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There are numerous examples of how future and options can be used to manage economic risks inherent in commercial operations and in investment portfolios. This module discusses risk management using COMEX and NYMEX Precious Metals futures.

Market prices respond to changing circumstances. We all know that prices will be different in the future to how they are today, but we do not know how different they will be. At a more basic level, while some people make predictions, no one knows with certainty whether prices will be higher or lower in the future.

One of the most well-known risk management uses of futures contracts is to hedge against uncertain outcomes in the future.

Example

Consider an auto parts manufacturer who has won an order to deliver catalytic converters. Platinum is a significant constituent in the production of these items and the production run will require 32 kg, approximately 995 ounces. of platinum. The firm will take delivery of platinum in two months at the prevailing spot price.

The current spot price is around $867 per ounce and NYMEX April futures are priced at $870 per ounce. To hedge the future payment, the manufacturer needs to buy futures. His requirement is for 995 ounces. Each NYMEX futures contract is for 50 ounces. Buying 20 contracts would provide exposure to 1,000 ounces of metal.

Two months later, the spot price has risen by $90 to $957 per ounce. The firm will take delivery of the metal it needs from a local supplier and does not wish to take delivery through the futures contract. It closes out the futures position in the market at a price of $954 per ounce. The gain made on the futures transaction is $84,000.

This gain offsets the rise in the price of platinum in the physical market, which has resulted in the manufacturer paying $89,550, or over 10%, more for their supply compared to the spot market price at the time they knew they had the exposure. The futures trade therefore provides an effective hedge against the rise in price of the physical supply.

Adding Precious Metals to your Portfolio

Precious metals are widely used in investment portfolios. Futures contracts can be the means of making an investment in precious metals but can also be used as a hedging tool for portfolios consisting of other precious metal assets.

Example

Consider a fund that has an investment in gold. Most of this is held through a holding of gold bars, but around 1% of the fund is held in cash to cover short term cash flow requirements. At the end of May, the spot price of gold is $1,212.1 per ounce. The fund has 20,000 ounces in gold bars and $250,000 in cash, and therefore has an end of month valuation of $24,492,000.

At the end of June, the spot price has risen to $1320.7 per ounce, an increase of 8.96%. Because of the cash balance, the value of the fund has risen to $26,665,000, which is an increase of 8.87%, which is an underperformance versus the benchmark spot price.

This underperformance could be managed with futures. COMEX Gold futures has a 100-ounce contract size. A two lot position therefore represent 200 ounces, or 1% of the physical holding. At the end of May, the August futures settlement price was $1217.5 per ounce, and at the end of June was $1320.6 per ounce. The two lot position has therefore netted a gain of $20,620 over the month. When added to the gain in value of the physical holding, the performance of the fund including the futures position is 8.96%, in line with the benchmark.

Managing Economic Exposure

Futures contracts can be used to overlay physical positions to adjust the economic exposure.

Example

An investor has a holding of 1200 ounces of gold. The current spot price is $1236.5 per ounce, and therefore the value of the holding is $1.48 million. The investor expects that over the next few weeks silver will outperform gold; however she does not wish to close her long term physical position.

The investor modifies her market exposure by selling COMEX Gold futures and buying COMEX Silver futures. The COMEX Gold June futures contract is currently priced at $1231.5 per ounce. The contract size is 100 ounces; therefore the investor needs to sell 12 contracts in order to neutralize her exposure to gold. At the prevailing futures price this transaction has a notional value of $1.477 million. The COMEX Silver May futures contract has a price of $14.756 per ounce, and a contract size of 5,000 ounces. In order to most closely replicate the notional value of the gold futures trade, 20 Silver futures contracts should be purchased.

Over the next few weeks, the prices for both gold and silver increase, but silver has outperformed gold, with the silver spot price rising 16.7% compared the gold spot price rise of 4.7%.

The investor’s physical holding of gold has increased in value by $69,000. However, as planned, this is neutralized by the return on her short position in gold futures. The COMEX Gold June futures price is now $1291.8 per ounce, and this leg of the trade has lost $72,360 in value. The silver futures transaction increased in value to $17.474 per ounce, therefore her silver futures transaction has made a gain of $271,800.

Overall the combined position has made a net gain of $268,440. The investor can close out her futures positions with her physical gold holding being unaffected.

Summary

COMEX and NYMEX Precious Metals futures contracts can be used to manage risk exposures to precious metals.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Precious Metals Delivery

CME Group offers a range of precious metals futures contracts that result in physical delivery on maturity. The most significant of these are COMEX gold and silver futures and NYMEX platinum and palladium futures.

Physical delivery helps to ensure that there is a convergence in pricing between the physical market and the futures market at the futures’ expiry. To be able to assess the price of a futures contract with confidence, an investor needs to understand the process for delivery and the nature of the metal that can be delivered.

Precious Metals Brands

Precious metals are minerals, found in rock deposits around the world. These natural deposits are mined and transported to refiners who turn them into a standardized product, typically in the form of a bar or ingot, suitable for use by industry or investors. Each refiner has its own production processes, and imprints its name or logo on the bar. In the industry, the refinery name is referred to as the brand. Other information is also imprinted on the bar, such as a serial number and the weight and purity, or fineness, of the metal.

CME Group only allows certain brands of metal to be delivered against its futures contracts and brands must meet pre-set minimum standards. The exchange also specifies the minimum fineness of the metal in each bar that is acceptable. For example, the minimum fineness of COMEX gold futures is 995, or 995 parts per thousand, i.e. 99.5%. For platinum, the minimum fineness is 99.95%.

Designated Depositories

To be delivered against a futures contract, a precious metal must be deposited in one of the exchange’s designated depositories. A depository provides secure storage of metal and provides inventory management to the exchange and its members.

To become designated, a depository must meet the requirements of the exchange, including providing the necessary level of security.

Additional Delivery Requirements

The exchange has additional requirements in order for precious metal to be suitable for delivery. Gold and silver bars must be of a certain size: 1,000 ounces for silver, and either 100 ounces or 1 kilogram for gold. Gold refiners must adhere to international standards relating to responsible sourcing. Gold, platinum and palladium must be accompanied by a certification of assay and must be delivered to the depository by an exchange-approved carrier in order to maintain the chain of integrity.

Warrant

Once metal that meets the exchange’s specifications has been delivered to an exchange-approved depository, the owner of the metal can choose to register the metal with the exchange, a process often referred to as placing the metal on warrant.

A warrant is a legal document of title. At CME Group, warrants are created and stored electronically. The warrant contains all relevant information related to the metal and is created by the depository to be held in the exchange’s systems by the owner’s clearing member firm.

For precious metal’s futures, the warrant is used as the means of delivery.

Delivery Month

Futures contracts typically reference a calendar month for assessing a price reference or for effecting delivery. Gold, silver, platinum and palladium delivery can be made on any business day during the contract month.

The Delivery Process

The seller of the futures contract starts the delivery process by providing a formal notice of intention to deliver to the clearinghouse. The seller must identify the warrant they intend to deliver. In turn, the clearinghouse assigns the obligation to take delivery to a holder of a long futures contract.

Delivery occurs by the transfer of ownership of the metal warrant two business days after the seller provides the notice of intent. The transfer takes place at the settlement price set by the exchange on the day the seller provided the notice of intent.

The amount of metal in a bar can vary. While a futures contract is for a standardized amount of metal (e.g. 100 oz. for gold futures), the exact weight of metal is taken into account when the payment amount is calculated.

When futures buyers take delivery of metal warrant, they can choose what to do with it.  For example, they can choose to leave it on warrant in the depository, take it off warrant and sell the metal privately or ask for its removal from the depository for use or storage elsewhere, a process known as load out.

The process described above covers gold, silver, platinum and palladium futures contracts at CME Group. Alternative delivery processes are used for other contracts, including delivery via loco London unallocated accounts.

Information about the amount of metal held on warrant at the exchange’s depositories and the volume of deliveries taking place in precious metals contract is available on cmegroup.com.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Contango and backwardation are terms used to define the structure of the forward curve. When a market is in contango, the forward price of a futures contract is higher than the spot price. Conversely, when a market is in backwardation, the forward price of the futures contract is lower than the spot price.

Contango

In the chart below, the spot price is lower than the futures price which has generated an upward sloping forward curve. This market is in contango – the futures contracts are trading at a premium to the spot price. Physically delivered futures contracts may be in a contango because of fundamental factors like storage, financing (cost to carry) and insurance costs. The futures prices can change over time as market participants change their views of the future expected spot price; so the forward curve changes and may move from contango to backwardation.

Backwardation

In the chart below, the spot price is higher than future prices and has generated a downward sloping forward, or inverted, curve which is in backwardation. The futures forward curve may become backwardated in physically-delivered contracts because there may be a benefit to owning the physical material, such as keeping a production process running. This is known as the convenience yield, which is an implied return on warehouse inventory. The convenience yield is inversely related to inventory levels. When warehouse stocks are high, the convenience yield is low and when stocks are low, the yield is high.

Convergence

Over time, as the futures contract approaches maturity, the futures price will converge with the spot price, otherwise an arbitrage opportunity would exist.

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How and Where Precious Metals Are Traded

Review the marketplaces where precious metals are traded around the world.

Precious metals have always been used as means of exchange between traders and as a store of wealth, with gold being the metal most commonly used for this purpose. Today there are many ways to invest and trade in gold and other precious metals.

Precious Metals Bars

Investing directly in gold bars is a popular way to access these markets. Bars come in many sizes to suit the needs of the investor. One of the largest markets for gold bars is organized in London. Here the standard size of bar is 400 troy ounces, which is referred to in the market as a large bar. Other bar sizes frequently used around the world include 100 troy ounces, 1 kilogram and 5 tael. The standard size for silver bars in the London market is 1,000 troy ounces. For platinum and palladium, the acceptable size in the London market is between 1 and 6 kilograms.

Taking Ownership

Taking direct ownership of precious metals often involves the use of specialist vaulting and custody arrangements, secure transportation and insurance coverage. In addition to direct investment, the London market has also developed a system of indirect investment.

Precious metals can be bought on an unallocated basis through a bank or intermediary. The bank retains control of the metal whilst the buyer holds the metal on account. Owning metal on an unallocated basis introduces an element of counterparty risk, but provides for a more straight-forward mechanism for completing transactions: trades are completed by the banks moving balances between account.

The London markets for precious metals are organized on a private, over-the-counter basis, without a central exchange coordinating trading. In a number of other locations around the world, exchanges have developed to provide trading facilities in metal. One of the most active of these is the Shanghai Gold Exchange, which provides a centralized spot market for gold and silver bars.

Buying Coins

In addition to bars, investors looking for a direct investment in physical gold and silver can also buy coins. Many countries mint coins from gold and silver, and there are many private markets and agencies that support this form of investment.

Indirect Investment

Another popular way to invest in precious metal is through a mutual fund or an exchange traded fund. This is an indirect form of investment, where investors place their assets into a fund and in turn the fund invests in metal. The fund charges a management fee to cover its costs. With an exchange-traded fund, equity in the fund is traded on a stock exchange, with the most active of these funds being listed in New York and London.

Technology is widely used in the trading arrangements for all these products. A new development that is emerging is the is use of blockchain technology to support the ownership and the efficient transfer of precious metal.

Trading Precious Metals

It is difficult to make an accurate assessment of the amount of precious metal that is traded in these markets, as many trades are in private markets that do not report transaction information.

Data for the London market shows that on average over 19 million ounces of gold and 170 million ounces of silver are transferred every day, with the amount traded likely to be a multiple of this. Volumes on the Shanghai Gold Exchange show an average daily trading volume of over 6 million ounces of gold and 140 million ounces of silver. Trading in the shares of the largest exchange-traded fund for gold can be equated to approximately 1 million ounces of gold per day. It is clear that the amount of precious metal traded on the world’s markets is many times the amount produced from mining and recycling activities.

In the middle part of the twentieth century, the U.S. dollar was convertible into gold at a fixed official fixed rate of $35 per ounce, as part of the Bretton Woods system. This convertibility ended in 1971, and the price of gold became subject to the forces of supply and demand. As a consequence, the need for risk management tools developed. Coinciding with a change in U.S. law that had previously barred private ownership of gold, COMEX launched its Gold futures contract in 1974. The COMEX Silver futures contract had been available since 1933.  Platinum futures were launched on NYMEX in 1956, and Palladium futures launched in 1968. Precious metals futures are also available on a number of other exchanges, most notably in Asia, such as the Shanghai Futures Exchange and the Tokyo Commodity Exchange.

Futures contracts provide a mechanism to manage exposure to the underlying market. In the precious metal markets, the futures contracts offered by COMEX, NYMEX and others are a part of the wider global market for precious metals. They provide transparency and price discovery to the market. Options contracts on precious metal and precious metal futures are also offered by exchanges. Options contracts add to the range of trading and hedging strategies that can be employed by an investor.

Volume (2016) in COMEX Gold futures contracts averages the equivalent of 22 million ounces per day. Each contract is for 100 ounces of gold, and is for delivery at specified time in the future. Each COMEX Silver futures contract is for 5,000 ounces of silver. Its traded volume is equivalent to over 350 million ounces per day on average. The NYMEX Platinum contract is for 50 ounces of platinum, and the NYMEX Palladium contract is for 100 ounces of palladium. Together these two contracts trade in excess of 1.25 million ounces of metal per day.

In conclusion, the world’s precious metals markets consist of a wide range of products to invest in, and tools to assist in managing the risks associated with these investments, and the financial risks of dealing in the physical supply chain.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Precious Metals Supply and Demand

Understanding the forces and drivers of supply and demand in the physical market is essential for understanding the derivatives markets.

Supply

For all four of the main precious metals, gold, silver, platinum and palladium, new supply comes to the market from mining production and recycling of scrap and obsolete material.

Mining product accounts for between 70-85% of the total new supply, depending on the metal, with recycled material accounting for the remainder. The proportion fluctuates with time, reflecting the changing cost of production, reclamation values and the economic outlook, amongst other factors.

Gold

For gold, supply from these two sources amounts to around 120 million troy ounces per year, equivalent to around 3,700 metric tons. This production has a value in the order of $150 billion, which represents the highest value of production in the precious metals space.

Gold mine production comes from countries throughout the world. Chinese mine production has risen considerably in recent years, and now China is the world’s largest producer, accounting for around 16% of global output. In contrast, South Africa, which used to be largest producer has seen declining output in recent years, and now accounts for around 5% of production. Australia, Russia, the U.S., Canada, Mexico, Peru and Ghana also produce significant quantities.

Silver

Silver has the largest supply volume of the four metals at an excess of 30,000 metric tons per annum. This has a value in the order of $17 billion. As with gold, Chinese mine production of silver has increased substantially in recent years, although Mexico remains the largest source of silver mine supply. Australia, Russia and Peru are also significant suppliers of mine production. Silver is often a co-product of the mine production of other minerals, such as gold or copper.

Platinum and Palladium

Platinum and palladium have lower production volumes; 230 metric tons for platinum and 290 metric tons for palladium. South Africa and Russia are the most significant producers of mined metal. For platinum, South African production dominates the market, representing around 2/3 of global mining output.

The mined ore, and recycled metal is refined and normally formed into bars for transportation and storage. Platinum and palladium are also formed into a powder, known as sponge, for use in various industrial applications.

Production from mines and recycling is not the only source of supply to the market. Once manufactured, bars are stored in vaults. The stock of stored metal in these vaults that has accumulated over many years is also available as supply to the market.

There are no reliable estimates of the amount of precious metal stored in vaults. Some is owned by central banks, some is owned by investment funds and some is owned by individual and corporate investors and intermediaries.

Demand

Investment demand is a significant element in the market for precious metals and has an important role to play in establishing market prices for metals. However, investment transactions usually represent the transfer of ownership of stored material. This brings valuable liquidity to the market, but will have little impact on the overall supply and demand. Taken as a whole, investment behavior can be seen as either a net buyer of metal, and therefore a source of demand, or a net seller of metal, and therefore a source of supply. The overall impact of investment will reflect investor sentiment of how ownership of metal will compare to other investment opportunities over their investment horizon.

Gold is the most widely held investment commodity. As well as private investments in gold, central banks hold a significant amount of their reserves in gold. The IMF and the World Gold Council estimate that the world’s central banks hold around 33,000 metric tons of gold, worth over $1 trillion. Changes in this amount will affect the net supply or demand in the market.

Silver is widely used in the production of coins. The U.S. and Canada are the largest producers of silver coins. The U.S. Mint produces in excess of 40 million American eagle silver dollars each year. It is estimated that the global use of silver for coinage accounts for around 14% of annual silver production.

Industrial Use

Also, on the demand side, all four metals have a wide range of industrial uses, reflecting their physical properties.

Gold is used in electronics and in medical and dental applications, amongst other industrial uses.

Silver also has extensive demand from the electronics sector, and has seen increased use in photovoltaic cells. Silver used to be used extensively in photographic production, but this has decreased sharply with the advent of digital photography.

A major use of platinum and palladium is in the creation of vehicle emission control devices. They also have applications in the electronics sector.

Jewelry

Precious metals are also widely used in the manufacture of jewelry. Jewelry use is the primary physical use of gold, with the amount used equating to over 2/3 of annual production, i.e. over 2,500 metric tons each year. The use of silver and platinum for jewelry is relatively lower, at just under 1/3 of annual production. Palladium is used in jewelry, but the amount is much less significant.

Conclusion

In conclusion, thousands of tons of precious metal are produced each year from mining operations, adding to the stock of metal available. These metals are used in industry and in jewelry, from where they can be recycled back into the market.  Precious metal is also held in store as an investment and as part of countries’ official reserves. The combination of all these factors creates an active global market for precious metal.

Further Reading:

1) CPM Group precious metals yearbooks
2) Thomson Reuters GFMS
3) World Gold Council
4) The Silver Institute
5) International Monetary Fund
6) US Geological Survey

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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