Last update Friday 23rd – 3pm
A Detailed Look at Gold Hedging
Ammar Al-Joundi
Vice President and Treasurer
September 2002
Agenda
I
Details of How Gold Hedges Work
II
The Primary Risks Associated with Gold Hedging
III The Importance of Credit
IV
An Explanation of “Mark-to-Market”
V
The Myths of Gold Hedging Risks
VI
Conclusions
2
How a forward gold sale is priced:
1 oz of gold
P
R
O
D
U
C
E
R
$300 +($80 – $35) = $345
(contango)
(interest rate – lease rate)
Gold Sales Contract:
§ Price fixed to 5 yrs
B
U
L
L
I
O
N
B
A
N
K
1 oz of gold
upfront flows
flows at maturity
STEP 1 – 5 year Gold Loan
CENTRAL
BANK
1 oz at maturity + 2%/yr = ($31)
(lease rate)
1 oz of gold
STEP 2 – Spot sale of gold
SPOT
MARKET
$300
$300
STEP 3 – 5 year deposit
BANK’S
FUNDING
DESK
$300 at maturity + 5%/yr = ($83)
(USD interest rate)
3
Who Wins and Who Loses?
Entity
Action
Why
Producer
§ Enters into
§ Price protection
§ Ability to deliver gold
§ Can take advantage of § Potential opportunity
contract to sell
gold production at
fixed price.
Bullion Bank
cost.
§ Intermediary role
§ $7/oz with no market
§ Ability to receive
§ Lends gold.
§ Receives $31/oz for
§ Ability to receive gold
in creating the
gold lending and
gold hedging
markets.
Central Bank
$45/oz higher forward
premiums to spot.
Risks
exposure.
lending gold versus
$0/oz in the vault.
§ Higher return on
assets (objective of all
Central Bank
deposits).
production from
producer (credit risk).
back from Bullion Bank.
Well thought out gold hedging/lending makes sense for all parties involved.
4
Some Key Facts About Gold Hedging
§ Producer does not borrow gold.
§ Producer has future gold production to deliver.
§ Producer simply enters into a contract to sell gold in the future.
§ Hedging is done by the Bullion Bank. They take on the borrowing of gold,
the spot positions, the deposit risk, etc.
§ The $345 contract price includes $7/oz. of profit locked-in by the Bullion Bank.
§ Nobody is buying gold for $345/oz.
5
How the Forward Price is Determined
§ Function not just of current gold price, but also:
1) Interest rates (the deposit on US$)
2) Lease Rates (the cost to borrow gold)
3) Time (the effect of compounding)
Example of a 5-year Forward
Dec. 2000
Dec. 2002
Spot gold price
$280
$315
Interest rates
7.5%
4.5%
Gold lease rates
1.5%
1.5%
Forward price
$360
$355
Despite the $35
difference in
spot gold prices
the future value
of the contract is
similar
6
Four Year Forward Price of Gold
500
450
$/oz
400
4 year average
$334
350
(Today at $332
Off of $315 spot)
300
250
Jan-92 Mar-93 May-94
Jul-95
Sep-96
Spot Gold
*Based on floating lease rates of 1.75%
Nov-97
Jan-99
Mar-00 May-01
Jul-02
4yr Forward Price*
7
I
Details of How Gold Hedges Work
II
The Primary Risks Associated with Gold Hedging
III The Importance of Credit
IV
An Explanation of “Mark-to-Market”
V
The Myths of Gold Hedging Risks
VI
Conclusions
8
The Risks: Step 1 – The Gold Borrowing
1 oz of gold
P
R
O
D
U
C
E
R
B
U
L
L
I
O
N
B
A
N
K
STEP 1 – 5 year Gold Loan
CENTRAL
BANK
1 oz at maturity + 2%/yr = ($31)
(lease rate)
SPOT
SPOT
MARKET
MARKET
BANK’S
FUNDING
DESK
§ The Central Bank is at risk that it doesn’t get gold loan back from Bullion Bank.
§ That is why Central Banks deal with “AA” rated Bullion Banks and not with Producers
directly.
§ The Producer is NOT at all involved in this loan, nor can the Producer be made
responsible for the Bullion Bank’s obligation to return gold to the Central Bank.
§ Of course, the Bullion Bank does depend on the gold from the purchase contract
with the Producer to offset its separate and distinct obligation to the Central Bank.
9
Historical Gold Borrowing Rates
3-Month Lease Rates (%)
7
6
5
4
3
2
1
0
Jul89
Median = 1.0 %
Jul90
Jul91
Jul92
Jul93
Jul94
Jul95
Jul96
Jul97
Jul98
Jul99
Jul00
Jul01
Jul02
10
Distribution of 3 Month Gold Lease Rates
1989 - Current
25%
86% of the time the 3-month
lease rate was under 2%
Time as %
20%
15%
10%
5%
0%
0
0.25 0.5
0.75
1
1.25
1.5
1.75
2
2.25 2.5 2.75
3
3.25 3.5
3.75
4
4.25 4.5
4.75
Lease Rate
11
The Risks: Step 2 – The Spot Sale of Gold
P
R
O
D
U
C
E
R
B
U
L
L
I
O
N
B
A
N
K
CENTRAL
BANK
1 oz of gold
SPOT
SPOT
MARKET
MARKET
STEP 2 – Spot sale of gold
$300
BANK’S
FUNDING
DESK
§ There is no risk in this step as it is simply a spot sale of gold into the market.
§ All cashflows occur on the initiation of the hedge. No future cashflows,
obligations or risks.
§ The Producer is not involved in any way.
12
The Risks: Step 3 – The Cash Deposit
P
R
O
D
U
C
E
R
B
U
L
L
I
O
N
CENTRAL
BANK
SPOT
SPOT
MARKET
MARKET
B
A
N
K
$300
STEP 3 – 5 year deposit
$300 at maturity + 5%/yr = ($83)
BANK’S
FUNDING
DESK
(USD interest rate)
§ The Bullion Bank deposits the $300 with its own funding desk, thus there is no
credit risk between the two counterparties (as they are the same entity).
§ The interest rate is locked in at the time of deposit (in this example).
§ The Producer is not involved in any way.
13
The Risks: The Sales Contract
$345
P
R
O
D
U
C
E
R
B
U
L
L
I
O
N
CENTRAL
BANK
SPOT
SPOT
MARKET
MARKET
B
A
N
K
BANK’S
FUNDING
DESK
1 oz of gold
From the Bullion Bank’s Perspective
From Producer’s Perspective
1) Only risk - The gold is not delivered
1) If they can’t produce gold for less than $345/oz.
§ The Bullion Bank then may have to pay
more than $345/oz to purchase gold
from the market that they owe to the
Central Bank.
§ If gold spot is below $345/oz, no risks.
2) Committed ounces are more than production.
3) Margin calls, early terminations.
4) Counterparty risk if spot gold price is $200/oz and
the Bank renegs/defaults on contract.
5) Potential opportunity cost.
14
Producer Risks – Production/Margin
Calls/Early Termination
§ Production must be low cost, and assets diverse and politically secure.
§ Contracts must have no margin calls.
§ Contracts must have no early termination rights because this could mean forced
to deliver gold early (before production?).
The MAJOR risks a producer has to hedging are not how many ounces
they’ve hedged, or even at what price, but are dependent on:
§ How low cost are their mines? (cost of production)
§ How well diversified and certain is their production (certainty of having gold)
§ How good is their credit (defines the terms of the contracts – including
margining on termination rights)
§ Does management know what they are doing (complexity of hedges, senior
management involvement and understanding, experience).
15
Producer Risk: Bullion Bank Declares
Bankruptcy
P
R
O
D
U
C
E
R
Gold Purchase Contract
at $345/oz
T
R
U
S
T
E
E
1 oz Gold Loan
$300 Deposit
CENTRAL
BANK
US$
DEPOSIT
Trustee may:
1) Default on gold loan repayment to central bank
2) Cash-in the deposit with funding desk
3) Determine value of gold purchase contract.
If Asset: (i.e. Spot price higher than contract price of $345)
§
Holds onto contract or will try to sell to another bullion bank
If Liability: (i.e. Spot price below the contract price of $345)
§
§
§
§
Default on gold purchase agreement
Producer still owns gold production and can sell gold at spot
Producer will look to recover difference between spot sale and contract price of $345
Worst case scenario is to sell at spot (same as unhedged producers)
16
I
Details of How Gold Hedges Work
II
The Primary Risks Associated with Gold Hedging
III The Importance of Credit
IV
An Explanation of “Mark-to-Market”
V
The Myths of Gold Hedging Risks
VI
Conclusions
17
§ A large bullion bank once said:
“There are three things that are important when considering
the terms of hedging contracts with gold producers:
1. Ability to deliver;
2. Ability to deliver;
3. Ability to deliver.”
18
The Importance of Credit
Quality assets and a strong credit rating allow hedge contracts to:
§ Have multi-year terms (up to 10 – 15 years) that provide
tremendous flexibility as to when producer must deliver gold.
§ No margin, and no early termination rights.
§ Better pricing on long-term contracts.
§ Ability to receive much higher forward prices based on
long-term vs. short-term interest rates.
19
I
Details of How Gold Hedges Work
II
The Primary Risks Associated with Gold Hedging
III The Importance of Credit
IV
An Explanation of “Mark-to-Market”
V
The Myths of Gold Hedging Risks
VI
Conclusions
20
Mark-to-Market (MTM)
MTM is the replacement value of the hedge position at a particular point in time
As an example, consider
the following overall
producer hedge position
$3.5 Billion in 5 years
P
R
O
D
U
C
E
R
§ 10 mm ounces in five
years at $350/oz
B
U
L
L
I
O
N
B
A
N
K
S
10 mm oz gold plus leases (fixed for 3.0 years)
Market Move
Impact on MTM
Gold up $10/oz
Negative $100mm
Impact on Realized
Contract Price
None
Producers Position
None
Wants US rates higher
because results in higher
future contango
Negative $3/oz.
Wants lease rates low
(even though negatively
impacts MTM)
10mm x $10/oz. = 100mm
US rates down 1%
Positive $147mm
3,500 x 1% x 5yrs = 147mm
(1.035)5
Lease rates up 0.5% Positive $45mm
(0.5% x 3.0 yrs x 10mm oz.)
(0.5% x 2.0 yrs)
Wants gold price to rise
as company and unhedged
reserves increase in value
21
Why Mark-to-Market May Matter
§ Mark-to-market represents the “replacement value” of contracts.
§ This creates credit exposure to counterparties.
§ MTM thresholds can be used to mitigate credit exposure through margining,
or early termination.
22
I
Details of How Gold Hedges Work
II
The Primary Risks Associated with Gold Hedging
III The Importance of Credit
IV
An Explanation of “Mark-to-Market”
V
The Myths of Gold Hedging Risks
VI
Conclusions
23
“A Rising Gold Price is Bad for Hedged Producers”
§ If you hedge more gold than you can produce, or if the banks can force you to
§
§
terminate contracts early, then there is a risk to rising gold prices.
However, the vast majority of experienced gold hedgers hedge responsibly:
– Typically 2 – 4 years worth of production
– Under 1/3 of reserves
– No margin calls
– No termination clauses ( acceleration of contracts)
These producers want gold prices to rise as:
– Typically only small portion of reserves hedged
– Amount of reserves increase at higher prices
– Cashflows improve on unhedged production, and for producers who can
use “SPOT-DEFERRED” contracts even better cashflow leverage
24
“These are Complex Derivatives and Impossible to
Understand”
§ Vanilla gold hedging (forwards, caps, collars) are about as simple as
§
§
§
§
hedging gets.
Exactly the same as F/X hedging which has been around for over 30 years.
The economics are NOT rocket science, simply the cost of a gold loan
versus a dollar deposit.
NOTE: The legal contracts, however, need to be carefully constructed so
that banks cannot terminate early.
Irresponsible hedging or inexperienced hedgers can lead to problems.
– Experience
– Capability
– Controls
25
“Gold Hedgers Must Take Huge Risk to Make Money”
§ This is absolutely not true.
§ In early 1995, spot gold was $380 and you could lock in the price in 2000 for
over $500/oz. In 2000 the spot price was $270/oz. A producer would have
made an incremental $230/oz with:
– A very simple forward hedge on existing production
– Only risk was opportunity cost above $500/oz
26
“Who Buys Gold at $350/oz when spot is $300?”
§ Nobody.
§ The forward price is fixed upon inception of the contract based on i) the then
§
spot price and ii) the interest rate differential between borrowing gold and the
US$ deposit.
In our example,
P
R
O
D
U
C
E
R
$345
5 years
1 oz
B
U
L
L
I
O
N
B
A
N
K
FIXED
1 oz + $31 interest
FIXED
$300 + $83 interest
CENTRAL
BANK
US$
DEPOSIT
§ The Bullion Bank deposited $300 at 5% for 5 years. They will get back
§
$383 regardless of what happens to future gold prices.
They owe the central bank 1 oz + $31, regardless of what happens to
future gold prices.
27
“If Banks Blow-up, the Producers are on the Hook”
§ Absolutely not true.
§ Producers have no obligations or connections to central bank gold loans.
§ Producers have no credit exposure to Bullion Banks if gold prices climb above
hedge price. None.
§ Producers only have credit exposure to Bullion Banks if gold prices decline, and
even then the downside is limited to selling gold at spot (same as unhedged
producer).
§ In our example, the $345 owed by the Bullion bank is part of the same contract
as the 1 oz of gold owed by the producer. These obligations “net” together.
Producers can’t be forced to deliver the 1 oz of gold if they don’t get their $345
in cash.
§ The central bank can’t ask for the gold to be paid by the producer if the bullion
bank defaults.
28
I
Details of How Gold Hedges Work
II
The Primary Risks Associated with Gold Hedging
III The Importance of Credit
IV
An Explanation of “Mark-to-Market”
V
The Myths of Gold Hedging Risks
VI
Conclusions
29
Conclusions
§ The economics of gold hedging are relatively simple.
§ Nobody buys gold at the higher hedged price. That is simply a price that was
constructed by the bullion bank.
§ The major risks for Producers are related to termination rights or margining
within the sales contracts themselves.
§ Asset quality, diversity and credit strength are the most important elements to
mitigate termination risk.
§ Irresponsible hedging can cause problems:
– Experience
– Understanding
– Internal processes, tracking, controls.
30