A Sound Investment Choice
While obviously there is no such thing in the real world as a guaranteed, safe and high-earning investment, the purchase of gold and silver bullion appears to be about as close as we can hope to get today to a sound investment strategy. The number of mortgage foreclosures and the collapses of even world famous business names have raised many concerns about the advisability of investing in property or the stock market in the current climate. While government stocks retain their reputation as solid investment choices, they remain low interest earners that offer poor protection against inflationary pressures. In contrast, bullion dealers seem to be enjoying great prosperity with demands for their services so healthy. Gold bullion coins and other kinds of bullion are in high demand. Just consider the rapid rise in gold prices. In 2008 gold crossed the dramatic $1,000 per ounce barrier, and by the end of 2011 it had passed the $1,900 barrier.
Certainly there are sound reasons for exploring investment options in the bullion markets today, but for the average person the nature of these markets remains shrouded in mystery. How is the price of bullion determined, and what is exactly the nature of physical and futures bullion purchases and the relationship between them?
Understanding the Bullion Market
For historic reasons London hosts the world’s most important physical (sometimes also called over-the-counter) gold and silver bullion exchanges. Bullion supply consists of both newly-mined metals and recycled bullion. National central banks and mining companies are the key suppliers to the markets. Central banks are also prominent amongst the leading gold buyers, but in addition there are many purchases made by private enterprise for industrial and investment purposes.
In effect the bullion exchanges are auctions where the classic forces of demand and supply are balanced to give spot prices set twice daily. Take for example, the London gold exchange. The chairperson announces an estimated price for spot gold – usually this applies to gold due to be delivered in a couple of days. According to the interest of buyers and sellers to trade above or below this estimated price, the actual price is determined.
In addition to the physical bullion market, there is also a major futures market in bullion in New York. The cost of trading that involves physical gold movements is beyond the means of most private investors. The futures market offers the possibility of buying bullion without the costs of transporting and storing it. Normally the futures market deals in bullion for delivery in three months time but at a price determined today. In actuality it is unlikely that any physical bullion movement from seller to buyer is going to take place, since both buyers and sellers aim to dispose of their purchases, or buy back what they sold, before the delivery date ever arrives. Since this trading is detached from physical bullion delivery, the amounts of bullion that can be traded are significantly larger than in the physical bullion market.
There are many factors affecting the amounts of precious metals passing through the hands of the bullion dealers. The value of gold and silver and other precious metals are directly related to the amount mined each year, plus the amount recycled and bought and sold by central banks. Mining companies can try to restrict supply to increase prices, and demands from jewelers and various industries also exert their influence on pricing.
As a general rule, an increase in demand for bullion and consequent rising prices are seen as clear indicators of uncertainty over the state of the economy. For example, starting around 2007, the consistent rise in the prices of silver, and in particular the prices of gold bullion coins, has corresponded with a severe economic crisis affecting the United States and much of Europe.
The Bullion Pricing Matrix
In theory the prices of bullion on the physical market and the futures market should adjust themselves to reach a broadly similar level, but a distinct difference in the nature of the markets creates a differential. When you buy bullion futures, you are delaying the full payment for the bullion until the time for the settlement arrives. The money you avoid having to pay out right away can be invested and earn interest. However, the seller of the bullion (who now has to hold onto it for three months) loses the potential interest to be made by selling the bullion now and depositing the money earned immediately. The difference between what the buyer can earn by investing his money, and what the seller loses by not selling the bullion immediately, raises the costs of the bullion futures beyond the physical bullion purchase rate.
Bullion prices are also affected the by the way bullion dealers try and balance gains and losses between the physical and futures market, and base their purchases and sales on such considerations. For example, suppose you need to buy a certain amount of gold for your business on a regular basis. If it seems like physical gold prices are going to rise rapidly, buying gold futures can provide a protection against the physical price rise. If the physical price falls, although you are going to lose on the futures deals, you gain from the opportunities to buy cheaper gold on the physical market.