Friday, September 14, 2007

Gold Carry Trade....

The following has corrupted most Central Banks around the world:

Central banks sit on huge supplies of gold that earn them no interest and cost them money just to store securely. To earn a little revenue on these static assets, they loan their gold to banks, called buillon banks, at a ridiculously low interest rate on the order of 1%.

The banks turn around and sell the gold in the market, typically in the London bullion market, and invest the proceeds in a higher-paying asset, such as long-term Treasury bonds. If bonds pay 4.8% then the banks earn an easy 3.8%.

The problem is that if the gold price starts to rise, profits can be wiped out or turned to losses. The banks, of course, realize this and hedge their gold sales by buying gold futures. The hedge, however, is not perfect. If central banks call in their gold loans, the banks cannot wait for contract expiration to take delivery on the gold they purchased via their futures contracts. They have to pay back their loans right away and if gold prices are stable, there is no problem for the banks going into the physical market to buy back their gold. However, if gold starts to rise quickly, the added demand from the banks to buy gold can exacerbate the rally causing what amounts to a mad dash for the metal. The market responds with steeply higher prices, bankrupting the entire bank chain.



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