The Differences Between Gold Financed vs Gold Hedged Transaction
Treesdale Partners, portfolio manager of the AdvisorShares Gartman Gold/Euro ETF (GEUR), AdvisorShares Gartman Gold/British Pound ETF (GGBP), AdvisorShares Gartman Gold/Yen ETF (GYEN) and AdvisorShares International Gold ETF (GLDE), share their thoughts about the gold space.
Following our previous discussion piece on commodity fund taxation, this week we discuss the differences between a gold position financed in a (given) currency versus a gold position hedged into a currency. Broadly speaking the objective of a “currency financed” transaction is to give an investor the flexibility to choose the currency with which gold purchases are made. By contrast in a “currency hedged” transaction the objective is to protect the value of gold when expressed in a different currency. In reality in the US, there are few investment products available to US investors which offer the flexibility to choose a different financing currency other than the US dollar but there are many currency hedged products and as we show below, the two types of product are fundamentally different, offering investors quite distinct types of risk exposure.
We use the scenario of a gold purchase financed in Japanese yen to breakdown a “gold financed” transaction into its components but we take as the starting point a gold purchase financed in US dollars. This is typically the “financing method” which most investors in the US would utilize to make asset purchases of all types (including gold). In the diagram below we show the flow of funds resulting from the transaction:
Another way in which an investor might describe this transaction is LONG GOLD / SHORT USD. In other words by purchasing gold financed in USD, investors are in effect expressing the view that they expect the value of gold to increase relative to the value of the USD. By purchasing gold financed in USD an investor, whether by choice or not, is expressing a currency view on the USD.
If instead a foreign currency is used to make the gold purchase, the flow of funds is the same but the USD is substituted for foreign currency. Using the gold financed in Japanese yen example, this transaction can be broken down into the following components (i) borrowing yen, (ii) converting the yen into US dollars at the foreign exchange rate and then (iii) using the US dollar proceeds to purchase gold. The cash flows are as follows:
Another way in which an investor might describe this transaction is LONG GOLD / SHORT YEN. In other words by purchasing gold financed in yen, investors are in effect expressing the view that they expect the value of gold to increase relative to the value of the yen. The key feature to note in the cash flow diagram is that the USD cash flow from the gold purchase and the USD cash flow from the foreign exchange transaction net to zero and the investor only holds a long position in gold and a short position in the yen (with no USD exposure) – hence the transaction can be more simply described as “using yen to make gold purchases”.
The general point to highlight from this analysis then is that a gold purchase financed in US dollars is structurally similar to a gold purchase financed in yen but in the former the investor expresses the view that gold will rise in value relative the US dollar and in the latter that gold will rise in value relative to the yen.
Finally we turn to the scenario of a gold purchase hedged into yen. Upfront however, we should stress that a “currency hedged” transaction is economically quite different from a “currency financed” transaction. Using the same framework as above, an investor could construct a currency hedged transaction by combining a gold purchase financed in USD and with a currency transaction to convert from USD into yen (the reverse of the currency financed transaction). The cash flows are as follows
Another way in which an investor might describe a currency hedged transaction is to be LONG GOLD / LONG YEN / SHORT 2x USD – the differences between the “hedged” and “financed” transactions are stark. In such a transaction, the investor is expressing the view that they expect the value of gold to increase relative to the USD in addition to expecting the value of the yen to increase relative to the USD. Most importantly from a risk perspective the cash flow table shows how a “currency hedged” transaction actually increases the investor’s exposure to the USD. This compares to the yen financed transaction which would neutralize an investor’s exposure to the USD.
In this short discussion we do not argue the merits of one type of transaction versus the other but rather demonstrate to investors how the two types of transactions offer significantly different risk profiles. The objective of “currency financed” investment products are to provide investors with an investment vehicle that offer the flexibility to choose an alternative financing currency (other than the USD) with which to make gold purchases and by so doing to limit exposure to the USD to the desired level.