Sovereign gold bonds are naked calls written by the government

The Reserve Bank of India (RBI) issues sovereign gold bonds (SGBs). These bonds are denominated in grams of gold at current prices. I believe SGBs are the best way for individuals to invest in gold. They offer a 2.5% return each year on the invested amount. At redemption after 8 years, the bondholder will receive the equivalent price of gold in grams. Additionally, SGBs are exempt from capital gains. No other gold investment scheme can compare. In fact, regular gold-indexed funds charge management fees.

From the government's perspective, SGBs are similar to "naked calls". No matter what the future value of gold is, the government will give the bondholder that price at redemption. While the government pays a 2.5% annual coupon, it also writes this "naked call" on top, due to the price promise. Is the government losing money? Let's examine.

The government can raise money by issuing regular sovereign bonds, which it usually does. Currently, these need to pay around 7% interest for a 10-year duration bond, to the subscriber. With SGBs, the government only pays 2.5% to the subscriber every year. This means the government saves on annual payouts. Another difference is that at redemption, regular bonds only pay face value, while SGBs pay the market value of the subscribed gold. If the price of gold stays the same, the government makes a profit. But if the price rises, the government loses. To protect against this, the government can buy "naked calls." To determine if the government is losing money, we can compare the cost of these options to the gains from the lower coupon rates.

I had done this analysis sometime back here where I found that government loses money on SGB. 

I have now updated the results to include latest figures. You can find a copy of draft paper here (feel free to comment) 

I find that governemnt loses money on SGB. I am not claiming that this is wrong. It's a public policy choice. I am just uncovering the price that the government is paying to run this policy. The conclusion reads: 

"For every 100 Rupees of SGBs issued, the Government is facing a risk between 43.8 to 45.9 Rupees in terms of naked call value. It is partly offset by the gains that arise from cheaper money raised through SGBs. Yet, the offset falls short by around 15 to 17 Rupees for every Rs 100 raised through SGBs. Thus, the government is not sufficiently compensated for the risk."

If the government issues Rs 1000 crores of SGBs this year, it is losing around 150 to 170 crore Rupees on it over the duration of the bond.