By Julian D W Phillips

The visible danger of financial derivatives have been well documented, writes Julian Philips of Gold Forecaster, as the risk of their collapse has the same potential as the sub prime crisis to create havoc worldwide.

But for Gold and silver investors, the long term upward drive in commodity prices should limit the threat to a process of de leveraging, as we have already seen in the large lowering of net speculative long gold positions on COMEX, the US commodity futures exchange.

Here we are going to highlight a potentially more destructive facet of derivatives: the threat of government interference in open markets as a result of so called speculative excess .

Gold, Derivatives Risk

Simply put, a derivative is a paper instrument founded on an asset. Its value is derived from that underlying asset, and it can be a purchase or sale of a commodity in the future it can be a share in a trust based structure such as an Exchange Traded Fund (ETF) or it can be an option or one of many other similar instruments.

The classic use of a derivative is to smooth out price volatility for commodity producers. When a silver or gold user say, a large bullion wholesaler found they had to buy or sell metal, they would usually buy ahead of the date of their need. That would ensure its availability on that date.

But this protection left them exposed to the Gold Price. The danger was of paying too much or selling for too little. How could they remove this risk? They had to hedge their future sale. But how?

If delivery of gold sold (or bought) were to take place, say, in a year's time, they would sell (or buy) that position in the futures market or take out a put or call option (the right to sell or buy at a certain price at that future date).

This left them both a long position and a short position on gold, netting out at a neutral position on the metal.

If the Gold Market then moved substantially either way, far outside its expected price levels, they could protect themselves fairly easily. How? If the price were to go down they could then close the short position by buying the same quantity at the lower price to close out at the same date as the put option. This would leave them net long at the lower price.

They would then sell that position again at the lower Gold Price, with the profit from the closed position in hand. Their customer would then get their bullion at the future market price on delivery date.

But perhaps the price suddenly rose on the original netted out position, what then? Then they could sell the same amount a second time to establish the higher price, which their customer would accept as the market price. After this the price may reverse in which case they would the buy the gold back at the lower price, profiting from the 'short' position, leaving the 'long' position that they originally had, again and still able to repeat the operation for profit.

This could happen time and time again during the life of the contract until delivery, ending up as perhaps 100 positions having been dealt, but all of them netting out eventually at the single sale of bullion, which would then be delivered to the customer as originally planned.

As you can see this would be relatively low risk and allow the gold wholesaler to protect himself against future moves in the metal's price, even making a profit on any fluctuations.

Speculative vs. Investment Gold Derivative Positions

Now add pure speculation in to the market, bringing with it volatility to the Gold Price as well as all other items on the futures and options markets.

As we can see in the commodity markets at the moment, this speculation is being led by investment funds trying to protect the value of their capital against perceived rises in the cost of living, driven by commodity price rises. This use of commodity derivatives is where market distortions are beginning to wreak havoc.

The dangers we now focus on are the effects of the huge investment funds being parked in these instruments, enjoying the price rises in commodities but with no intention of taking delivery or consuming the items.

We have already seen this happen in oil, wheat, rice as well as Gold and silver and other precious metals plus other items demanded by a growing percentage of the globe's population, particularly in emerging and poor nations.

If this feature of speculative inflation hedging were not present, the prices of these items would be much lower right now, at least for the near term, while real demand continued to grow with the emergence of poorer economies across the globe.

For instance, some 37% of the COMEX positions in the oil market are investment positions riding the oil price with no intention of taking delivery. Of course, poorer nations are struggling to afford these high prices. So how can the authorities help on this front?

Any move to discourage speculation by raising margins the initial stake, usually a 10% deposit asked whenever a futures contract is entered into would prove relatively ineffective. This ploy is used occasionally to take the steam out of a price, but rarely on a permanent or even semi permanent basis.

Alternatively the commodity derivative exchanges could refuse to allow options and futures dealing unless the trader can show he both intends and is able to take delivery of the underlying asset at the end of the contract. This would be a Capital Control by another name, and we already see this control presently expressed in the form of the restrictions of exports of food items from countries where local demand is not being met by domestic output.

We see these controls in several emerging nations as prices move out of their affordable range. Riots in places like Haiti against food prices are becoming more and more common. This situation can only get worse inviting only more meddling in food and energy markets from worried governments.

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