Futures Pricing Basis Essay

Introduction

It is the universal nature of man to try and secure his future and that of his family. Since thousands of years ago, gold has been the primary means of trading among the oldest cultures and civilization. It is used as a means of exchanging goods and services, and at times, of bribing or coaxing someone to do another person’s bidding.  Fast forward into the 20th century, the value of gold in the modern and contemporary economy is even more significant and pronounced.  Globalization of the world’s economy made the value of each currency even more prone to various economic booms and busts, not only within a specific country or region, but is now affected by events halfway across the world. People turned to gold as a “safe haven” to assure the value of their assets (Siddioi, 2004).   Remember the fragile boom of China’s economy?  When the Chinese Yen faltered and the stock market in China dropped, the New York Stock Exchange (NYSE) index also went down for both the NASDAQ and Dow Jones (FT.com 2006).

The interwoven indicators and characteristics of the global economy make the intricacies of investing into gold even more important to understand and master – if possible. To do this, let us closely examine the parameters or indicators that influence the prices of gold in the market.  Before embarking on this, let us go back further to explore why the US dollar was made the comparable basis of world trading.

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Influence of the US and its use of gold vis a vis the US dollar and Why

            As early as 1792, the US was the first to assign gold a monetary value when Congress acted to back its currency, the UD dollar, with gold and another precious metal, silver. When the Great Depression of the 1930s hit, all other currencies freed their own currencies’ association with gold so as to stabilize their own economies.  The “gold backing” was re-introduced in 1944.  To quote: “Gold formally reentered the world’s monetary system in 1944, when the Bretton Woods agreement fixed all the world’s paper currencies in relation to the U.S. dollar, which in turn was tied to gold” (Commodity Futures Options Trading). From then on, the US dollar was made the basis of exchange in relationship to the value of the US gold deposits.  Other countries followed suit and the value of each nation’s or region’s currency (as in the case of the Euro) now relies on its gold deposits.

Determinants of Gold pricing in the future

            There are several questions that need to be answered when trying to predict the future of gold prices in the market.  Going through the news headline the last 3 to 5 years, the ups and down of the price of gold is closely tied to any negative event all over the world.  Several recent events can illustrate this point.  One such event that sent tremors in the stock market and prices of gold is the dot-com bust in the late 1990s to early 2000. Another is the uncertainty of a protracted war in Iraq by the US and its allies.  During these periods of uncertainty, people rush to secure their holdings by converting their assets and purchasing gold certificates or deposits (Wong, 2006).

What factors then determine future prices of gold?

            Going through the same six to seven year period scan from the year 2000 to the early part of 2007, market analysts and even regular investors look at the news headlines and closely watch world events unfold.  These same people make split second decisions whether to buy or unload – usually at a trading place like the New York Stock Exchange market or NYSE.  The following events have served as determinants or factors of gold prices during this period of time: Oil prices/ Energy prices; Inflation index; Supply and demand for gold as a hedge fund; Security Threats/ or war or terrorism (example: 9/11/2001); Value of US dollar; Political and economic indicators of stability – usually regional (i.e. possible protracted war in Iraq); Prices of related minerals and industries like mining, etc; and  the boom and bust of specific industries – example, dot com bust in 2000.

           Expounding further on each of the enumerated factors and determinants in the price of gold there are more factors to look at..  First is the effect of oil prices or energy and petroleum products.  Last January 25, 2007, the headline in Bloomberg.com indicated “Gold Declines as Lower Oil Costs Curb Metal’s Investment Appeal” (Jae Hur, 2007).  The first few line further stated “Gold declined for a second day, retreating further from a five-month high, as a drop in oil prices curbed the metal’s appeal as a hedge against inflation” (Jae Hur, 2007).  The news line says it all.  People buy less gold when the demand for security, or hedges against inflation is also down.  In summary, people feel more secure when prices of oil drop.  The movement of the price of oil and other petroleum or energy products is synonymous to a decline in the demand for gold securities.

            News of the inflation index also affects the pricing of gold. Last February 26, 2006, newsflash stated this headline: “Gold May Approach 25-Year High as Investors Seek Better Returns” (Nguyen, 2006).  This is because when inflation index increases, prices and demand for gold increases as well.  Again, it’s all about the feeling of security that people want to hold on to.  Gold has been known to be a precious and resilient metal and this has been proven for several thousands of years.  However, just to sum up the sentiment during this period being quoted, Citigroup Inc. analyst John Hill said it all on February 23, 2006: “We regard gold as an essential barometer in the grand battle between hard and financial assets… Gold prices have been resilient following oil, nuclear, geopolitical jitters, lackluster earnings for broader equities and fretting global economic imbalances” (Nguyen, 2006).

To prove the point above even further, the trend in gold prices is logically affected and influenced by its supply and demand (Universal Law of Economics).   Jason Goulden, director of corporate exploration strategy at Metals Economics stated “The drop in new reserves followed years of reduced spending on exploration as gold fell to a 20-year low of $253.20 an ounce in 1999. Worldwide exploration budgets fell to a 12-year low of about $780 million in 2002… (Yeong, Dec. 2006)”. Whenever there is a huge demand for gold set by frantic investors trying to get a hedge fund versus any other diminished investment, whose value can bring about by an event or catastrophic developments, people set to find and buy gold.  When supply is low, prices go sky high as was the case in this newsflash when the statement by Jason Goulden was made.

Another volatile parameter or indicator being used to influence the rice of gold is news of security threats, news of war or terrorism.  The most far reaching damage during recent times was caused by the post 9/11 tragedy.  It wasn’t just the tragedy itself but its far-reaching consequences and aftermath that caused the prices of gold to soar and the other bond securities and certificates of value to drop like a hot potato.  Five years after the 9/11 attacks, financial headline news states: “Sept. 11 Attacks Drag on the World Economy Today” (Hassett, 2006). According to the same author, 9/11’s effects can be distinguished in two ways: first is its being the immediate and significant single cause of the US economy’s 1.4 GDP decline for the last quarter of the year 2001, and second, its impact on the entire world economy which is both immediate, far reaching and also long lasting.  He pointed out the events that happened right after 9/11: the closure of the US borders, the decline of international travel, the ramifications on all Arab states and nations, the jitters over the pre-Iraq war period, and the protracted war in Iraq.  In 1999, the price of gold topped at US$253.00 per ounce (Wong, 2006).  Five years after 9/11, prices of gold went up to US$732.00 per ounce last May 12, 2006 (Yeong, 2006). To quote further in closing this point: “Just as significant has been the intangible damage to the economy. The attacks taught the world that the risk to all of us is much higher than we believed. That realization has made market participants a great deal more risk averse… that increased risk aversion has driven up the prices of assets that are perceived to be safe and depressed those of assets that may be more exposed to a sharp decline if another terrorist attack occurs….” (Hassett, 2006).

The price of gold also moves inversely of the value of the US dollar (Nguyen, 2007).  In his article, “Gold Prices Fall From Six-Month High as Dollar Gains” published in Bloomberg.com last February 2007, Nguyen articulated the reasons why.  He wrote: “Gold generally moves in the opposite direction of the U.S. dollar, which today rose against most major currencies tracked by Bloomberg. The metal climbed 23 percent last year, while the dollar dropped 7 percent against a basket of six major currencies” (Nguyen, 2007). Furthermore, Tom Hartmann, a commodity broker at Altavest Worldwide Trading Inc. in Mission Viejo, California  stated: “The combination of the dollar being up and a decent decline in oil puts pressure on gold…. If oil weren’t down as much, gold would be seeing more support.” (Nguyen, 2007)

The influences on the price of gold aren’t limited to events happening in the US though.  As any one country is affected by the global economy in general, all other political and economic indicators of stability – usually regional (i.e. China’s volatile economy) affects everything in its path – directly or indirectly.

Speaking of global cause and effect, prices of related minerals and industries like mining wherever the group interest may be located, also affects the rise and decline of gold prices. To quote: “Copper and aluminum futures in Shanghai fell today by the daily limit of 4 percent amid concern rising inventories indicate demand for the metals is weakening…. meanwhile, gold prices fell as much as 0.6 percent in Asian trading” (Shiyin ; Tsang, 2006).  In the same article, effects of these are visibly shown halfway across the globe: “The price of crude in New York fell 1.3 percent on May 19 to $68.53 a barrel, the lowest close since April 7. Prices dropped 4.9 percent last week, the biggest weekly decline since March, and the contract recently traded at $68.22… (Shiyin ; Tsang, 2006)”.

The parameters, indicators or factors – whatever the term used to predict and gauge the price of gold at any given time hinge not on one factor alone, but is affected by a multitude of any combination of events and investor reactions to news around the globe.  This is also the reason why people – particularly investors, turn to gold in times of instability or uncertainty. There are other reasons why investors turn to gold.  Bill Fleckenstein enumerated these reasons in an article for MSN’s Money Central: “Owning precious metals is an insurance policy against the Fed, inflation, tough economic times and a currency debacle…” (Fleckenstein, 2003).

 Gold is a viable precious metal and although its value may not dramatically rise, neither would its value be totally diminished by any one event, however catastrophic it may be.  As shown by the previous discussions above, the price of gold in 1999 was at an all time low of US$253.00 per ounce (Wong, 2006).  Between then and now, and despite the far reaching effects of 9/11 which was deemed the single biggest catastrophic and long lasting tragedy in modern times, the price of gold increased to a peak of  US$732.00 per ounce in March 2006 (Yeong, 2006). The price fluctuation of gold was a far cry from other bonds and stock certificates like the boom and bust of specific industries, for example, the dot-com bust in 2000.

In closing, gold as a hedge against all the intangibles in the world of investing is a good investment for sure.  However, as always, diversifying even when investing in gold is still a good advice for any speculator – then and now.  As King Solomon himself said: “Cast your bread upon the waters, for you will find it after many days.  Give a portion to seven, or even to eight, for you know not what disaster may happen on earth.”  (Ecclesiastes 11:1-2, King Solomon, ca 1000 BC).

Works Cited:

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http://www.technicalindicators.com/gold.htm

Fleckenstein, Bill  (9/29/2003). Contrarian Chronicles: Making the case to own gold. MSN Money Central. Available at : http://moneycentral.msn.com/content/P59638.asp

Hasset, Kevin. (September 26, 2006). Sept. 11 Attacks Drag on the World Economy Today: Available at: http://www.bloomberg.com/apps/news?pid=newsarchive;sid=aEhdk8yf5pV8

Hur, Jae. (January 2007).Gold Declines as Lower Oil Costs Curb Metal’s Investment Appeal. Bloomberg.com. Available at: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a5SZc86c5giQ

Johnson, H. & Hayward, S. (December 22, 2005)

U.S. Stocks Rise for 2nd Day on Inflation Gauge; Humana Rises. Bloomberg News. Available on:  http://www.bloomberg.com/apps/news?pid=newsarchive&sid=akyFv9VeGRGc

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Nguyen,  Pham-Duy. (February 26, 2006). Gold May Approach 25-Year High as Investors Seek Better Returns. Available at: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aptP66Ss6.gs

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