By Sarah Koshie
Gold is finding its way back to the global investment community. For Indians, it has always been an investment of first choice. The Indian’s love affair with gold goes back in history. In India gold has a religious and a social significance.

It is also valued both as a savings and investment vehicle. These factors have helped India emerge as the largest importer of gold contributing to around 25% of world gold demand.

Gold price has experienced a spectacular rise in recent years notwithstanding certain amount of volatility and intermittent downward corrections, rallying from $ 530/troy oz at the beginning of 2006 to its current level of around $670/troy oz, an increase of more than 25 percent.

The retail bullion investor in India holds the metal primarily as a hedge against financial distress. Investors in gold encounter a number of difficulties: inadequate hallmarking facilities, limited avenues for the investor to encash the metal and high fabrication charges.

Benefits of Futures Trade

With the introduction of bullion futures on commodity exchanges like NCDEX, investors can take positions in gold and will have to give or take physical delivery on expiry of the contract. The Exchange also allows for the investor ease of entry and exit from the market as he can always square off his position before the close of the contract. Commodity exchanges also provide an efficient hedging platform.

Let us now understand the role of gold futures using an example from the Indian social context. India’s insatiable demand for gold jewellery is well known. Even today gold remains the Indian bride’s ‘Streedhan’, the wealth she takes with her at the time of marriage.

The example we are considering illustrates how the futures platform can act as a mechanism to cover against price risk when buying gold futures on the Exchange.

Suppose Mr. A’s daughter will be getting married in April 2007. As a typical Indian father A wants to ensure that his daughter has an adequate stock of gold ornaments for the occasion. He intends withdrawing Rs 9,00,000 from his provident fund for this purpose. At current prices this translates into around 1 kg of jewellery. He will however not get this money until April since the paper work takes time. He wants to ensure that the gold prices do not adversely affect him in the meantime. Mr. A decides to protect himself by trading gold futures contracts on NCDEX. In January 2007 he buys 1 April gold futures contract (the equivalent of 1 kilo) at Rs 8500 per ten grams. Since a futures contract requires only a small upfront payment, generally less than 10% of the value of the contract, as a margin Mr. A can enter this transaction without too much of a problem. By the time of his daughter’s wedding in April, the futures price rises to Rs 9500 per 10 grams due to an increase in demand caused by the marriage season. The spot price of gold also rises to Rs 9600 per 10 grams to mirror this change.

Now the futures market can serve a dual purpose for Mr A. He can square of his position by selling a 1kg gold futures contract at Rs 9500 and buy 1 kg of gold from the spot market at Rs 9600. Thus despite making a loss of Rs 600 in the spot market he makes a profit of Rs 1000 in the futures market, thus making an overall gain of Rs 400 /10 gm in his overall transaction.

Alternatively he can take physical delivery of gold on the NCDEX platform at Rs 8500/10 gm and make an overall profit of Rs 1100/10 gms.

The evolution of a robust warehousing system where warehouse receipts and commodity balances are held in an electronic form through bank accounts ( very similar to securities being held in an electronic account) have greatly helped in improving the convenience and making trading more hassle free for market players.

The dematerialization of commodities has helped boost trading due to its manifold benefits:

• Elimination of risks related to physical WH receipts such as mutilated WH receipt, loss / theft, fake WH receipt etc

• Reduction of paper work and saves physical movement of WH receipt and risk associated therewith including settlement failure

• Buying and selling gold in the demat form is as easy as buying and selling shares

• Different commodities in different units such as Gold (Kilos), Cotton (Bales), Agricultural products (Metric tons) can be held in the same demat account

• Change of address needs to be communicated only to the DP and not to all warehouses

• Facilitates easy transfer of holdings through the electronic mode

NCDEX currently offers futures trading in 1 kg gold contracts for the months of September, October and November. The basis price of the gold contracts is 995 purity. NCDEX has also offers 100 Gm Gold for its retail investors.

Price Analysis of Gold: Historical Perspective

-Price Trends
o Average annual gold prices have risen from $20.67/troy oz in 1900 to $603.92/ troy oz in 2006
o Prices were non-volatile and relatively stable upto 1970
o The post 1970 phase can be divided into 3 parts
     o Phase I: Bull run 1970-1980 where average annual prices increased from $36.07/troy oz to all time high of $614.61/troy oz in 1980
     o Phase II: Bear Run 1980-2001 when prices plunged from the record high in 1980 to its nadir in 2001 at $272.67 /troy oz
     o Phase III: Bull Run 2001 till date. Prices have displayed a strong upward since 2001

-Volatility
Gold has displayed an annual price volatility of 14.4% over the period 1900 to 2006.
o Price Volatility between 1900-1968 was 6.5%
o Price Volatility since 1970 has been 22.3%

-Price Growth
The compound annual growth of prices (CAGR) since 1900 has been 3.2%
o CAGR over the period 1900-1969 : 1.0%
o CAGR over the period 1970-2006 : 8.1%

Comparison across asset classes

Attractive returns vis-à-vis other asset classes makes bullion an ideal investment option and an effective portfolio diversifier. The absolute cumulative returns on gold have seen more than a four-fold increase from 4.5% in 2004 to 20.9% in 2006.

The correlation factor can be a key element in determining a good risk strategy. It has been found that gold has a very low level of association with stocks. The co-efficient of correlation between gold and stocks was as low as 0.21 over the period 2004 till date making it an effective portfolio diversifier.

Gold is appealing to the investor for its stability and predictability of returns. Absolute returns per se may not be too relevant for comparison purposes since the risk factor is of paramount significance. Gold has been found to provide attractive risk adjusted returns (RAR). Over the period 2004-06, RAR for gold was 2.27 compared to 2.13 and 0.20 in the case of silver and Government securities. The Nifty was found to have a risk adjusted return 3.04 over this period.

Factors propelling Gold price in recent years:

-Depreciation of the dollar
The depreciation of the dollar vis-à-vis the euro has been one of the key supportive theme’s behind gold’s phenomenal bull run. Gold appears to have stepped back into line with traditional close inverse correlation with USD in recent times after the linkage broke down during much of 2005. Since 2006 the precious metal has appreciated on the back of a weaker dollar which has seen a fall of 14% vis-à-vis the euro. The strong positive bond which exists between the gold price and the dollar rate ($ per euro) is reflected in the high co-efficient of correlation of 0.84 between the two variables over this period. A weaker US currency makes gold, which is priced in the US dollar on world markets, more attractive to buyers using other currencies.

-Strong Global Demand
Surge in gold investment has been a key force in pushing gold to multi year highs. In the second half of 2007 total identifiable investment demand for gold rose 11% to 1,744 tonnes and 24% in value terms year on year, taking the total value of identifiable investment for the first half of 2007 to $36.9bn according to the World Gold Council (WGC). The increase in investor demand was particularly strong in Q2 2007 with identifiable gold demand rising by 19% and 27% respectively in tonnage and value terms.

The second quarter of 2007 saw Dollar demand for gold in the jewellery, retail investment and industrial sectors all scale record heights according to the WGC. Particularly noteworthy was the 37% y.o.y. surge in global demand for gold jewellery touching a record $14.5 billion on the back of strong demand from Greater China, India, the Middle East and Turkey.

The WGC notes that a key factor behind the rise in identifiable gold demand has been a reduction in price volatility in 2007 which has improved consumer confidence and also led to greater industry marketing activity.

Net retail investment rose by 51% in tonnage terms to 132.9 tonnes, and 60% in dollar terms to $2.9 billion, compared to Q2 2006, however total identifiable investment witnessed a fall of 4.8% in tonnage terms to 130.4 tonnes but was 1% higher in dollar terms at $2.8 billion compared with Q2 2006.

-Surge in Indian gold demand
India, which is the world's largest gold market in tonnage terms, achieved all-time records in gold jewellery and retail investment. Indian demand for jewellery and retail investment saw a massive 72% rise in the first half of 2007 amounting to 528 tonnes. India’s total demand for gold in Q2 2007 totaled 317 tonnes which was equivalent to half the global mine output for the quarter.

-Geo-political tensions and rising crude oil prices
The overall rising strength in crude oil prices since the beginning of 2005 has encouraged investment in gold as a hedge against an increase in global inflation. Escalating tensions in Iran, broader geo-political tensions in the Middle-east and worries over North Korea’s nuclear ambitions have helped spur investment in gold. Gold typically rises during times of unrest due to its attractive safe haven properties.

-Constrained Total Supplies
Overall supply of gold in the first half of 2007 has remained constrained witnessing a 4% fall over the same period last year.

Greater stability in prices has resulted in reduced supply of scrap in the market however this was partly offset by a 17% rise y.o.y. in official sector sales. The pace of selling under the Central Bank Gold Agreement (CBGA 2) stood out during the Q2 2007 reaching 148 tonnes, up 26% y.o.y. The first half of the year saw a 3% increase in total mine supply however mine supply in the second quarter of 2007 saw a 1% drop y.o.y.

-Miner De-hedging
A compelling explanation for the robust gold price has been the strong gold de-hedging trend among gold producers in recent times. Global dehedging reached new highs in the second quarter of 2007, with a record reduction in the global producer book of a provisional 5.2-million ounces. However, according to analysts the rate is expected to slow down in the second half of the year.

Sarah Koshie is an Economist with National Commodity & Derivatives Exchange Limited (NCDEX)