4. Gold
Teaching rewrite of the gold market: physical chain, London conventions, price drivers, leasing, hedging, trading, and yield enhancement. Original wording; worked numbers recomputed. Prices around USD 1,300 are teaching values from the source era — see the price note below. Not investment advice.
Introduction
On 24 January 1848, James Marshall spotted gold flakes in a stream at Coloma, California — triggering one of history’s largest migrations. Gold has fascinated people for millennia, and it remains unlike any other commodity: almost indestructible, mostly still above ground, held by central banks, and traded more like a currency than a raw material.
This lesson covers:
- Precious metals and the physical supply chain
- The London market: LBMA, Good Delivery bars, loco London, allocated vs unallocated, the LBMA Gold Price auction
- Supply and demand — mines, scrap, central banks, jewellery, investment
- Price relationships: inflation, real yields, the US dollar
- The leasing market, forward pricing, GOFO, implied lease rates, gold-in-gold
- Producer hedging: forward variants, unwinds, gold swaps, structured swaps, vanilla/Asian/barrier/two-asset options
- Trading: gold swaps as collateralised loans, non-deliverable swaps, deferred margin accounts
- Yield enhancement with covered calls
The source uses gold near USD 1,300 and notes the August 2020 record of about USD 2,048. Gold has since set much higher records (above USD 4,000 in 2025). The mechanics in this lesson don’t depend on the price level.
4.1 The gold market
Precious metals
- Gold and silver
- Platinum group metals (PGMs): actively traded platinum and palladium; less-traded rhodium, ruthenium, iridium, osmium
Physical supply chain
flowchart LR
M[Mine<br/>ore: <1 g/t open pit, <10 g/t deep] --> D[Mill + on-site refine<br/>doré bars]
D --> R[Refiner<br/>bullion bars, jewellery blanks]
R --> F[Fabricators<br/>jewellery, electronics]
R --> I[Investors & central banks]
Gold’s corrosion resistance and thermal and electrical conductivity make it valuable in electronics as well as jewellery.
Intermediaries and central banks
Banks and trading houses: help miners hedge, lend metal to refiners and fabricators, borrow from central banks, manage central-bank holdings, intermediate the chain, and trade with hedge funds.
Simple model:
| Supply | Demand |
|---|---|
| New mine production | Jewellery |
| Central bank holdings (sales) | Physical investment (bars, coins, ETPs) |
| Recycled scrap (“urban mine”) | Industrial use |
The London market
London is the largest OTC gold market; futures trade on CME and other exchanges.
| Body | Role |
|---|---|
| LBMA (London Bullion Market Association) | Standards for the wholesale precious metals market |
| LPPM (London Platinum and Palladium Market) | Same for PGMs |
| LPMCL (London Precious Metals Clearing Ltd) | Clearing between member banks using unallocated accounts |
Around 2020, London cleared roughly USD 70 bn a day in gold — large, but small next to FX (~USD 6.5 trn a day).
London Good Delivery
| Feature | Standard |
|---|---|
| Gold content | 350–430 fine oz (≈ 10.9–13.4 kg); most bars ≈ 400 oz (12.5 kg) |
| Fineness | ≥ 995 / 1,000 (“two nines five”) |
| Weight reporting | Troy oz in multiples of 0.025, rounded down |
| Marks | Serial number, approved refiner’s assay stamp, year (4 digits) on the larger face |
| Shape | Trapezoid prism |
Carats measure purity out of 24: 18 carat = 18/24 = 750 fineness; 24 carat ≈ pure. Wholesale markets use fineness, not carats.
Loco London: default delivery location; settlement T+2 London business days (trade Wed 15 Jan 2020 → settle Fri 17 Jan 2020). Other locations or purities trade at an adjustment.
Allocated vs unallocated
| Unallocated | Allocated | |
|---|---|---|
| What you own | A general claim on the bank’s pool | Specific, segregated, numbered bars |
| Legal position | Unsecured creditor | Owner (secured) |
| Cost | Minimal | Higher storage/insurance fees |
| Bank balance sheet | On it — capital-intensive under newer rules | Off it — banks nudge clients here |
The LBMA Gold Price
A benchmark is needed for transparency (central banks), unbiased contract settlement, and option exercise. The old twice-daily “fixing” (since 1919) was replaced in 2014–15 by an independently administered electronic auction (ICE Benchmark Administration), held at 10:30 and 15:00 London time.
How a round works:
- Administrator proposes a price.
- Direct participants submit buy and sell volumes within 30 seconds.
- If |buy − sell| > 10,000 oz, the price moves toward the excess side and a new round starts.
- Once within tolerance, volumes trade and the price is published (then converted to other currencies).
Worked example: auction rounds
| Round | Price | Bids (oz) | Asks (oz) | Imbalance | Action |
|---|---|---|---|---|---|
| 1 | 1,329.15 | 80,579 | 30,223 | +50,356 | Raise |
| 2 | 1,329.55 | 80,579 | 35,223 | +45,356 | Raise |
| 3 | 1,330.15 | 80,579 | 114,223 | −33,644 | Lower |
| 4 | 1,329.90 | 80,579 | 94,223 | −13,644 | Lower |
| 5 | 1,329.75 | 80,579 | 85,223 | −4,644 | Within 10,000 → set at 1,329.75 |
Checkpoint 1: market structure
Checkpoint — section 4.1
1 / 5What minimum fineness must a London Good Delivery gold bar meet?
Pick an answer to see if you are right.
4.2 Gold price drivers
Supply and demand flows matter less for gold than for any other commodity — because almost all gold ever mined still exists.
Supply
- About 187,000 t mined in history; ~80% still exists; 90% mined since the 1850s, 60% since the 1950s.
- Production has shifted from South Africa (≈ 1,000 t ≈ 70% of world output in the early 1970s → 118 t ≈ 3% in 2019) toward China (largest producer, ≈ 383 t in 2019), Russia, Australia, the Americas.
- Remaining reserves ≈ 53,000 t (USGS, 2020) — roughly 14 years of output, increasingly deep and costly (South African mines reach ~4 km).
- Scrap rises when prices rise (stronger trade-in culture in Asia than the West).
- Producer hedging adds supply: the bank buying a miner’s forward borrows gold and sells it spot today. De-hedging does the reverse — banks buy spot and lend, adding demand and pushing lease rates down.
Demand
| Source | Notes |
|---|---|
| Jewellery | Largest, but price-sensitive; peak ≈ 3,350 t (1997); ≈ 2,137 t (≈ 44%) in 2019 |
| Investment | Volatile; ≈ 70% of demand in 1980, ≈ 6% in 2001, ≈ 39% at the 2011 peak — boosted by exchange-traded products |
| Central banks | Net sellers in the 1990s–2000s (≈ 4,400 t), net buyers since about 2010; emerging markets (e.g. China ≈ 600 t in 2009 → ≈ 1,948 t in 2020) |
| Industry | Electronics, dentistry |
Central bank holdings (Oct 2020): US ≈ 8,134 t, Germany ≈ 3,362 t, IMF ≈ 2,814 t, Italy ≈ 2,452 t, France ≈ 2,436 t.
Heavy central bank selling pushed gold toward USD 250 in the late 1990s → Central Bank Gold Agreements (Washington Agreement 1999 onward): coordinated sales, annual caps (400 t in the later agreements). The last agreement expired in 2019 and signatories said no renewal was needed — they had become buyers.
Price relationships
Fisher equation: nominal yield ≈ real yield + expected inflation + risk premium.
Example: 3% deposit, 2% expected inflation, zero risk premium → real yield ≈ 1% (strictly 103/102 − 1 ≈ 0.98%). With a 1% deposit and 3% inflation → real yield ≈ −2%: saving loses purchasing power.
| Relationship | Evidence |
|---|---|
| Expected inflation (breakevens) | Weak and inconsistent |
| Real yields | Clearer negative relationship — gold pays no coupon, so higher real yields raise its opportunity cost |
| US dollar | Generally inverse; gold trades like a currency (XAU) and a safe haven — though a much smaller market than major currencies |
One bank’s model found significant drivers including price momentum (+), the US dollar index (−), physically backed ETP holdings (+), Euro Stoxx 50 (−), emerging-market equities (+), US breakevens (+), consumer sentiment (−), US real yields (−), presidential approval (−), and industrial production (+).
Worked example: real yields and gold
Nominal 10-year yield 4.5%, expected inflation 2.3% → real yield ≈ 2.2%. If nominal yields fall to 3.5% with inflation expectations unchanged, real yield ≈ 1.2% — the opportunity cost of holding gold falls by a point, typically supportive for the price.
Checkpoint 2: price drivers
Checkpoint — section 4.2
1 / 5Why do mine supply changes barely move the gold price in the short run?
Pick an answer to see if you are right.
4.3 Leasing and forward pricing
Because so much gold sits above ground, holders lease it out: title transfers temporarily in exchange for interest (in cash or gold). Central banks and institutions lend to earn something on an otherwise non-yielding asset — though lease rates are usually below cash rates (an opportunity cost).
In gold, use lease/deposit. In base metals, a “borrow” means a simultaneous purchase and sale for different dates — a different trade.
Forward price formation
“If you can hedge it, you can price it.”
A producer wants to sell gold in 6 months (182 days). Spot 1,300, cash rate 2%, lease rate 0.25%:
| Bank’s hedge | USD per oz |
|---|---|
| Sell gold spot | 1,300.00 |
| + Deposit proceeds: 1,300 × 2% × 182/360 | +13.14 |
| − Lease cost to borrow gold: 1,300 × 0.25% × 182/360 | −1.64 |
| Forward | 1,311.50 |
The forward is a carry calculation, not a forecast; it converges to spot as maturity nears.
GOFO / swap rate
The market quotes the forward premium as % p.a. — the GOFO (gold forward offered rate), swap rate, or contango:
Swap rate = (forward / spot − 1) × 360 / days = (1,311.50 / 1,300 − 1) × 360 / 182 ≈ 1.75%
And swap rate ≈ cash rate − lease rate (2% − 0.25% = 1.75%).
| Maturity | Swap bid | Swap offer | Outright bid | Outright offer |
|---|---|---|---|---|
| 1 month | 1.66% | 1.76% | 1,332.55 | 1,332.85 |
| 3 months | 1.79% | 1.89% | 1,336.67 | 1,337.19 |
| 6 months | 1.87% | 1.97% | 1,343.23 | 1,344.08 |
| 12 months | 2.07% | 2.17% | 1,358.58 | 1,360.11 |
Positive swap rates (cash rate > lease rate) give an upward-sloping curve; negative swap rates are rare.
The LBMA GOFO fixing was discontinued in 2015, though the concept is still used. And LIBOR in the source is now replaced by SOFR for USD.
Implied lease rates
Actual lease trades aren’t widely reported, so lease rates are inferred:
Lease rate = cash rate − swap rate (“LIBOR minus GOFO”)
Cash rate 2.0%, swap rate 1.5% → implied lease 0.5%.
The source writes “swap rate − LIBOR = lease rate” and gives 2% − 1.5% = 0.5%. The correct identity is cash rate − swap rate; the example above uses the numbers the right way round.
Who lends and borrows
| Lenders | Borrowers / demand drivers |
|---|---|
| Central banks, institutional investors | Producer hedging (drives the 12-month+ end); fabricators (borrow gold instead of buying it — no price risk, and lease rate < cash rate); short sellers; overall cash-rate level |
Central bank lending tends to drive the short end of the lease curve.
Gold-in-gold interest
Lend 100,000 oz for one year (365 days) at 0.75%, interest paid in gold:
- Interest = 100,000 × 0.75% × 365/360 ≈ 760 oz
- One-year forward = 1,300 × (1 + 3.75% × 365/360) ≈ 1,349.43 → value ≈ 760 × 1,349.43 ≈ USD 1,025,567
- Cash-paid equivalent = 100,000 × 1,300 × 0.75% × 365/360 ≈ USD 988,542
To be equivalent, the gold-in-gold rate must be lower: (988,542 / 1,349.43) × (360/365) / 100,000 ≈ 0.7225%.
Checkpoint 3: leasing and forwards
Checkpoint — section 4.3
1 / 5Spot 2,000, cash rate 4%, lease 0.5%, 180 days (360 basis). Forward price?
Pick an answer to see if you are right.
4.4 Hedging
Producers favour hedges that are simple, good value, system-friendly, and get good accounting treatment — so vanilla forwards and options dominate.
Forward variants
| Product | How it works |
|---|---|
| Physical forward | Fixed gold for fixed cash, physically delivered |
| Book-entry forward | Same, but unallocated balances change in the vault records |
| Spot deferred | Spot price agreed now; no fixed maturity; rolled daily with cash and lease rates, terminable with notice — earns the short-term contango |
| Floating rate forward | Spot and cash-rate parts fixed; lease component floats (e.g. average 3-month lease rate) until maturity |
| Flat rate forward | Several deliveries at one price = discount-weighted average of the individual forwards |
| Convertible forward | Buy a put, sell a reverse knock-in (up-and-in) call at the same strike, zero cost by setting the barrier. If the barrier trades, −C + P = −F → the producer is effectively short forward at the strike |
Unwinding a forward
A producer sold gold 3 years forward at USD 500. Two years later the 1-year forward is USD 1,100; 1-year rate 3%.
Break cost = (500 − 1,100) / 1.03 ≈ −USD 582.52/oz — paid by the producer. (Several miners, e.g. Barrick in 2009, unwound hedges under shareholder pressure; rising prices had also forced them to post collateral.)
Gold swap to defer delivery
A producer must deliver 50,000 oz at 1,300 in two days but can’t. With spot 1,330 and 6-month forward 1,343:
| Leg | Gold | Cash (per oz) |
|---|---|---|
| Original forward | Sell 50,000 | Receive 1,300 |
| Swap — spot leg | Buy 50,000 | Pay 1,330 |
| Swap — 6-month leg | Sell 50,000 | Receive 1,343 |
Spot gold nets to zero; the producer pays 30/oz (1,330 − 1,300) = USD 1.5 m now and will deliver in six months at 1,343.
Structured swaps
Gold “swaps” can mean many things. Standard commodity swaps (cash-settled, fixed vs monthly average) exist; structured ones embed options:
| Structure | Terms | Embedded option sold by client | Risk |
|---|---|---|---|
| American barrier reset swap | Pay fixed 1,250 (vanilla 1,300); if LBMA price ≥ 1,400 in a month, that month’s fixed resets to 1,400 | Strip of monthly digital calls (payout 100 above vanilla) | Pays more than vanilla in high-price months |
| American barrier knock-out swap | Pay fixed 1,200; if price ≥ 1,400, the swap terminates | A swaption to enter an offsetting swap | Left unhedged just as prices are high |
Options for producers
| Option | Premium (6 months, 50,000 oz context) | Notes |
|---|---|---|
| Vanilla put, K 1,300 (forward 1,306, vol 20%) | ≈ USD 70/oz (≈ USD 3.5 m) | Insurance for a producer who expects higher prices but wants protection — if it expected lower prices, selling forward would be cheaper |
| Asian (average) put, K 1,300, vol ≈ 15% on the average | ≈ USD 28.59/oz | Lower cost because averages vary less — but the payout is lower too, so it isn’t simply “cheap” |
| Up-and-out put, K 1,300, barrier 1,350 | ≈ USD 35.03/oz | Cancelled if gold trades above 1,350 — unhedged if it then falls |
| Down-and-in put, K 1,300, barrier 1,250 | ≈ USD 66.70/oz | Only activates below 1,250 — then born USD 50 in the money |
| Two-asset barrier — copper put (K 7,100) that knocks in if gold trades below 1,000 | ≈ USD 52.83/t vs vanilla copper put ≈ USD 562/t | Value depends on gold–copper correlation |
Two-asset barrier vs correlation:
| Gold–copper correlation | Premium |
|---|---|
| +1.0 | 93.35 |
| 0.0 | 52.83 |
| −1.0 | 0.01 |
Positive correlation: gold falling through the barrier likely coincides with copper falling → put likely in the money → dearer.
Checkpoint 4: hedging
Checkpoint — section 4.4
1 / 6A miner sold forward at 900; the current matching forward is 1,400; discount rate 4% for one year. Break cost per oz?
Pick an answer to see if you are right.
4.5 Trading gold
Gold swaps = collateralised USD loans
A gold swap (or “FX swap”) is a spot and a forward deal in opposite directions, executed together.
At the market maker’s bid (spot 1,330.65; 2-month swap 1.73%; outright 1,334.42):
| Date | Gold | Cash |
|---|---|---|
| Spot | Bank delivers 1 oz | Bank receives 1,330.65 |
| 2 months | Bank receives back 1 oz | Bank repays 1,334.42 |
Read horizontally: the bank borrowed USD, securing it with gold — a collateralised loan at ~1.73% p.a. At the offer, it lends USD and borrows gold.
Because swap ≈ cash rate − lease rate, strong demand to borrow dollars against gold pushes the forward (and swap rate) up — so the implied lease rate can turn negative. Like the FX basis, it means borrowers pay a premium to raise USD on a secured basis.
Example: spot 1,300, 12-month cash rate 3%, lease 0.10% → swap 2.90%, forward 1,337.70. Demand to borrow USD pushes the forward to 1,345 → swap 3.46% → implied lease 3% − 3.46% = −0.46%: borrowers pay cash rate + 0.46%.
Non-deliverable (cash-settled) gold swaps
Settled in USD only — for users who don’t want metal.
Settlement = USD notional × (1 − forward / settlement price) Positive → paid to the gold (XAU) buyer; negative → paid by the gold buyer to the seller.
Example: 10,000 oz forward at 1,343 → USD notional 13,430,000. At maturity gold is 1,320:
13,430,000 × (1 − 1,343 / 1,320) ≈ −234,008 → the gold buyer pays USD 234,008; a hedge fund that was short (bearish) collects it.
The source’s wording of who pays whom is inconsistent with its own example. The sign rule above follows from the formula: if gold settles above the forward, the result is positive and the buyer gains.
Deferred margin accounts
Leveraged gold exposure without owning metal. Client takes 10,000 oz at 1,300 (USD 13 m), posts 8% (USD 1.04 m); the bank funds USD 11.96 m.
Requirement: market value − initial balance + initial margin ≥ 8% × max(market value, initial balance)
| Gold | Left side | Required | Result |
|---|---|---|---|
| 1,300 | 1,040,000 | 1,040,000 | Balanced |
| 1,250 | 12.5 m − 13 m + 1.04 m = 540,000 | 8% × 13 m = 1,040,000 | Top up USD 500,000 |
| 1,350 | 13.5 m − 13 m + 1.04 m = 1,540,000 | 8% × 13.5 m = 1,080,000 | May withdraw USD 460,000 |
Some banks add an auto-close threshold (e.g. 5%). The bank hedges by selling 100 CME futures (100 oz each) — leaving basis risk between spot (client) and futures (hedge), i.e. carry.
4.6 Yield enhancement: covered calls
Central banks hold gold that earns little. A covered call: sell calls on part of the holding.
Example: spot 1,300, 12-month call strike 1,400, vol 20% → premium ≈ USD 18.35/oz.
| Gold at expiry | Outcome vs just holding |
|---|---|
| Below 1,281.65 (1,300 − 18.35) | Loses money overall — but less than holding alone |
| 1,281.65 – 1,400 | Better off by the premium |
| At or above 1,400 | Profit capped at 1,400 + 18.35 = 1,418.35 |
| Above 1,418.35 | Worse than simply holding gold |
Not risk-free. Strike closer to spot → more premium, more chance of exercise. A smile (higher vol for OTM calls) or upward gold term structure (longer options at higher vol) raises premiums.
Rank: gold practice
Gold practice
1 / 2Rank these holdings from MOST to LEAST secure for the owner if the custodian bank fails.
OrderDrag the handle to rearrange — top should be first.
- 1Allocated bars in a segregated account
- 2Deferred margin account (no metal rights)
- 3Unallocated balance at a large clearing bank
Drag items into the correct order (or use ↑↓), then check.
Check: gold
Gold
1 / 6What is “loco London”?
Pick an answer to see if you are right.
Calculate: numeric practice
Type the number (no units; minus sign for losses or payments). Use 360-day years unless stated.
Formula sheet
| Item | Formula |
|---|---|
| Fineness from carats | carats / 24 × 1,000 |
| Gold forward | spot × (1 + (cash rate − lease rate) × days/360) |
| Swap (GOFO) rate | (forward / spot − 1) × 360/days |
| Implied lease rate | cash rate − swap rate |
| Gold-in-gold interest (oz) | oz × rate × days/360 |
| Unwind (break) cost | (original price − current forward) / (1 + r) |
| NDF settlement (to gold buyer) | USD notional × (1 − forward / settlement) |
| Deferred margin top-up | 8% × max(MV, initial) − (MV − initial + margin) |
| Covered call cap | strike + premium |
Calculate: gold
1 / 12Fineness of 18-carat gold (parts per thousand)?
Enter a number (at most 0 decimal places).
Randomized practice
Practice: gold drills
1 / 6Locational swap: sell 30,000 oz loco New York at 2159, buy loco London at 2159.5. Cash the client pays (USD)?
Enter a number (at most 2 decimal places).
Takeaways
- Gold is a stock, not a flow, market — almost all of it still exists, so supply/demand flows move price less
- London sets conventions: Good Delivery (350–430 oz, ≥ 995), loco London T+2, allocated vs unallocated
- The LBMA Gold Price is an independently run auction twice daily
- Supply has shifted to China/Russia/Australia; central banks turned from sellers to buyers
- Gold’s clearest macro link is to real yields (inverse); it trades like a currency (XAU)
- Forward = spot × (1 + (cash − lease) × t); lease = cash − swap (GOFO)
- Producers hedge with forwards (spot deferred, floating, flat, convertible) and options (vanilla, Asian, barrier, two-asset)
- A gold swap is a collateralised USD loan; heavy USD demand can make implied lease rates negative
- Covered calls add yield but cap upside and don’t remove downside
Further Reading
- 3. Risk management principles
- 2. Derivative valuation — cash-and-carry and convenience yield
- Next: 5. Base metals
- LBMA (lbma.org.uk) — Good Delivery rules and the LBMA Gold Price; World Gold Council (gold.org) — supply and demand data
- Background: N. Schofield, Commodity Derivatives: Markets and Applications (Wiley) — used as a study outline; J. Cross, Gold Derivatives: The Market View (2001)