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Monday, January 7, 2008

The Gold CD Scam

I saw an advertisement for "Gold Denominated CDs" (Certificate of Deposit). They are offered by Everbank. When I read the detailed terms of the CD, I was deeply offended. They are a scam, just like Liberty Dollars.

The "Gold Deonomicated CDs" are FDIC insured, just like any other deposit. Your principal is guaranteed. Even if the price of gold tanks, you are guaranteed your original investment back.

The CDs I looked at were offered for a term of 5 years. The gain is based on the average price of gold, sampled 10 times every 6 months. If the average price of gold over the next 5 years is 50% more than when you bought the CD, then your return is 50%. If the average price of gold over the next five years is 25% less than when you bought the CD, your return is 0%; your principal is protected.

Do you see the scam yet? I'll give you a chance to figure it out for yourself.

If you can't see the scam yet, you are completely illiterate about economics. I'll provide some spoiler space, as is customary.

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To see the scam, let's work out an example. Suppose the price of gold is $800 when you buy the CD, and the price of gold goes up at a uniform rate of $100/year. (In practice, it would be exponential growth on average, but that makes it an even worse deal for the CD buyer.)

After 5 years, the price of gold is $1300, and the average price of gold was $1050. A direct investment in physical gold would have yielded a return of 62.5%, but the stupid CD buyer received a return of 31.25%.

The bank who sells the CD buys gold put options, as insurance against a tank in the price of gold. Initially, the bank buys gold futures equal to the amount deposit. After one year, now the exposure to gold is only 4/5, and the bank only needs gold futures equal to 4/5 of the amount deposit, and so on. I summarize now.

In the first year, you have 100% exposure to the price of gold.
In the second year, you have 80% exposure to the price of gold.
In the third year, you have 60% exposure to the price of gold.
In the fourth year, you have 40% exposure to the price of gold.
In the fifth year, you have 20% exposure to the price of gold.

In years 2-5, the bank can invest the surplus in any riskless investment, such as government bonds.

Instead of buying the "Gold Denominated CD", you could buy the right combination of gold futures and put options, and be guaranteed a better return. The bank selling the "Gold Denominated CD" can make a guaranteed riskless profit by investing in the right combination of gold futures, gold put options, and government bonds.

An outright gold investment would be a superior investment, hedged with put options if you want protection against a contraction of the money supply. The value of gold itself does not tank, but the dollar-denominated price of gold could decrease if the money supply shrinks during the bust phase of the economic cycle.

If you do not understand the above explanation, IMHO your level of financial literacy is zero.

As always, if you want to invest in gold, physical metal in your possession is the safest investment, provided you can store your metal in a safe place.

2 comments:

Taran Jordan said...

Well, ALL banking is a scam. And most of 'em don't even do you the service of informing you how they're investing your money.

But that aside, why do people even bother to invest in government bonds at 4 or 5%, for instance, when gold or stocks can do a lot better?

Because they want to play it safe, and they think government promises are safe, right? They'll sacrifice a lot of potential profit for that safety.

I imagine that lots of people are feeling the safety thing pretty heavily about gold lately, even with its impressive performance since 2001. So the gold CD is a product serving a certain customer base.

Caveat emptor, that's all.

gilliganscorner said...

You are correct in your analysis. I was offended as well when I did my analysis and shook my head at all the financial illiterate people who would be duped into it.

Everbank actually posts sample calculations they know most people won't even read. You can see them here.
on page 2(PDF format)

Thanks FSK - yet another good post.

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