Indian Gold Futures



The price of gold depends on a host of factors, which makes it very difficult to predict. In a  fashion similar to  shares, gold is an asset class by itself. In fact, in many villages and small towns of India, gold is preferred to bank deposits as a savings and investment instrument.

Till a year ago, to gain from price volatility, one would have to hoard and trade in gold physically. Not any more, however. With the commodity futures market operating in full swing, one has the option of not physically stocking gold to gain from its price movements.

Let us see how trading in futures is better than the option of hoarding gold. Firstly, there are several costs associated with the process of physically stocking gold. The costs include the cost of the gold itself, the cost of carrying, cost of physical storage, finance cost and last, but not the least, the safety element. 

While futures might have some advantages, there is also a danger of losing big as your risks are also magnified and hence, one must tread carefully in this area.

In this context, if the going cost of gold is Rs 6000 per 10 grams, with an investment of Rs 6 lakh, one can buy 1kg of gold. Now,  suppose, three months hence, when the going price of gold is Rs 6,500 per 10 grams, the person decides to sell the gold. The gross profit made by the person is Rs 500 for every 10 grams and hence, for 1 kg, it stands at Rs 50,000. To arrive at the net profit, one would have to deduct the cost of financing; the cost of storage in a bank and transaction costs, including sales taxes. 

Now, lets see what the same Rs 6 lakh can achieve in a futures market, assuming the same sequence of prices. In Indian exchanges, currently, futures contracts up to four months are available. Lets assume that three-month gold futures are trading at a little over the spot price, with the market expecting  gold prices to remain stable over the next three-month period. Let this price be Rs 6050. 

Since a futures contract is an obligation to buy or sell a specific quantity of the commodity, one does not have to pay for the entire value of the commodity. Buying futures obligates one to take delivery of the underlying commodity at a particular date in the future. This is also known as taking a long position.

To trade in gold futures, one has to go to a brokerage house and open a trading account. A trading account involves keeping an initial deposit of Rs 50,000 to Rs 1 lakh. Part of the money accounts for the margin money, which is required by the exchange when one enters trading.

For a high amount, however, the deposit amount is usually waived by the brokerage house. The whole investment is then generally treated as margin money. For commodity futures, there is usually a lot size or the minimum volume of the commodity of which one has to buy a futures contract.

Lets assume, for our case, the minimum lot size is 1 kg (lot sizes are usually 100gm or 1 kg). Thus, if the going futures rate is Rs 6,050 per 10 grams, the minimum value of a contract is Rs 6,05,000. The beauty of a futures contract is that to trade in them, one has to only invest the margin money. If we assume a flat 5% margin rate for the contract (margin rates vary from 5-10%), the margin money for a single lot is Rs 30,250.  Add to that, a brokerage amount, which is usually .1% to .25% and some start-up charges. Applying these rates, which are  prevalent in the market currently, a single lot of gold futures contract should come at around Rs 32,000.

Thus, with Rs 6 lakh, one can buy 19 lots of gold futures.  One can , however, expect margin calls from brokerage houses if the margin money falls short of the margin money required for trading in the exchange, determined at the end of the trading session each day.

Now, suppose that at the end of 3 months, the spot price of gold actually reaches Rs 6,500 per 10 grams.

The novelty of the futures market is that as long as there is sufficient liquidity in the markets, the futures price always converges to the price of the under    lying. Such is the leverage of futures, that with the same investment of Rs 6 lakh, one is actually commanding 19 lots of gold futures or in effect, 19 kgs of gold.

Thus, at the end of three months, assuming the above-mentioned course of events, on an investment of Rs 6 lakh, one can make a gross profit that is almost 17 times the profit made by physically stocking gold.

At the same time, the downside risk is also multiplied. To avoid the hassles of delivery, one must offset the futures contract just before the maturity date is reached. Delivery would entail gold certification and accreditation by an exchange-appointed assayer and increased transaction costs in general, as various taxes come into the reckoning.

The above example is about a case of taking a bullish view on the price of gold and hence, gaining from the price rise by buying futures. One can gain from a futures market even by having a bearish view on the price of gold. This aspect of gain is absent in the physical market for gold. If one believes that the spot price of gold is going to fall in the near future, all he needs to do is to sell gold futures. 

While all this seems pretty rosy, there are some things to be kept in mind. Firstly, any transaction in the futures market is possible only if a counter-party to the buy or sell order that is placed, exists. For unusually large investments, the exchange may find it difficult to find a counter-party and so it may take some time to match it. Also, with any futures, there may be a problem in exiting from a position by buying or selling when one would like to.
Global: Asia's Own Agenda

Stephen Roach (New York)

I spend a lot of my time these days in Asia. I am currently between trips to the Far East having just returned from Hong Kong and India a couple of weeks ago and getting ready to go back out to Singapore, Japan, and China in early November. My fixation on Asia reflects my view that this region is now where the action is. Most things we buy these days are made in Asia. Most of the incremental funding of the Wests excess spending is also provided by Asia. Yet signs are increasingly evident that this symbiotic relationship could be changing. Asia is now paying greater attention to its own agenda a refocusing that could have profound implications for the global economy.

A story in the weekend Financial Times (October 16/17, 2004) contained a fascinating glimpse of this shift in Asian thinking. The headline said it all: India to dip into forex reserves for domestic infrastructure upgrades. As I noted recently, Indias infrastructure gap is staggering it represents a very serious constraint on any manufacturing-led development strategy (see my October 4 essay, From Mumbai to Pune). The new Indian government is under intense pressure to follow the lead of China in modernizing its antiquated infrastructure of roads, port facilities, and power distribution. But unlike China, which is awash in domestic saving to fund such efforts, India faces the serious twin constraints of a private saving deficiency and a budget deficit problem. So it has turned to some creative financing in order to meet this urgent need: According to the FT story, India has elected to put some $10-15 billion of its nearly $120 billion in foreign exchange reserves to work in funding this effort.

India is not alone in following this approach. At the start of this year, China led the way in deploying some of its foreign exchange reserves for domestic purposes in this instance, injecting $45 billion of capital into two of its largest policy banks, the Bank of China and the China Construction Bank. Here, as well, the Chinese were earmarking a portion of what at the time was $415 billion in official currency reserves to deal with a major national issue the deadweight of nonperforming loans. This recapitalization was also aimed at facilitating the proposed public offerings for both of these banks.

The China and India efforts have a number of important characteristics in common: First, both initiatives commit about 10% of the total reservoir of currency reserves to domestic needs leaving an ample remainder for currency defense and other potential financial backstop measures. Second, both initiatives are not direct transfers of reserves from central banks to the private sector. For India, the reserves are reported to be earmarked for the backing of a $10-15 billion bond issue that would go toward setting up a public infrastructure fund. In the case of China, a similar bookkeeping transfer has taken place using reserves to fund a new oversight body (the Central Huijin Investment Co.) that will then supervise the purchase of equity stakes in the two policy banks.

But theres another aspect of these initiatives that has profound implications for the rest of us the growing inclination of Asian financiers to divert their financial resources away from funding Americas open-ended consumption binge. Theres no great secret as to the massive dollar overweight in Asias foreign exchange portfolio. As of year-end 2003, the BIS reported that Asia held about 62% of all official foreign exchange reserves; moreover, our calculations suggest that so far in 2004 Asias FX reserves have increased by nearly $350 billion, or another 20%. At the same time, BIS data reveal that about 70% of the $3 trillion in official foreign exchange reserves are held in the form of dollar-denominated assets. In other words, Asian central banks are leading the way in dollar buying a strategy that is aimed at preventing their currencies from rising and thereby impeding the regions export-led growth models. Asias official appetite for dollar-based assets also fills an important hole in Americas massive external funding gap a 5.7% current account deficit that now requires financing to the tune of some $2.6 billion of capital inflows each business day of the year. Without such generous Asian financing, the dollar would undoubtedly fall, and US real interest rates would most assuredly rise classic characteristics of the time-honored current account adjustment.

Its on this latter point that the alarm went off when I read the account of Indias infrastructure funding plans. The Financial Times story also quoted an unnamed Indian official as saying, We are subsidizing the American economy. These are scarce resources that can be put to better use. Thats been the biggest risk all along, in my view that Asia would recognize that it has a greater role to play than simply subsidizing excess US consumption in order to keep its export machine fully employed. Indias intentions, in conjunction with Chinese actions earlier this year, hint at a reordering of Asian priorities away from providing the vendor financing of a saving-short US economy and toward focusing on its own domestic development imperatives. To the extent that this puts a crimp in Americas low-interest-rate regime that has been so central in driving the demand side of the global economy, so be it. Asia now seems increasingly emboldened to take that risk especially in light of daunting needs of its own.

That very point was underscored by Montek Singh Ahluwalia, Deputy Chairman of Indias Planning Commission and one of the top advisors to Indias new Prime Minister. In the weekend FT article, he was quoted as leaving little doubt of the wisdom of using FX reserves to backstop an infrastructure fund. He suggested that since Indias FX reserves are probably too high anyway, the government should use a portion of these proceeds to take the lead in stimulating a broad-based attack on the Indian infrastructure gap.

I spent some time with Montek Ahluwalia on my recent visit to India. He is tough-minded and pragmatic and utterly determined to lead the way on new economic policies for the new government. His message should not be taken lightly. It has important implications for India, the US, and the broader global economy. On balance, China and India are basically on the same page: They are no longer committed to open-ended dollar buying in their foreign exchange reserve management operations. Given Americas massive current-account deficit, at the margin this shift is negative for the dollar and for US real interest rates.

Meanwhile, the China slowdown Asias main event appears to be gathering force. Import growth slowed to just 22% Y-o-Y September down sharply from the 36% gain in August and a 40% surge for all of 2003. Excluding distortions centered around the Lunar New Year, this was the slowest import comparison since mid-2002. The moderation occurred even in spite of surging demand for foreign materials and oil; mainly at work were outright contractions in imports of foreign manufactured goods, hinting at the first signs of the long awaited slowdown in Chinese domestic demand. The latest data on Chinese auto sales reinforce this possibility; sales in September were down slightly from the year-earlier pace a dramatic reversal from the 50% growth comparisons in early 2004. Car loans have been hit especially hard since the spring by the clampdown on bank lending that has been central to the Chinese cooldown campaign. At the same time, the Shanghai Futures Exchange has just raised margin requirements for copper trading, triggering a sharp sell-off in materials prices late last week. This is just the latest example of Chinas efforts to micro-manage the slowdown of its overheated economy.

Nor have the impacts of the China slowdown been lost on its trading partners. As I noted recently, export-led growth in Korea, Japan, and Germany all heavily dependent on Chinese import demand has slowed markedly in recent months (see my 8 October dispatch, Canary in the Coal Mine). In 2003, about 45% of the total growth in Japanese and Korean exports was traceable to surging exports to China; for Germany, the figure was 28%. Lacking in sustainable domestic demand and without another major trading partner to fill the void left by China, these three countries seem likely to see economic growth slip as the slowdown in the Chinese economy gains force. Chinas sharp recent falloff in import growth, in conjunction with emerging export-led weakness of its major trading partners, confirms the global impacts of the China slowdown.

Asia is on the leading edge of many of the changes affecting the global economy and world financial markets. Yet the risk is that we take much of the Asian impact for granted in looking to the future. If Asia begins to rethink its forex reserve management practices, interest rates and the interest-rate-led underpinnings of the US economy could be seriously affected. At the same time, the China slowdown promises to have equally profound effects on the trade and commodity market linkages that now bind China to the rest of the world. As Asia progresses down the road of economic development, there will be greater urgency for it to tend to its own agenda. That day is now starting to come into clearer focus.
Dear Friends

Gold prices seems to be showing no signs of cooling of. Some even expect the prices to hover around $470 for FH 2005. US $ is the single factor that is giving the strength

What are your view points on the same?
Pradeep unni
ur right... gold is in a secular bull market along with silver.. the main driver for gold is the weakening us $... this is a trend that is going to last for the next 20 yrs... the US $ will be doomed when internal consumption in china and india reach around 70 - 75 % of GDP. right now it is only 45 % in china ... dont know the #'s for india...

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