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# Gold and Silver Price Discovery: At and Despite the Margins

Commodities / Gold and Silver 2012 Jun 18, 2012 - 09:12 AM GMT

In most markets, price is discovered “at the margin” or from the transactions themselves. For example, in the real estate market, an entire block of homes can be valued by appraisers and agents based on the price at which the last house sold.

When it comes to precious metals prices, if discovery at the margin was a legitimate factor, the silver market would soon see much higher prices or it would at least reach a fairer equilibrium price that currently prevails.

How Paper Derivatives Influence the Physical Spot Price

Price discovery in metals and other commodities are currently determined by derivatives, specifically futures contracts. These instruments conform somewhat to technical trading patterns, but they are permitted to be cash settled at the seller’s option by the major exchanges on which they trade.

This situation could well be keep silver prices artificially low, since central banks can manipulate the price of silver secretly by trading as customers of the major bullion banks, who in turn could sell futures contracts to offset their risk without ever making delivery.

The central bank could then simply print more intrinsically worthless paper currency to cash settle any losses, rather than having to pony up the metal itself. Since the spot price of physical silver in private over-the-counter transactions is computed from the near month futures price, the central bank could then pick up physical silver cheaply in the over-the-counter market.

Computing Spot Prices From Futures Prices

The spot price for the physical delivery of silver is computed by over-the-counter traders from the near month silver futures contract’s price. This is typically done using a net present value calculation as follows:

Spot Price = Futures Price / (1+(i-d)t/360)

Where:
i = the interest rate for borrowing money
d = the deposit rate for silver
t = # of days from the spot delivery date to the near month futures contract delivery date.

Basically, the spot price for silver tracks the front month futures contract price by this sort of calculation, instead of being set by supply and demand factors within the physical market.

Another Kind of Margin

Within the futures market, the word “margin” has a different meaning. Futures margin is the amount of money you have to put up to control a futures contract.

Despite questionable claims that futures margins are used to quell volatility or enable orderly trading — unlike the market we saw in silver in April 2011 — the required amount of money needed to maintain control of a silver contract was raised multiple times after prices began falling significantly. This only served to exacerbate the already sharp decline in silver.

The point of all this is that the price of silver seen from the point of view of the market outsider is measured and evaluated by a mechanism that does not apply to the physical silver market given the disconnection of the paper futures market from physical delivery.

Furthermore, instead of the physical market driving the derivatives’ price as it should, physical silver’s price discovery is being determined by a process "derived" from the futures market, which is itself supposed to be the derivative market!

This situation allows large speculators and/or manipulators with no plan of actually delivering the physical metal to operate on margin and cash settle their silver futures transactions in order to artificially depress the price of physical silver.

By Dr. Jeff Lewis

Dr. Jeffrey Lewis, in addition to running a busy medical practice, is the editor of Silver-Coin-Investor.com and Hard-Money-Newsletter-Review.com

Copyright © 2012 Dr. Jeff Lewis- All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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