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Understanding The Price Movement Of Gold

Objective of this study to understand the price movement of Gold.

Trying to understand the Gold as an alternative asset, comparing the price movement of Gold with various Indices such as Nasdaq, S & P 500, Dow Jones, FTSE 100, Nikkie 225, Hang Sang and Commodities such as Oil.

Purpose of this research is to understand the spread strategy of Gold by using various models such as Garch / Arch/ EGarch. Understand the price movement of Gold. Understand demand for Gold and can gold be alternative stable asset against strong currencies such as USD and EURO.

hapter I:


Gold is one most precious commodity in this world and has become one of the most expensive commodities. Is it so precious or is there need for every government to treat Gold as one major reserve? In today’s era this Yellow metal has became an important commodity in all the countries. Gold is traded in major commodity markets. Today Gold is traded in exchange as ETF (Exchange traded Fund) and today it is one of the safest asset to invest. Gold is traded as a Futures & Options markets. Now the questions comes will Gold replace other major assets like property, Funds, saving? Well it could be possible if given a thought. Now the question comes how you measure the risk of investing money into Gold. Will it give you good return considering long term investment?

Statistics clearly indicates that Gold has always given return if you prefer to be long which will be proven based of the performance of last 30 years. Today gold is treated as a safe haven, as it is less risky investment with highly volatile returns. Thus, combining two assets with gold can yields a portfolio with a zero variance. Assets such as Gold can become as safe havens in our portfolio of stocks if they have less than zero or negative correlations with stocks during recession period crises.

Where does this Gold from?

Gold was first discovered as shining, yellow nuggets. "Gold is where you find it," so the saying goes, and gold was first discovered in its natural state, in streams all over the world. Gold is a part of every human culture. Its natural beauty, luster and brilliance and its great malleability and resistance to tarnish made it enjoyable to work and play

Gold is gift from nature to human being, Gold is found in the solid form in veins in siliceous rocks. Gold can also be found from the sea and it is also found from various gold mines which are available in South Africa & Australia and other parts of the world.

From the point of view for India Gold has a unique position in the heart & the society of the people. Some have sought to explain the process of accumulation of gold in India in terms of cultural factors alone, but there appear to be very strong economic underpinnings for this phenomenon.

History of Gold

1200 B.C - The Egyptians master the art of beating gold into leaf to extend its use, as well as alloying it with other metals for hardness and color variations. They also start casting gold using the lost-wax technique that today is still at the heart of jewelry making.

Unshorn sheepskin is used to recover gold dust from river sands on the eastern shores of the Black Sea. After slicing the sands through the sheepskins, they

In 4000 BC - A culture, centered in what is today Eastern Europe,begins to use gold to fashion decorative objects. The gold was probably mined in the Transylvanian Alps or the Mount Pangaion area in Thrace.

1986 A.D. The first new gold jewelry alloy this century, 990-Gold (1% titanium) is introduced to meet the need for an improved durability of 99% pure gold traditionally manufactured in Hong Kong. The very malleable alloy is easily worked into intricate design, but can be converted into a hard, durable alloy by simply heating it in an oven. The American Eagle Gold Bullion Coin is introduced by the U.S. Mint. Treasury resumes purchases of newly mined gold.

The first use of gold as money occurred around 700 B.C., when Lydian merchants produced the first coins. These were simply stamped lumps of a 63% gold and 27% silver mixture known as 'electrum.' This standardized unit of value no doubt helped Lydian traders in their wide-ranging successes, for by the time of Croesus of Mermnadae, the last King of Lydia (570 -546 B.C.), Lydia had amassed a huge hoard of gold. Today, we still speak of the ultra-wealthy as being 'rich as Croesus

The chemical symbol for gold is Au.

· Gold’s atomic number is 79 and its atomic weight is 196.967.

· Gold melts at 1064.43° Centigrade

· The specific gravity of gold is 19.3, meaning gold weighs 19.3 times more than an equal volume of water.

What is the need for Backwardation & spread Strategy?

Backwardation means the inevitable contraction of the world economy, the beginning of an era of diminishing enterprise and employment, an era of snowballing business failures

Gold going to permanent backwardation means that gold is no longer for sale at any price, whether it is quoted in dollars, yens, euros, or Swiss francs. The situation is exactly the same as it has been for years.

Gold price Dynamics

The above Graph clearly indicates that the Gold Price has always been rising constantly. Last 25 years Data indicate how Gold price was moving and there was a sudden rise in the price of Gold since the year 2002 and since 2002 there has no looking back, price of Gold has been rising constantly. Gold being considered as alternative measure during the crises period has become one of the most precious commodity. Since year 2002 it was observed that there was lot ETF and MF traded only on Gold.

Literature Review

In Nov 2009 (By Pham-Duy Nguyen and Claudia Carpenter) Indian central government purchased 200 metric ton of Gold from the IMF and with the speculation that the government will purchase more Gold from IMF. Now why does Indian government purchase so much Gold? Recent Economic recession in US since Sept 2008 has impacted the whole world, which has lead to the up and downs in the currency market. US Dollar was considered to be one of stable currency since last 50 years. But recent downturn in the US market has made US dollar weak against the other currencies. Another currency which traded in the market against US dollar is the EURO. Since it the biggest recession in Euro and some of the European countries on the verge of bankruptcy, there has been lot of Debt from these European countries which has lead to the downfall of Euro. Since the major 2 currencies of the world are facing major crisis one needs to find an alternative solution to this problem. Now the next alternative which the word is looking to be traded is the GOLD and considered to the most stable and risk free asset provided assed and analyst correctly. Some of the literature indicates a correlation ship between recessions against rise the price Gold.

Past research indicated that, over the period 1982-1983, the gold price rose by about 67% at a time when the economy, equity markets and inflation were all in bad shape. Over the period, 1999-2000, during the dotcom frenzy, gold rose by 24% between June and December. And latest data from year 2008 to 2010 Gold has gone up by 25% and the recession still on the US and some of the European countries. This clearly indicates that there is some correlation between recession and Gold Prices.

A research by Jason Simpkins in Nov 2009 Indicate that the near future Gold price will be surging near to 2000$ an Ounce and might touch 5000$ an ounce.

Investment in Gold commodity should be done only when there is a surplus or excess money during the period of unfavorable macroeconomic condition. And one should be always prepared for bad time and take advantage.

Some of the Research indicates that around world 7% to 10% Gold exists in India. The official estimate puts the figure at around 9,000 tones, although much higher estimates range between 10,000 and 15,000 tones which are unofficial. Total global stock of gold is being estimated at around 145,000 tones. Now why Does India have so much of consumption of Yellow Metal? Due to huge domestic consumption or protect against the US$ and use Gold as an alternative reserve.

Some of the key information / Statistics from IMF’s GOLD (Taken from IMF)

Between December 1945 when the IMF came into existence and 1978, all new members had to pay 25% of their subscriptions in the form of gold (the remaining 75% in their own national currencies)

At the end of 2000 the Fund held 3,217 tones (103 million ounces) of gold, worth $27 billion at a price of $265/oz. Apart from the US with over 8,000 tones and Germany with almost 3,500, no other country or institution holds as much but now India is one key countries who is holding around 10% of the Gold only after china and as the strategy suggest that they will keep buying Gold for the future reserves. Some of the statistics related to Commodities which are backwardated. Crude oil futures have been backwardated around half the time since 1998. Over this period, the natural gas market has been backwardated only 15% of the time, while copper has been backwardated 34% of the time. The futures curve for gold has almost always been in contango due to the large level of above-ground inventories. Since 1975, the gold market has backwardated only four times.

Today Gold gives a monetary the power and the degree of freedom for holding reserves in foreign currencies.

An research from Barclays Indicates that Gold prices will always trend higher; Demand will surge, thanks to China (on top of India); Supply is falling which will raise the price of the Gold and Long-term investors will return to gold. All these factor show favorable growth opportunities and consider Gold as one of key asset in the portfolio.

Demand to surge, thanks to China (on top of India) (Research from Barlcays on Nov 2004 By Kamal Naqvi)

Countries like China and Indian has become the topic one of the big commodities markets. There is a huge demand for gold in the Chinese and Indian market, demand largely stagnant over the past decade compared with several-fold increases for many other commodities. Since there is too much demand of gold in these market it has become extremely difficult to demand of Gold. China is already the world’s third-largest consumer of gold jewellery. Secondly, China has actually already experienced a surge in gold demand – this occurred from 1989 through to 1992 when gold demand increased four-fold from 40 tones to more than 210 tones. This increase was driven by general market liberalization, income growth, and depreciation of the renminbi. As a result of above measure gold can help the country to depreciate the currency

In the Feb 2010 in one of the literatures by Virginie Coudert and Hélène Raymond, it was found that gold is hedged against both stocks and inflation including gold in financial portfolios which will help to reduce the variance.

Gold is an attractive investment if you are planning to diversify in specific periods, for example in 1978-1983, whereas it yielded negative returns in 1984-1995. Think that gold can be a hedge for inflation, instead of stocks. However, one does not find any impact of the unexpected change in inflation on gold prices or returns, contrary to other commodities.

Intermittences in the relationships are further explored by studies linking the price of gold to the behavior of other variables. For example, Capie et al. (2005) emphasize the role of the US dollar exchange rate that they find negatively related to the gold price on weekly data over the period 1971-2004. Besides, Jensen et al (2002) highlight the role of the monetary stance. They show that commodities, and especially precious metals, yield higher returns during phases of restrictive monetary policy in the US. They link this to the fact that commodity prices increase with inflation, while interest rates are hiked up in reaction to inflation. According to them, including commodities in a portfolio does not necessarily improve its performance, but an active management of these assets can do it, when taking into account the monetary stance.(From Are there any Safe Havens in Bear Markets)

Research Problem

There is a Big Debate going during the major financial crisis in the whole world Whether Gold can replace major currencies like USD, EURO and Yen?

There has been very little research / attention in predicting the Gold price movement for the next 10 to 25 years. Will there enough Gold Supply in Future?

Few research show the actual trend of backwardation;

Few research papers explain deflation with the rate of interest movement & falling prices of different commodities such as Oil, Grains etc (From BACKWARDATION THAT SHOOK THE WORLD)..

There is a Conflicting results among the Gold Price & Inflation

Objective of the Study

Understand the Correlation of recession against the rise in the price of Gold.

Is Gold an alternative asset class?

Objective is to study and understands the dynamics of Gold in the portfolio and understand the Business cycle movement of Gold viz a viz other commodities.

To study the performance of Gold Vs General broad Market (Such as S & P 500) and test the long run performance of Gold against varies indices

To Find and estimate the trends of Backwardation & Spread strategy


The Methodology used in conducting analysis will be as follows

Data Collection

Data Segregation

Various Analysis for Data

Analysis of Various trends Backwardation and Spread Strategy from the data collected

Correlation between Gold, Inflation, Stock Indices and recession

Add Gold as one of the key asset to the Portfolio

Theoretical Framework


Backwardation is a term very common in commodities futures market.

When the futures price of the commodity is trading at a price lower than the spot price, the phenomenon is called backwardation.

Alternatively the prices of the futures which may expire earlier are higher than the price of futures expiring further away. Reverse of backwardation is called contango. Though the fundamental concept of backwardation remains same, backwardation is defined differently in the way they are explained by different authors or internet websites. For example, definition as explained by various websites is as below

Wikipedia definition:

Backwardation is a futures market term: the situation in which, and the amount by which, the price of a commodity for future delivery is lower than the spot price, or a far future delivery price lower than a nearer future delivery. Formally, backwardation means a downward sloping forward curve (as in an inverted yield curve). A backwardation starts when the difference between the future price and the cash price is less than the cost of carry.

Investopedia definition:

A theory developed in respect to the price of a futures contract and the contract's time to expire. Backwardation says that as the contract approaches expiration, the futures contract will trade at a higher price compared to when the contract was further away from expiration. This is said to occur due to the convenience yield being higher than the prevailing risk free rate. Pattern of futures prices trading at less than spot price is common in consumption based commodity. Commodities which are more of investment based like Gold, not necessarily show this behavior.

Why consumption based commodities are more inclined to have backwardation situation? Though storage cost might apply for all commodities, increasing the cost to carry in futures, consumption based commodities add another variable known as convenience yield.

Discussing on backwardation, one also comes across the term called Normal Backwardation which is not exactly same as backwardation.

This is explained in brief here, which also gives insight of supply and demand for consumption based commodities. The shape of the futures curve is important to commodity hedgers and speculators. Both care about whether commodity futures markets are contango markets or backwardation markets

Contango and Normal Backwardation: Patterns over Time

We have established that a futures market is normal if futures prices are higher at longer maturities and inverted if futures prices are lower at distant maturities. As we approach contract maturity, the futures price must converge toward the spot price. The difference is called the basis. That's because, on the maturity date, the futures price must equal the spot price. If they don't converge on maturity, anybody could make free money with an easy arbitrage

Now we can define contango and normal backwardation. The difference is that normal/inverted refers to the shape of the curve as we take a snapshot in time. Contango and normal backwardation refer to the pattern of prices over time. Specifically, is the price of our contract rising or falling?

Figure 7

Contango is when the futures price is above the expected future spot price. Because the futures price must converge on the expected future spot price, contango implies that futures prices will fall over time as new information brings them into line with the expected future spot price.

Normal Backwardation is when the futures price is below the expected future spot price. This is desirable for speculators who are "net long" in their positions: they want the futures price to increase. So, normal backwardation is when the futures prices are increasing. Because the futures price must converge on the expected future spot price, backwardation implies that futures prices will rise over time as new information brings them into line with the expected future spot price.

Hence, it is more precise to say that in contango, futures prices for a given maturity date are falling. In normal backwardation, futures are rising. This is not exactly the same as the shape of the futures curve because futures prices are constantly adjusting to consensus expectations about the expected future spot price.

Normal backwardation is not quite the same as backwardation. Backwardation is the same as inverted when futures prices are lower than spot prices.

Risk Exposure and Management Strategies

Depending on the type of exposures, risk management strategies can differ.

Exposure Type

Risk Management Strategy

Price of Gold Producer hedging: swaps or put options

Cost of transportation, Freight hedging

Insurance, duty/tariff

Cost of carry (time value Hedging with time spreads

Of money)

Refinery Margins Hedging cracks (spread between Gold

And Indices)

Refined Product price Consumer hedging: swaps or call options

Location/ basis risk Hedging product – product risk or

Regional risk

We will be looking at two spread trading strategies (time spread and crack spread), which might turn profitable even during backwardation market. If not be profitable at least, minimize risk.

Types of Spreads traded in the market

Time Spreads

Regional Spreads

Crack Spreads

Crude Grade Diff

Product vs. Product

Interfuel Spreads

Q1 vs. Q3; winter vs. summer, Cal 05 vs. Cal 06

NYMEX West Texas Intermediate vs. IPE Brent

Crude-gasoline; crude-heating oil / Refinery margins

West Texas Intermediate vs. West Texas Sour

Gasoline-heating oil

Natural gas-heating oil

Spread type Examples

Figure 9

Time Spreads

Strategy involves analyzing futures prices of various expiry dates with respect to interest rates prevailing in the economy.

A spread is defined as the sale of one or more futures contracts and the purchase of one or more offsetting futures contracts. A spread tracks the difference between the prices of a long position against the short position. Therefore the risk changes from that of price fluctuation to that of the difference between the two sides of the spread. Rather than taking the risk of excessive price fluctuation, the risk in the difference between two different trading months of the same futures is used to minimize risk. Spread trading is not only limited to trading futures of same commodity of different expiries but also the difference between two related futures contracts in different markets such as between commodity and equity or index or any benchmark being traded on exchange.

On a very broad level, spread trading can be categorized in three types

Intramarket Spreads : Intramarket spreads are created as calendar spreads, long and short futures in the same market, but in different months. An example of an Intramarket spread is being long on July WTI Oil and simultaneously Short December WTI Oil. We will be analyzing the data available for crude oil and creating strategies for Intramarket spread trading.

Intermarket Spreads : An Intermarket spread is accomplished by going long futures in one market, and short futures of the same month in another market. For example: Short May Oil and Long May Gasoline. Intermarket spreads can become calendar spreads by using long and short futures in different markets and in different months.

Inter-Exchange Spreads : A less commonly known method of creating spreads is via the use of contracts in similar markets, but on different exchanges. These spreads can be calendar spreads using different months, or they can be spreads in which the same month is used. Although the markets are similar, because the contracts occur on different exchanges they are able to be spread.

Are there any Dangers in Spread Trading?

There is always the danger that the prices of both the futures move contrary to

expectations. For instance, when the price of the futures which we have a long

position decreases and that of the other security which we have a short position

increases. In such a situation, the strategy will lose heavily with both contracts on

wrong footings. A pertinent point to note is that technical and statistical studies are all based on historical prices that do not necessarily predict future price movements.

Price movement of Oil is no doubt dependant on the global current supply and demand, it is also exposed any new policies taken by the Government on import/exports, slide or rise in US currency due to economic growth, and / or, discovery of any new oil rig which would have a supply impact in a years time.

To minimize risk under these circumstances, where a position was made to profit from rising Oil price believing the market to be in contango but there was a decline and the market turning into backwardation crack spreads can be traded.

Crack Spreads

What is Crack Spread?

Crude oil in its raw form is a thick, black, sticky hydrocarbon liquid. It can be distilled

and refined into many useful products such as petroleum gases, gasoline, jet fuel,

naphtha, kerosene, heating oil, diesel, lubricating oil, plastics and bitumen tar.

Cracking is a process of breaking the molecular structure of crude oil in order to

produce more of gasoline and heating oil as they are in greater demand. Crack

Spread measures the difference in the price of crude oil and the prices of gasoline

and heating oil in terms of USD per barrel of 42 US Gallons each.

Generally, prices of these by-products tend to move in tandem with the underlying

price of crude oil. However, due to fluctuating demand and supply of these byproducts, which can be affected by seasonal factors or the threat of war in the Middle East, their prices may rise or fall more rapidly than that of crude oil. If the spread increases, it means that refining profitability is likely to increase because the selling prices of gasoline and heating oil are getting higher than the cost of the crude oil to produce them. If the spread diminishes, refiners are likely to reduce the amount of crude they process in order to minimize losses from the softening of the gasoline and heating oil prices. Energy traders, refiners and even Oil companies can take advantage of the price anomaly by initiating a crack-spread. This involves the purchase of crude oil futures and the simultaneous sales of unleaded gasoline and heating oil futures contracts.

A Crack Spread can have different ratio denotations such as 211, 321, 431, 532 and

743. The 211 spread measures the difference in price of 2 parts of crude oil to the

prices of 1 part of gasoline and 1 part of heating oil; 321 is for 3 parts crude oil

against 2 parts gasoline and 1 part heating oil, and so on.

The most widely used crack spread is the 321 spread which can be executed with 3

lots of Crude futures, 2 lots of Gasoline futures and 1 lot of heating oil futures, or any higher multiple of the ratios. Crude futures, e.g. Western Texas

Intermediate, are priced in USD per Barrel. On the other hand, Gasoline and

Heating Oil futures are prices in USD per gallon. Thus, we need to convert the

prices of its by-product to USD per Barrel. The formula to create the 321 Crack

Spread is:


FUTURES PRICE x 0.42 x 1)] - (WTI FUTURES PRICE x 3)} ÷ 3

We can use the above formula to create a synthetic - CRACK Index.

Crack Spread can be traded by either:

Buying Crack i.e. buying the 2 products and selling WTI futures, or

Selling Crack i.e. selling the 2 products and buying WTI futures.

Strategy involved in trading Crack Spreads

Rising Crack Spread - a scenario where prices of gasoline and/or heating oil are

rising faster than WTI futures prices.

Hence, crack traders may enter into a long crack position. This involves going:

• Short 3 lots of WTI Futures

• Long 2 lots of Unleaded Gasoline Futures

• Long 1 lot of Heating Oil Futures.

Declining Crack Spread - a scenario where prices of gasoline and/or heating oil are

falling faster than WTI futures prices.

Hence, crack traders may enter into a short crack position. This involves going:

• Long 3 lots of WTI Futures

• Short 2 lots of Unleaded Gasoline Futures

• Short 1 lot of Heating Oil Futures.


Findings and analysis of convenience yield

Backwardation and Demand – Supply analysis

Managing risk through Spread trading

Time Spreads

Crack Spreads

Time Spread on Crack Spreads


Chapter V: Conclusion and Recommendation

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