You have just been hired as the finance director of a firm that mines gold from

Question

You have just been hired as the finance director of a firm that mines gold from a gold mine and sells gold on the world market. Production is stable, but you notice that the spot price of gold varies a lot.

(a) At your first meeting with the CEO you say that you plan to hedge the price of gold using futures contracts. The CEO says “No. There is no point in using futures. There is just as much chance that the price of gold in the future will be less than the futures price, as the chance that the price of gold will be greater than the futures price”. How do you address the CEO’s claim, and how to you make the case for using futures? (Hint: Make your answer short and to the point).

(b) Compare the following two strategies for hedging the price of gold: (i) Futures contract, and (ii) a collar based on gold options. (Hint: Make your answer short and to the point).

Explanation / Answer

(a)

Hedge strategies are always for the safety of an underlying. CEO’s claim of not using any hedging tool is not correct as there are also chances of adverse movement in gold market, if hedging is not done it means that company will carry the risk exposure of gold to the last settlement date. And if on settlement price is below than future price company will regret its decision. Using a future contract will certainly fix the income but the loss will be NIL, which seems much better.

(b)…(i) Gold is a commodity future. It is exchange traded, so physical settlement is not possible. Buyer has to buy a contract as per its exposure of underlying asset as well as he has to look for the lot size of market. It could be possible that hedge efficiency could be less than or more than 100%. At settlement date contract is completed at two places, one at Exchange market and other at physical settlement. Net cost would be equal to future price.

(ii) in a collar option strategy simultaneously buying of CAP and selling of FLOOR or buying of FLOOR or selling of CAP is done both having same expiry period. This action creates a cylinder i.e. Limited benefit and limited profit. Overall objective is to get protection and reduce cost of hedging. For protection of Gold company needs to Buy a FLOOR and sell a CAP to create a COLLAR.

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