On the Use of Gold as a Fixed Income Security

Abstract

Coincident with the legalization of gold in early 1975 was the emergence of an active market for gold futures contracts. The existence of a futures market made possible the hedged cash position (HCP), wherein an investor simultaneously purchases the metal and sells a futures contract for a desired delivery date. This trading strategy is also referred to as being long the basis. Kawaller has noted that, because the future selling price is agreed upon at the time the gold is acquired, one can regard the hedged position as a fixed income security.' The major advantage of forming a gold HCP would thus seem to be the investor's ability to lock in a guaranteed return over a given holding period. Of course, this return is fixed in a ndminal sense only. Unless the market prices for both gold and the futures contract are set in perfect anticipation of inflation, the real return to such a strategy is anything but certain. In his celebrated 1975 study, Fama showed that other fixed income securities (e.g., Treasury bills) are priced to allow adequately for short-term inflationary trends.2 Specifically, his evidence suggested that (1) T-bills offer a constant expected real (inflation-adjusted) rate of return and (2) the market consequently adjusts the nominal return in a one-to-one, unbiased correspondence with the inflation rate. Kawaller has suggested that the HCP may emulate the fixed income nature of a Treasury bill; we explore whether the market for gold futures contracts behaves in the same fashion. We chose gold for two reasons. First, the price of gold is widely believed to be sensitive to expectations about inflation. Second, the basis in gold is not complicated bv the presence of seasonal variation.