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Let's say I'm an investment bank and I want to create a derivative whose value tracks that of gold. I don't want this derivative to in any way trade in the underlying security, so no futures or options contract. I just want an abstract investment I can sell (as a bank) whose price has (ideally) 100% correlation with the price of gold.

How is this done?

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    $\begingroup$ I am puzzled. You obviously know how to do it (by trading in bullion, futures or options) but somehow you don't want to use any of the known methods, why? It is like traveling from here to Paris, but no airplane, ship, helicopter or car allowed. You need a concrete (not abstract) way to do it. $\endgroup$
    – nbbo2
    Mar 23, 2021 at 18:36
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    $\begingroup$ Depository receipts? If this is passe, how about an NFT? $\endgroup$
    – Sergei Rodionov
    Mar 23, 2021 at 18:39
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    $\begingroup$ @noob2 The variable driving this decision is contractual obligations under other positions the bank holds. The underlying security has a sizable market looking to invest making it a worthwhile derivative to offer, but there are contractual obligations restricting taking any position on the underlying. The goal, therefore, is to create a derivative whose value tracks it, but does not involve taking an actual position. $\endgroup$
    – TheEnvironmentalist
    Mar 24, 2021 at 12:17
  • $\begingroup$ Can you create a synthetic index, call it "notGold", which tracks gold but is not gold, and write a claim on this synthetic index? But I think nobody will be fooled by this kind of construction. $\endgroup$
    – user34971
    Mar 24, 2021 at 12:28
  • $\begingroup$ @FridoRolloos The problem is simple, but the solution may not be. I want the behavior of gold, but I’m not allowed to support the gold industry, so I want to reproduce the behavior with a derivative, but without touching gold itself $\endgroup$
    – TheEnvironmentalist
    Mar 24, 2021 at 15:08

2 Answers 2

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As noob2 says in the comments: it would be easier to create an Exchange Traded Fund/Product/Note which would involve trading in the underlying.

If you still want to do this: The bank enters a contract with their customers that says: on such and such dates you can sell this contract back to us for the price of gold. It's a matter of contract law more than of finance.

From a finance perspective there are two issues which are important and do need to be solved:

  1. What is the price of gold at a given moment. Ideally, this price is recognizable as 'the price of gold' and hard to manipulate. In the past, prices of derivatives have been manipulated. For instance by banging the close.
  2. The bank needs to hedge the contract if it doesn't want to expose itself to price risk.
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I don't know how to say this in any way that does not sound unkind, the avoidance of which is 100% my intention... [and I saw they pulled your other question, slightly unfairly in my more tolerant opinion, so I'll postscript answer that as well ;-) ].

Your gold example is a bad one... precisely because the issuing bank can, and will, hedge its gold exposures via any/all of the bullion, gold futures or options markets.

I can easily issue "gold notes" to my clients that pay 100% of what gold did; and those notes will never need hedge themselves. Or just launch a Gold ETF, which is a derivative (albeit an unlevered one) of the gold price.

And I could this for eg Rhodium, Carbon Prices, or perpetual preferred equity if the mutual urge to consummate was there between us. There's nothing special about gold here.

The problems start to arise when the bank wants to start to create products that are not simply 100% related to the underlying. Then the need to hedge becomes essential. This hedging requires the existence of a futures/options market in that underlying.

best, DEM

[Black-Scholes versus reality. You won't like this answer; but it's an answer nevertheless, maybe not of the EXACT question you intended. Look at XVV... you're long of VIX. VIX being settled against VIX futures. Which are hedged against a wide range S&P options. Which embed expectations of implied vol, that the hedging thereof by all banks etc. cause realised losses when realised vols are (usually) lower than implied. Put simply, the vast majority of equity returns has come from the put-selling versus the call-buying component of investors' buying equities There's a "compensation for insurance" within the "equity risk premium", when one compares to derivatives prices that, by definition of construction, have to assume zero returns on the forward (aka the risk-neutral measure, to prevent arbitrage.)]

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