Gold Forwards and Swaps
In the gold market, there are many derivatives available for investors who want to hedge or speculate. They may use gold futures which are quoted on exchanges (like Comex). In the over-the-counter market, gold forwards and swaps are traded instead.
Gold forwards (gold forward contracts) work essentially like futures – the main difference is that they are not traded in organized markets. It means that forwards have credit risk, as there is no clearing house, no mark-to-market mechanism. In exchange, forwards are not standardized, but customized to meet the investors’ special needs. Therefore, a gold forward contract is a transaction in which two parties bilaterally agree on the purchase and sale of gold at a future date. These contracts often contain terms that are party specific, that are difficult to transfer readily to other third parties – it makes them less transparent and liquid than futures traded in an open market. However, investors usually pay larger premiums for the privilege of customization. The majority of gold forwards are traded in the London gold market.
Gold swaps are contracts that exchange financial instruments (such as assets, liabilities, currencies, securities or commodities). They are non-standardized contracts that are traded over the counter. Most swaps involve cash flows based on a notional principal amount. Swaps are also used in the gold market. Usually, swaps in the precious metals markets are forward swaps and refer to purchasing bullion spot and selling the metal forward (from the borrower’s perspective), or selling the metal spot and buying bullion forward (from the lender’s perspective). It means that gold is borrowed (lent) against a currency. The gold swap rate for a gold-to-U.S. dollar exchange is the gold forward offered rate.
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