This is another post on backwardation, fourth in a row. Maybe I need to change this blog to www.backwardationchat.blogspot.com.
Anyway, I have been corresponding with Professor Tom Fischer of the University of Wuerzburg on backwardation and I've been remiss in not drawing my readers' attention to his Faux Gold Arbitrage article which was published by Bullion Vault on Sep 3rd or available from Tom's website as a pdf here.
Tom's article addresses the claim that backwardation is abnormal as it is profit that is not being arbitraged away and he picks up on the interest rate differential point I made in my 2008 "Gold isn't in backwardation, the USD is in contango" post.
An important point he makes is that arbitrage is "an investment that outperforms the risk-free rate of return in that currency ... “making money out of nothing”, or a “free lunch”, as we could borrow money if we do not have any, then outperform the loan's interest (the risk-free rate) by ways of the arbitrage strategy, and finally pay back the loan while keeping the profits over the risk-free return."
He goes on to note that if an investor had to first borrow gold to run the arbitrage, then at the end of the period the amount earned from selling gold at spot and buying the cheaper future would just equal the interest rate on the gold loan. Therefore no profit and thus no arbitrage.
Because gold is monetary (and not a commodity) and has an interest rate, OTC forwards and futures markets just reflect the interest rate differential between the two currencies USD and XAU. From this viewpoint, gold futures markets are just synthetic gold borrow/lend markets. Consider these simplified flows involved in a backwardation "trade" for someone with gold using Tom's numbers:
Start of trade:
Start of trade:
- Sell gold: -1000oz
- Receive cash: +$1,500,00
- Buy future (ignoring margin for simplicity) @ $1,470
- Put cash on deposit @ 1%: -$1,500,000
End of trade:
- Recall deposit with interest: +$1,515,000
- Pay cash for future: -$1,470,000
- Receive gold from future: +1,000oz
Consider these flows for a gold loan:
Start of loan:
- Loan gold @ 3% based on $1,500 price: -1000oz
End of loan:
- Gold loan repaid: +1,000oz
- Receive interest on loan: $45,000
Compare the net flows between the two:
|Date||Backwardation Trade||Gold Loan|
Backwardation (or contango) in a futures markets for currencies like gold is not an arbitrage trade, it is just a lend (for a backwardation or decarry trade) or borrow (for a contango or carry trade). Futures market prices just tell us what market participants think is the appropriate interest rate to receive or pay for a gold loan.
That interest rate is interesting and tells us something about the views of market participants, especially with respect to US dollars. But there is nothing right or wrong/abnormal about the fact that gold interest rates may be higher than USD interest rates, just like there isn't anything normal or abnormal about the fact that AUD interest rates are currently higher than USD interest rates.
PS - in emails Tom makes the case that if anything, backwardation should be the normal state for gold. But that is for another post.