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How to Price Gold Futures

A PMEX Tutorial

December 2006
NCEL 2007

Definition
Futures are the simplest form of Derivative Products Future: Contractual Agreement to Buy or Sell something in the future at a price which is agreed today Represents an Obligation Derivative, because price depends on spot market
NCEL 2007

Spot v Future
Spot
Agree Price Now Pay Money Now Get Commodity Now

Future
Agree Price Now Pay Money Later Get Commodity Later
NCEL 2007

Futures Pricing Basics


Futures Pricing Does Not Involve Predicting the Future Difference between Spot and Future is in the timing of Payment and Delivery Factors involved in analyzing deferred cash/delivery are also used in pricing Futures Opportunity Cost, Time Value of Money, Value of Todays Rupee versus Tomorrows
NCEL 2007

Futures Pricing Steps


Futures Pricing Involves comparing two strategies/decisions:
Buy Now OR Buy Later

If Buy Now, Must Pay Money Now If Buy Later, Can Save Money Now to Pay Later
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No-Arbitrage Principle
Economic Benefit of Buying Now or Buying Later should be the same Eg. Gold Spot is Rs 13,000/10gms 3 month Deposit Rate is 10% (Risk-Free, Market Rate of Return) Strategy A: Buy Gold Now, Pay Rs 13,000. Give up potential to earn 10% interest Strategy B: Agree to Buy Gold in 3 months, Save Rs 13,000 and earn interest for 3 months (Rs 325) Everyone would go for Strategy B if Futures Prices did not adjust for opportunity cost
NCEL 2007

No-Arbitrage Principle
Spot Gold Buyer: Loses 10% interest Spot Gold Seller: Earns 10% interest Futures Gold Buyer: Earns 10% interest Futures Gold Seller: Loses 10% interest Futures seller needs to be compensated for foregoing 10% interest income. He will only sell at a price which brings him at least the market rate of return
NCEL 2007

Fundamental Question
Need to weigh just one equation:
Cost and Benefit of Buying/Selling Now Versus Cost and Benefit of Buying/Selling Later

Opportunity Cost of Futures Seller is 10%. He will lose money if he sells futures at less than opportunity cost Futures Price = Spot Price + Cost of Carry Spot = 13,000 ; CoC = 10% ; Time = 3 months Future Price = 13,325 If F > 13,325: Sell Future and Buy Spot and Lock-in Guaranteed Rate of Return of > 10% If F < 13,325: Buy Future, Sell Spot and Earn 10% on Cash plus extra return from buying future cheaply
NCEL 2007

How do Prices Move over Time?


Prices Futures Basis Cash Credible threat of delivery ensures convergence Present
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Time Maturity

Mathematical Representation
F = S x (1 + r)t Does Futures Price Calculation Mean Prediction? NO Futures Price depends on three variables:
Spot Cost of Carry Time
NCEL 2007

International Gold Price


Continuously traded round the clock globally in OTC, inter-bank, inter-broker/dealer markets
London AM/PM Fix 10.30(2.30pm PST) am / 3.00 pm (7.00 pm PST) Buying Gold in Spot Market results in a Gold Account being credited with Fine Troy Ounces If want Physical Delivery, Have to pay Fine Ounces in exchange for Physical Bars of desired weight and Fineness
NCEL 2007

Gold Futures Pricing

International Gold Price is in USD/Fine Troy Oz. Fine Troy Ounces i.e. Pure Gold International Price is for London Delivery All traders have to factor in their specific costs of delivering to locations other than London NCEL Contract is for delivery Karachi Have to include Costs of importing gold into Pakistan Have to determine Cost of Carry
NCEL 2007

Karachi Landed Price Calculation


1: International Gold Price - $/Troy Oz 2: Convert to PKR using Open Market Offer Rate 3: Convert to Grams 3.11034768 4: Freight Cost Average $1 5: Customs Duty, CAA Charge, Handling 6: Withholding Tax 1% 7: Spot Gold Karachi Landed Price in Rs/10gm
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PMEX Gold Futures Cost of Carry


1: Rupee Landed Price
2: Cost of Carry/Time Value of Money/Opportunity Cost/Interest Rate/Market Rate of Return - Kibor

3: Time to Expiry
4: F = S x (1+r)t
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Gold Futures Sensitivity Analysis


SPOT: $1 change in USD/Oz price = Rs 20 / 10gms FX: Re1 change in PKR/USD FX rate = Rs 220 / 10gms INTEREST RATE: 1% change in Kibor rate = Rs 35/10gms for 3-month futures TIME: 1 day closer to maturity for 3month futures = Rs 3 / 10gms
NCEL 2007

Box Arbitrage Analysis


Can use International Spot or Futures Prices as base to obtain the same Rupee Futures price, but need to be consistent due to No-Arbitrage Principle
Implied $ Cost of Carry International Spot Gold $/oz 656.85 5.51% US Gold Futures $/oz 665.90

PKR/USD Spot FX Rate 61.00

PKR/USD Fwd FX Rate 61.57 61.00 WRONG!

13,064 Pakistan Spot Gold Rs/10gms


(includes landed costs of Rs 180/10gms)

9.26% Calculate Rupee Cost of Carry

13,363 PMEX Gold Futures Rs/10gms


(includes landed costs of Rs 180/10gms)

NCEL 2007