The Price of Physical Gold vs Paper Gold

Discussion in 'General Precious Metals Discussion' started by Fraser, Nov 24, 2019.

  1. Fraser

    Fraser Active Member

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    First Some History of Physical Gold and Futures Pricing

    In August 1971, Richard Nixon ended the fixing of the USD to physical gold and the gold price then jumped from $35/oz to $195/oz in December 1974 (a 6X increase). The first date is infamous, but the second is more important, because it is the date that COMEX launched its Gold Futures Contract, enabling TPTB is create "paper gold" (out of thin air) and sell it into the market to control the physical price. The scheme worked well and the gold price fell back to $100 in September 1976. But then a mixture of the Hunt Bros (cornering silver) and economic inflation saw gold ultimately rise to $800 in January 1980 (a 23X increase from 1971).

    Price Control of the Underlying Value

    When a price is controlled by decree (such as gold before 1971), the question naturally arises - What would be the price without that control? And the historical answer (from 1971 to 1974) was that gold jumped by around 6X before a new control mechanism (COMEX futures) could be established. In other words, physical gold was undervalued by nearly 6X in 1971 and was therefore a strong buy (due to the price control).

    Today (November 2019) the physical gold price is still controlled by the same COMEX futures, but (once again) the question arises what would be the price if the control mechanism was removed? Would the price again jump 6X from US$1,550 to US$10,000 as many pundits are calling for?

    The first question is what would cause the control mechanism to be removed and the answer is simple and obvious - a delivery failure. Because in reality, COMEX futures is a game of musical chairs with around 200 players for every chair and the music has to stop sometime. In other words, the demand for physical gold will simply overwhelm the paper market's ability to deliver.

    The second question is what is the underlying value of physical gold in the absence of price control? And this question has many components, including (1) the current total demand for gold (physical plus paper) and (2) the economic shock caused by a COMEX failure and (3) when the control mechanism ends.

    The "Physical Premium" over the Futures Price

    Jim Sinclair (of JS Mineset) argues that the value of a futures contract denominated in fiat, with no possibility of exercise into physical, is actually zero. Indeed, there is some merit to this argument because (I think) when physical goes into hiding, there will be no choice other than to cash settle the futures. And shortly after that date, fiat will drop substantially relative to physical gold. In other words, if you hold futures and only receive a cash payout, then you will be substantially worse off than holding physical metal (which continues past the settlement date).

    However (I think) a better interpretation is that the current futures price simply measures the coming (non-zero) cash settlement price. BUT does not measure the current value of the physical metal due to the jump in physical price after the cash settlement date. In other words, owning physical and futures have different payoffs and so should be priced differently, with physical metal having a substantial "physical premium" (currently not understood or priced in).

    For example, suppose tomorrow at 10am, TPTB give up and cash settle COMEX futures at US$1,550. But then what would be the fair price (today) of physical metal if the COMEX failure means that the physical price jumps by 6X to $10,000 (by 4pm tomorrow, or in 3 years)? My point is that the price of physical (today) should carry a substantial "physical premium" to the futures price, due to the almost certain possibility that (one day) the futures will be cash settled AND the physical price will jump higher on the same date.

    PS> I have a PhD in maths and well understand option pricing. So will work on what the "physical premium" attached to the COMEX price should be, given expectations on the probability and date of a COMEX cash settlement. But this is important work, so would appreciate some help...
     
    Last edited: Nov 24, 2019
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