes also the rationale for the whole debt-fueled derivatives 'adventure'/theft and how such is washed away and balance restored. What happens to CB balance sheets with Phys Gold reset PUBLICLY to TRUE VALUE? They are repaired!! Wondered why such recent hefty CB Gold BULLION buying? Wondered why BULLION is being repatriated, 'all of a sudden'? The idea still advanced by the dinosaurs out there declaring that the world class store of wealth par excellence is comparable to a Comex-lie piece of toilet paper is utterly hilarious!
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Wow..... the unparalleled ignorance!

This is why the deceit continues; this is how the fraud continues. There is NO connection between paper gold and Physical Gold prices!! NONE! You are being sold an illusion, a magician's trick, which requires only that you BLINDLY accept the 'evidence' -more accurately, the 'show'- before your eyes in order to be misled. (Pssttt: the magician's assistant was not cut in half and put back together again)...

Why do you think such an outrageously minute amount of metal is available to the public at the fraudulent paper gold price? To cement the illusion in non-questioning minds!

Go and try to get your hands on any half-decent amount of Physical Gold; it will be an education for you.

There is no longer any excuse for the absurdly shallow and wholly misleading nonsense produced here. Gold market insider since 1978, preciousmetalspete at his blogspot, FOFOA, Turd, Brodsky, et al are producing analysis several billion light years ahead of this pure piffle found here.

To the uneducated who find any merit whatsoever in this article, I recommend they advance their thinking and post haste.
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To Goldgirlme
To tell you that Karandash gave you a thumb up.

re: wong tak says sorry (Jan Johnson)
Trade LYC with
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The Hotcopper message board. That's what I'd like to see on this message board. Every message gets a number. If you get a reaction you know whom it comes from. Do I care now whether I get 10 arrows down. I'd like to know who is behind them.

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