ARBITRAGE AND THE FORWARD GOLD PREMIUM.

This section comments on an article which observed a positive relationship between the dollar forward premium on gold and the ratio of gold to dollar assets in international reserve portfolios. The author concluded that this shows that gold is not a sterile asset; it has an expected rate of return that acts as a yield variable in the calculus of central banks making portfolio choices between gold and dollar assets. The expected rate of return on gold is represented by the size of the forward premium on gold, which mirrors expectations of capital gains to be realized in the event of appreciation of gold with respect to the dollar. The analysis, as the author recognizes, depends crucially on the assumption that an observed forward premium on gold reflects expectations of an increase in the dollar price of gold. The behavior of the forward gold premium, however, should reflect, in addition to expectations about the future price of gold, movements in the rate of return on dollar securities. Covered interest arbitrage between the dollar and gold should establish a positive relationship between the rate of interest on dollar securities and the forward gold premium, just as it creates a link between interest differentials and forward premiums in currency markets. If the three months' rate of return on dollar-denominated securities rises above the three months' forward premium on gold by an amount greater than the costs of moving into and holding dollar securities, arbitragers can profit by replacing gold with dollar securities in their portfolios and simultaneously buying an equivalent amount of gold forward. On the other hand, if the rate of return on dollar securities falls below the forward premium on gold by an amount greater than the costs of moving into and holding gold, arbitragers can profit by replacing dollar-security holdings with gold and selling an equivalent amount of gold forward.