P1. T3. Ch11. Commodity Forward and Futures

[thanhtam92]

In this chapter, the study notes mention the following paragraph regarding lease rate
"The lease rate of gold varies with the supply of gold that can be borrowed along with the
demand to borrow gold. Recall that when gold producers hedge future production, the banks
on the other side of the transaction borrow gold. As gold producers hedge more (less), the
demand for borrowed gold will increase (decrease) and the lease rate will rise (fall).
Similarly, as asset owners become more (less) willing to lend gold, the lease rate will tend to
fall (rise). Occasionally the lease rate is negative and may therefore allow arbitrageurs to buy
the metal and sell it forward for a profit."

I am trying to explain that red text above. So if the gold producers hedge more, which means they produce more. Therefore, increase in supply leads to a drop in price which leads to an increase in demand. Is my train of thoughts correct?

 

[David Harper CFA FRM]

@thanhtam92 no, not quite. If gold producers hedge, like any commodity producer who plans to sell in the future (at the then-prevailing, currently unknown price such that their risk is a drop in the gold/asset price), the producer employ a short hedge: they enter into short gold futures contracts. The bank is their counterparty, who enters into the contract as the corresponding long contract; but the bank wants to hedge its own risk so it sells short gold: the bank borrows gold to sell it short (again, to neutralize or match the long required by its customers/counterparty trade). Or, I am thinking, the bank who acts as intermediary, might alternatively be able to directly neutralize simply by borrowing gold (to the same effect: the hedge its own long position created due to its customer's request). The point is: the bank wants a "matched book" (it does not want the price risk), but its customer's short hedge requires a long position which must itself (from the bank's perspective) be price hedged by borrowing gold, which itself is a demand factor that increases the lease (borrowing) rate of gold.

The point is that the short gold position (i.e., selling short of gold) requires borrowing gold, which increases the borrowing rate (aka, lease rate) of the gold. The lease rate should primarily respond to supply/demand.

I have a video on lease rate here https://forum.bionicturtle.com/threads/t3-18-commodity-eg-gold-lease-rate.22431/
per tag https://forum.bionicturtle.com/tags/commodity-lease-rate/