Gold-linked deposits with paper gold as initial investment
Gold-linked deposits with paper gold as initial investment (GLDs) are unlisted non-principal protected structured investment product embedded with a call option over Loco London Gold (Gold) as the reference asset against a specified currency.
You pay the offeror in the form of paper gold as the initial investment to acquire a GLD in a specified currency. The potential gain/loss for the GLD depends on the final fixing price of Gold in comparison with the pre-determined strike price.
At maturity of the GLD, you will receive the maturity payout in either of the ways below:
Here are some key terms used in this article that you should understand before you consider to purchase a GLD.
Loco London gold:
It is the basis for international trading and settlement in gold for the London bullion market. It must have a fineness of not less than 99.5% as specified by the London Bullion Market Association or its successor.
The specified currency is the currency in which any cash deposit and/or payment under the GLD is made. It is also the currency quoted for the strike price and the final fixing price. It can be chosen by you or specified by the offeror of the GLD.
The number of paper gold units you credit to the offeror to acquire a GLD, which may be subject to a minimum investment amount set by the offeror. The offeror will debit such number of paper gold units as the initial investment from your paper gold account maintained with them.
The maturity payout is either a payment in cash in the specified currency or delivery of paper gold units that you will receive at maturity.
The underlying asset to which the potential gain/loss of a GLD is linked, which is Gold.
You may receive paper gold as the maturity payout in certain circumstances. Paper gold means a notional amount of gold credited to your paper gold account maintained with the offeror. You can only trade your paper gold units with the offeror at such prices as quoted by the offeror. For the purpose of this article, paper gold is assumed to be denominated in HKD. You should read the relevant paper gold offering documents for further details.
It is a predetermined price in the specified currency quoted on a per gold unit basis. It will be used to compare with the final fixing price to determine the maturity payout on the final valuation date.
Final fixing price:
It is the price of Gold per gold unit quoted in the specified currency at the valuation time specified by the offeror on the final valuation date.
Final valuation date:
It is the date on which the price of Gold is recorded at the valuation time to determine the maturity payout of the GLD.
It is the date on which you will receive the maturity payout under the GLD.
Potential gain or loss
Example: A GLD with paper gold as initial investment in USD
|Deposit tenor||30 days|
|Initial investment||1,000 paper gold units|
|Gold price quoted in USD at the time
the GLD is placed (Initial USD gold price)
|Annualised distribution rate||8.4% per annum|
|Actual distribution rate||Actual distribution rate
= Annualised distribution rate x (deposit tenor/day count)
= 8.4% p.a. x 30/360 = 0.7%
|Distribution amount||= Initial investment x actual distribution rate
= 1,000 x 0.7% = 7 paper gold units
Please note that the assumptions below apply to the following scenarios:
- It does not take into account any fees or charges that may be payable by the investors.
- The annualised distribution rate is based on the hypothetical assumption that the GLD can be rolled over on the same terms for a period of 360 days. It does not reflect the actual distribution rate for the deposit tenor of the GLD. You should not rely on the annualised distribution rate as an indication of the expected return for the GLD.
- 1 paper gold unit corresponds to 1 troy ounce of Gold.
On the final valuation date, is the final fixing price AT or BELOW the strike price?
Scenario 1: YES - Assume the final fixing price is USD 1,500, i.e., below the strike price
- In this scenario:
-The call option over gold against the specified currency will lapse.
-You will receive a particular quantity of paper gold equal to the sum of the initial investment and the distribution amount as the maturity payout. The increased number of paper gold units represents the maximum potential gain in terms of paper gold units.
-However, your realised gain/ loss will depend on the prevailing paper gold price at which you sell such paper gold units. Even though you receive an increased number of paper gold units, the prevailing paper gold price may have decreased. Hence, if the value of the paper gold received is less than the value of initial investment, you will suffer a loss.
-In the worst case scenario, the paper gold you receive as the maturity payout may be worthless and you may lose all of your initial investment. If the paper gold price drops to HKD 0, the value of the maturity payout will be zero and you will lose your entire initial investment.
- Quantity of paper gold units received:
= Initial investment + Distribution amount
= Initial investment + (Initial investment X Actual distribution rate)
= 1,000 paper gold units + 7 paper gold units = 1,007 paper gold units
- Therefore, an increase of 7 units of paper gold is the maximum potential gain of this GLD in terms of paper gold units.
- Assume you sell the paper gold units at the paper gold price*, your realised gain/loss will be:
= Value of the maturity payout as of the final valuation date - Value of the initial investment as of the order date
= (1,007 paper gold units X USD 1,500) - (1,000 paper gold units X USD 1,800)
= - USD 289,500 (i.e., you suffer a loss of USD 289,500)
- * Assuming the paper gold price when being converted into USD is the same as the final fixing price
Scenario 2: NO - Assume the final fixing price is USD 2,500, i.e., above the strike price
- In this scenario:
-The call option over Gold against the specified currency will be exercised.
-You are obliged to sell a fixed quantity of Gold (corresponding to the sum of the initial investment and distribution amount in paper gold units) at the strike price, and get the cash proceeds in the specified currency.
-This cash proceeds you received as maturity payout is fixed.
-You make a gain in this case which is limited to the difference between such cash proceeds and the value of your initial investment.
-However, you will lose the opportunity cost of selling such number of paper gold units at the prevailing paper gold price which is higher than the strike price.
- Cash amount received:
= (Initial investment + Distribution amount) X Strike price
= (1,000 + 7) paper gold units X USD 2,000
= USD 2,014,000
- Your gain will be:
= Maturity payout - Value of the initial investment of paper gold as of the order date
= USD 2,014,000 - (1,000 paper gold units X USD 1,800) = USD 214,000
The diagram below illustrates the potential gain/loss (with the assumptions stated previously) as measured in the specified currency with different final fixing prices.
Credit risk of the offeror
- If the offeror becomes insolvent or defaults on its obligations, you will not receive any maturity payout on the maturity date.
- You can only claim as an unsecured creditor of the offeror.
- In the worst case, you may get nothing back and the potential maximum loss could be 100% of your original initial investment.
The impact of Gold price and exchange rate on the maturity payout
Gold prices are customarily quoted in USD in the international bullion market. If the specified currency is not USD, the final fixing price will also be affected by the prevailing exchange rate between USD and the specified currency, and in turn affect your payout at maturity. Let's see the example below
Example: GLD in Australian dollar
|Deposit tenor||30 days|
|Initial investment||500 paper gold units|
|Initial Gold price in USD||USD1,800|
|Initial exchange rate between AUD and USD||1|
|Initial Gold price in AUD||AUD1,800|
|Annualised distribution rate||6% per annum|
|Actual distribution rate||0.5% (6% p.a. x 30/360)|
|Distribution amount||2.5 paper gold units (500 paper gold units x 0.5%)|
Potential gain or loss scenario
|Scenario 1||Scenario 2|
|Final Fixing price||≤ Strike price||> Strike price|
|Form of maturity payout||Paper gold units||Cash|
|Amount of maturity payout||502.5 paper gold units||502.5 paper gold units x AUD 2,000 = AUD 1,005,000|
|Gain/loss||Your realised gain/ loss will depend on the prevailing paper gold price at which you sell such paper gold units. Even though you receive an increased number of paper gold units, the prevailing paper gold price may have decreased. Hence, if the value of the paper gold received is less than the value of initial investment, you will suffer a loss.||Your gain is limited to the difference between the cash proceeds received as maturity payout and the value of your initial investment,
=AUD 1,005,000 - (500 x AUD 1,800) = AUD 105,000
The effect of the final exchange rate and final USD Gold price on the final fixing price
|Example||Final Gold price in USD
(+increase/-decrease compared to the Initial Gold price)
|Final exchange rate
(+AUD appreciate/- AUD depreciate against USD compared to the initial exchange rate)
|Final fixing price
(= final Gold price in USD / Final exchange rate)
|1||USD 1,512 (-16%)||0.7 (-30%)||AUD 2,160
(> strike price)
|2||USD1,800 (no change)||0.833 (-16.7%)||AUD 2,160
(> strike price)
|3||USD 1,800 (no change)||1.167 (+16.7%)||AUD 1,542
(< strike price)
|502.5 paper gold units|
|4||USD 2,005 (+11.4%)||1.3 (+30%)||AUD 1,542
(< strike price)
|502.5 paper gold units|
Referring to the above table, your maturity payout is subject to both the volatility of Gold price in USD and the prevailing exchange rate between USD and the specific currency, i.e. AUD.
If the final Gold price in USD decreases by 16% and the AUD depreciates by 30%, the final fixing price will be above the strike price. A depreciation of AUD against USD will result in an increase in Gold price quoted in AUD, because for the same quantity of Gold, you will use more amount of AUD to change for the corresponding USD amount at the prevailing exchange rate to buy such quantity of Gold. In this example, the decrease in final Gold price in USD is more than offset by the depreciation of AUD against USD.
Examples 2 and 3:
Even if the final Gold price in USD remains unchanged, the final fixing price can still rise above the strike price if AUD depreciates, and vice versa.
If the final Gold price in USD increases by 11.4% and the AUD appreciates by 30%, the final fixing price will fall below the strike price. In this example, the increase in final Gold price in USD is offset by the appreciation of AUD against USD.
Therefore, even if the prevailing Gold price in USD remains stable, the change in the prevailing exchange rate between the USD and AUD could cause the final fixing price to move against you and lead to a loss to your GLD.
Key risks of GLD investment
As always, you should fully understand the features and risks of GLDs before deciding whether to invest. Some of the key risks of GLDs you should be aware of include:
- Not principal protected: GLDs are not principal protected. In extreme cases, you could lose your entire investment.
- Not protected deposits: GLDs are unlisted structured products embedded with derivatives and are not protected deposits under the Deposit Protection Scheme.
- Limited maximum potential gain: The maximum potential gain is limited to the difference between the maturity payout in the form of cash amount in the specified currency and the value of the initial investment in paper gold.
- No collateral: GLDs are not secured by any assets or collateral.
- Credit risk of the offeror: When you purchase a GLD, you rely on the credit-worthiness of the offeror. In the worst case scenario, you could lose your entire investment regardless of the performance of Gold.
- Liquidity risk: If the investment period is 6 months or below, there is no market making arrangement for GLDs and you cannot transfer or early terminate your GLD without the consent of the offeror. Even if there is market making arrangement, you may receive an amount which is substantially less than your original investment amount when you early terminate your GLD.
- Investing in a GLD is not the same as investing in gold: You do not own any gold by investing in a GLD. Changes in the Gold price may not lead to a corresponding change in your potential gain/loss under the GLD.
- GLDs do not involve physical delivery of gold and paper gold prices are quoted by the offeror which may be worse than the prevailing USD Gold price: When the final fixing price is below the strike price, the maturity payout will be settled in the form of paper gold units, rather than physical gold, which will be credited to your paper gold account maintained with the offeror. You do not have any rights, ownership and possession of any physical gold in such account. Paper gold units are only traded in paper gold price quoted by the offeror, which may be worse than the prevailing USD Gold price due to (1) the fluctuation of exchange rate between the currency in which the paper gold is quoted and USD, and (2) profit margin built in by the offeror.
- Volatility of USD Gold price: The potential gain/loss of a GLD will depend on the final fixing price in comparison with the strike price. The final fixing price will be affected by the prevailing USD gold price at maturity, which is affected by a number of unpredictable factors.
- Exchange rate risk: If USD is not the specified currency, in addition to the prevailing USD Gold price at maturity, the final fixing price will also be affected by the prevailing exchange rate between USD and the specified currency. Even if the prevailing USD Gold price remains stable, a change in the prevailing exchange rate between USD and the specified currency could cause the final fixing price to move against you and lead to a loss to your GLD.
- Risk of paper gold account: Paper gold account involves risks such as the risk of relying on the creditworthiness of the offeror in holding and trading paper gold with you and the risks of lack of liquidity and secondary market as you can only trade your paper gold with the offeror.
- Conflicts of interest: Conflicts of interest may arise from the different roles played by the offeror, its subsidiaries and affiliates in connection with the GLD and your paper gold account.