Gold, the 'currency without borders' is a secure asset that can be tapped into at any time, under virtually any circumstances.
The dawn of futures trading in gold in India after almost a gap of 41 years will provide investors an unparalleled asset for diversification of their portfolio.
This can help protect their investments against fluctuations in the value of any one asset class. Since gold price is influenced by the economic forces that are different from, and in many cases opposed to, the forces that influence most financial assets, it is an ideal diversifier.
Gold is both money and a commodity. As a result, it is bought and sold by different people for a wide variety of reasons, ranging from adornment, industrial applications , investment and so on.
Historically it has maintained its value and has frequently been stable when other assets have been volatile or struggling to show positive returns.
Gold bears little or no relationship to other mainstream asset classes. It therefore provides investors with a powerful risk management tool, a study by World Gold Council (WGC) states.
Because returns on gold tend not to be correlated with returns on equities, including gold in portfolios is likely to enhance the consistency of performance by reducing overall portfolio volatility, particularly during periods of stress in the financial markets.
Although the gold market is relatively small compared to the stock and bond markets, it is a deep and liquid market in which it is relatively easy to execute trades, and is active 24-hours per day.
It is traded right from the rising sun in the East (Japan-Tocom market) to Europe (London) to a next sunrise in US (Comex). With now India joining the futures trading band wagon, Indians are poised to benefit from the price cues generated through continuous trading sessions beginning at Tokyo and ending in US.
Moreover, since trading spreads are narrow and subject to market conditions, it does not tend to widen until sizeable volume is generated. There are instances when trades of up to five tonnes (US$50 million approximately) have been executed through the market without having any significant impact on price.
WGC in its report states that at end-March 2003, while the gold market was only some 18 per cent of the size of the NYSE by market capitalisation, it had been more than 2.5 times as liquid in terms of turnover.
Best estimates suggest that turnover in loco London gold is approximately three times the "clearing" figures reported monthly by the London Bullion Market Association (LBMA).
In summary, therefore, although the gold market is small by comparison with some of the other capital markets, the liquidity is higher. Given this background, it makes a strong case for an investor in equities and bonds to have gold as an asset class included in the portfolio.
However, it will be a while before the futures trading in the country actually generates equal depth and liquidity, it would be prudent to formulate an investment horizon to be implemented in time when it actually comes of age.
Gold futures contracts are firm commitments to make or take delivery of a specified quantity and quality of gold on a prescribed date at an agreed price. Investors may take or make delivery of the gold underlying the contract on its maturity although, in practice, that is unusual.
The contracts are generally settled or squared off before the expiry of the contract.
The major benefit is that such contracts are traded on margin, that is only a fraction of the value of the contract has to be paid up front. As a result an investment in a futures contract, whether from the long or the short side, tends to be highly geared to the price of bullion and consequently more volatile.
Futures prices are determined by the market's perception of what the carrying costs ought to be at any time. These costs include the interest cost of borrowing gold plus insurance and storage charges.
Where the future price is greater than the spot price, as is almost invariably the case, the difference is known as the 'contango'. Very rarely, the future price is lower than the spot price in which case the difference is known as a 'backwardation'.
The cost of a futures contract is determined by the 'initial margin', that is the cash deposit that has to be paid to the broker.
This is only a fraction of the price of the gold underlying the contract thus enabling the investor to control a value of gold that is considerably greater than the cash outlay.
In the event of significant movements in the gold price which could lead to losses the broker will call for additional, so called variation, margin.
While such leverage can be the key to significant trading profits it can also give rise to losses in the event of an adverse movement in the price of gold.
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