Hedging At Its Most Basic
Ian Levy, Gympie Gold
Click here to download paper as PDF
INTRODUCTION
Do this as a worked example – it saves words.
The gold price has “jumped” to A$500 per ounce and we, the Miner, want to lock this “good” price in for 1,000 ounces to be delivered in exactly 12 months time.
Rates For This Example
Spot price = A$500 per ounce.
Australian 12 month cash interest rate = 7%
12 month gold lease rate (or gold borrowing fee) = 2%
Banker’s profit margin = 0.25% (depends on “credit rating”)
How Hedging Happens
- Miner (ie. our company) advises its “dealer” counterparty (eg. Rothschild Bank) to sell 1,000 ozs forward for 12 months at this spot price.
- Dealer immediately borrows 1,000 ozs of gold from a major Central Bank (eg. Bank of England) and sells it into the spot market: Dealer raises 1,000 x 500 = $500,000 cash and promises to repay the gold in 12 months plus the interest rate charged by the central bank on gold, usually called the gold lease rate or more legally, the gold borrowing fee.
- Dealer’s bank (eg. Rothschild) immediately invests the $500,000 onto the cash interest rate market to earn normal interest minus the lease rate.
Therefore, in 12 months time, Dealer can pay Miner more than the $500,000 for 1,000 ounces of gold because the Dealer:
| Still has the $500,000 it raised on the 1,000 ozs | $500,000 |
| Earns cash interest on the$500,000 of 7% | $35,000 |
| Pays the gold borrowing fees of 2% | $10,000 |
| Takes a bankers fee of 0.25% | $1,250 |
| Net amount payable to Miner | $523,750 |
So, all Miner needs to do is deliver 1,000 ozs of gold to Dealer in 12 months time to receive $523,750 – an effective gold price of $523.75 per ounce.
Nobody has “bet” against the miner/dealer, this all happens because of the prevailing interest rates for cash and gold loans. Nobody loses if the gold price falls below $500 in 12 months time. Miner loses an opportunity to make more money if the gold price rises above $523.75 in 12 months time because the 1,000 ozs must be delivered into the $523.75 contract with the Dealer so that the gold can be returned to the Reserve Bank.
And that is all that happens in basic gold hedging, the rest is jargon and variations on this theme.
We complicate this process a bit by paying a fee or taking a fee and contractually making the hedge transaction optional for one or other party. Option pricing is beyond the scope of this note. Options are a valid activity and are actually not overly complex until we start creating multiple-option “derivatives”.