This is How the Price of Gold is Determined

The Gold(en) Inflation!

In 2002, a 24K Troy ounce cost just under $300! An unimaginably low figure in these times of economic recession.

For any economy, gold and silver are its most priced assets. The stock markets, world economy, inflation rates, and, of course, demand and supply determine the prices of these precious metals.

With many investors exploring the gold and silver markets to invest, it is always helpful to understand the pricing process. Here, we have tried to explain this complicated process by considering the fixed and the spot pricing technique. The factors that affect gold prices are demand-supply and world economy. Let us see the consequences of these factors.

Demand-Supply

Like any other commodity, the demand and supply of gold and silver play a pivotal role in the determination of their price. When the demand for any commodity increases, its price is bound to increase. Similarly, if there is an abundance of supply and the demand is less, its price will go down. In terms of this metal, the demand is from three primary sources:

Investment Demand

Gold and silver are considered to be one of the safest investment options. This draws demands from individuals, institutions, and governments in terms of coins, bars, and Exchange Transfer Funds (ETFs).

Industrial Demand

Though these metals are considered for domestic use, they do have industrial applications. A lot of applications use these metals due to their conductivity, malleability, and durability.

Jewelry Demand

This is the most common type of demand. The demand for gold jewelry is always on the higher side, and thus, plays an important role in determining gold prices.

World Economy

The effect of the world economy on the price of gold is immense. Most people tend to invest in gold and silver, and this makes these metals pricey. When gold prices are on the higher side, it indicates a struggling economy. When the markets are doing well, the ROI on these metals is attractive enough to pull investments.

The ROI is higher than the inflation rate. In case of a struggling economy, the ROI is cut down to a point that is lower than the inflation rate. This means the investment will give a negative return. However, during a struggling economy, the safest bet is either gold or silver investment. So, investors again invest in these metals, and their prices rise.

Thus, in any economy, whether booming or struggling, investments in gold and silver are always on the higher side. However, the effect of these investments on the price of gold is different. In case of a booming economy, there is continuous supply of gold, and thus, prices are on the lower side.

In case of a struggling economy, supply may be interrupted, and thus, prices are on the higher side. As the U.S. dollar is considered to be the world's reserve currency, most countries trade gold in dollars. So, if the foreign currency weakens against the dollar, gold prices increase because countries have to shell out more money.

On similar lines, gold prices decrease when the foreign currency strengthens. So, if the dollar weakens against foreign currencies, investors lose their trust in the dollar and start investing in gold.

Inflation is also an important factor in determining gold prices. Due to inflation, the purchasing power of people decreases. Inflation means a country will have to spend more dollars to buy any product. So, instead of investing on commodities, investors turn to gold/silver investment. This increases the demand for gold, and its price increases.

Gold Fix Price

As mentioned earlier, the price of gold is divided into categories, namely, fixed price and spot price. The fixed gold price is determined by a procedure known as London Gold Fixing or Gold Fix. Let us see this process, in brief.

London Gold Fixing

The London Bullion Market Association (LBMA) is a trade association that encompasses 100 world banks, alongside financial institutions and precious metal stakeholders. The London Gold Fixing is the method used to determine the fixed price of gold.

This process is done twice in a business day, at 10:30 GMT and 15:00 GMT. There are five members who take part in the pricing process. Though this gold price is fixed for settling contracts in the London markets, this price is taken as a reference by world markets, as well.

The first gold fix took place on September 12, 1919, with the five participating members being N M Rothschild & Sons, Mocatta & Goldsmid, Pixley & Abell, Samuel Montagu & Co., and Sharps & Wilkins. The price fixed at that time, in terms of dollars, was $19.39/ounce.

This fixing took place at the London offices of N M Rothschild & Sons in St. Swithin's Lane. However, today, this fixing takes place by telephone conference. While the entire process is complicated, let us try to explain the process for a layman to understand.

As mentioned earlier, there are five participating members in the process, headed by the chairman. Each of these members have orders on their own behalf, or on their client's behalf. These orders determine the demand of each member. When the pricing process starts, the lead participating member will fix a standard price, considering the previous gold rate.

Each of the banks, by looking at their orders, determine whether they can trade at the proposed price. The other constraint in this process is the demand-supply. Let us understand this demand-supply condition with the help of an example.

If one of the participating members has 10 orders, the second one has 15 orders, and the remaining members have 5 orders each, the total orders will be 40. If there is reserve for 40 orders, and the proposed price of say, $10/ounce is agreed, the price is fixed for the trading session at $10.

However, if the proposed price is not agreed upon, the chairman steps in. If the amount of gold that is demanded (40 orders) is higher than the actual reserve (say 30 orders), the chairman raises the proposed price of gold.

This is done to match the deficient supply as the increase in price means there are chances of order cancellations and the demand-supply situation will be met. However, if the amount of gold demanded (40 orders) is less than the actual reserve (say 50 orders), the price of gold reduces. This is done to get more orders and balance the demand-supply situation.

This continues until a fix is achieved. Once the fix is achieved, the fixed gold price is determined. This price plays an important role in the determination of spot prices. The prices are fixed in United States Dollars (USD), Pound Sterling (GBP), and European Euros (EUR).

The current chairman of the procedure is N M Rothschild & Sons, and the five participating members are ScotiaMocatta, Barclays, Deutsche Bank, HSBC, and Société Générale.

Gold Spot Price

The spot price is nothing but the actual price of gold at the present moment. This is the same price that we see on the websites, and what we are charged for our favorite jewelry. When the fixed gold prices are released by the London Gold Fixing method, this price is taken as a reference for fixing the spot price.

However, changes in the entire trading day can affect the spot price of gold. The futures market is one of the main decisive factors to calculate the gold spot price. The futures market trades are carried out by placing an order for the current proposed price of gold, for which the delivery and payment is done on a future date.

As there is hardly any physical trading in the futures market, and the current changes in gold prices are immediately known, this price acts a useful tool for speculators to determine gold prices.

The spot price is the latest price at which the last transaction took place in the futures market. Thus, the way the futures market ends is important for spot prices. This price is mostly expressed in US dollars, but of late, spot prices are expressed in Yen, Yuan, and Canadian, Australian, and Hong Kong dollars.

Gold prices are thus determined based on a number of factors. However, the ever-changing world economy and inflation rates play an instrumental role in determining the prices as well.