‘One may buy gold too dear’ suggests a German proverb, but for centuries gold has been treated as a currency in its own right and used as a basis to set the relative value of other currencies. Unlike other commodities, gold is not prone to spoiling or rotting and could be stored and kept for many years. Somewhat more recently, gold standards were set and the US dollar (USD) was pegged to gold until this arrangement was suspended by the Nixon administration in 1971. The last country to link its own currency to the gold standard was Switzerland, up to the year 2000.
Through history, the demand for gold has been driven by several factors, including jewellery use, industrial use, and as a safe haven in troubled times for protecting the value of money against inflationary risks. Unlike other commodities, most of the gold extracted exists over the ground and could potentially return to the market, once the underlying price is high enough. Therefore, the price of gold is mostly driven by either demand or fear – rather than consumption and supply.
History and Volatility
Central banks investing their excess reserves have been traditionally major holders of gold. As Switzerland detached its currency from gold, central banks have sold the precious metal, pushing its price to the level of US$250 per ounce by late 2002. By 2004, central banks held about 19% of the overall estimated gold above ground. Figure number 1 below displays the 10 largest holders of gold and the respective quantities:
Figure 1: World Official Gold Holdings as of June 2013.
Source: World Gold Council.
Through financial crises, investors have fled towards buying gold as a hedge against inflation, deflation or stagflation. In 2008, as the subprime crisis emerged, gold traded at the range of US$750 to US$980 per ounce. Since then, given the unprecedented monetary easing by central banks across the globe, as well as the fear of inflation and depreciation of local currencies, gold has traded all the way up to US$1,907 per ounce, touched in September 2011.
Figure 2: Gold Ten Year Spot Chart.
Since that 2011 peak level, gold prices have weakened steadily. At the beginning of April 2013, gold was hovering at around US$1,600, but following the release of weaker gross domestic product (GDP) data for China that same month, gold prices sank below US$1,400 an ounce. Two main drivers that have contributed to the correction in the gold price were related to derivatives trading:
- Put gold options purchased by hedge funds.
- Auto-callable structures bought by investors, containing barriers that were triggered as the gold price weakened.
As the gold price softened, the sellers of these options had to sell gold as a delta hedge. As a result, the price drop accelerated and more gold had to be sold. Traders were scrambling for gamma (being long short-dated options, to benefit from fluctuations in the price of one troy ounce of gold in US dollars (XAU/USD)) and the price of these options went higher as the implied volatility also moved higher. To illustrate, one month implied volatility traded at 11 as of 1 April and hit 28 on 15 April.
The question being asked is: ‘How can one effectively hedge against this volatility in gold prices?’ In a Numerix study, the example was chosen of a gold mining company that was seeking protection against the gold price declining. The reason being was that over the course of several years, the gold price kept moving steadily higher and made downside hedging seem redundant. Gold miners have paid up billions of dollars over the past decade in order to eliminate hedge books, which were acting as a significant drag on profits as the gold spot price trended upwards. Today, following the violent price correction, a hedge is very much required – although at the current level it is less favorable and more expensive.
The hedging suggestions outlined below are based on a spot rate of US$1,377.40 to one ounce, six months implied volatility trading at 18, an underlying exposure of $10,000,000 and a hedging horizon of six months as of 10 June.
Forward: The most basic hedging tool is selling gold outright and locking in the forward rate, of which the US$10m would be received – $1,378.40. The main benefit for the mining company hedging is that the rate is now known and locked; further depreciation in the gold price would have no impact on the financial performance of the company. The main shortcoming is that the current level is 2013’s low and if the firm’s budget is based on a higher spot rate, losses are being locked. In case of gold’s price appreciation, no profits would be registered for the company.
Vanilla Options: This hedging tool provides protection from additional gold price weakening with the possibility of benefiting from upward gold moves – in exchange for a premium paid upfront. Figure 3 below illustrates the premium required given various strike prices. The mining company is purchasing Put Gold Vanilla Options. The higher the strike price is, the higher is the required premium.
Figure 3: Purchasing Vanilla Options – Premium Required at Various Strike Prices.
Knock Out Options: This option class limits the potential upside from favourable gold strengthening, in exchange for a lower premium paid up front. If the barrier level (1,500 in this example) trades during the coming six months, the option would cease to exist and the mining form would sell its gold at the prevailing market rates (US$1,500 to one gold ounce). Figure 4 presents the cost of each Knock option, as well as the savings when compared with Vanilla options.
Figure 4: Purchasing Knock Options and Savings as Compared to Vanilla Options.
Zero Cost Collars: Some hedgers do not have a hedging budget, or prefer hedging without having to pay an initial premium. These hedgers may enter zero cost collars. The hedger would buy a vanilla put gold option and would sell a vanilla call option, for the same expiry date (six months) and notional amount (US$10,000,000). At expiry, if the market trades below the strike price of the put option, the firm would exercise the put option. In case the market trades above the strike price of the call option, the market maker – typically the bank – would exercise the call option.
In case the market trades between the two strikes, no option would be exercised and the firm would sell its gold at the prevailing market rate. The main benefit is that no initial premium is paid upfront and the firm is hedged against additional losses, below the strike price. However, the upside is limited to the strike price of the call gold option. As the strike price of the put option gets lower, the strike price of the call option is higher, granting a higher upside but a lower protection on the downside. Figure 5 below displays the corresponding call options for zero cost collar structures.
Figure 5: Zero Cost Collars.
Forward Extra: Another zero cost strategy would be forward extra. The firm would buy a vanilla put gold option and would sell a reverse knock in call option struck at the same strike price as the put gold option. The call option would be activated only if the preset trigger level is met. The strategy provides a protection from unfavourable downside moves below the strike price and participation to the upside up to the trigger level. The strike price for both options, put and call, is the same. Typically the forward extra strategy is set as zero cost upon inception. Figure 6 below illustrates the corresponding trigger levels. The table clearly shows that the lower the strike price is set; the participation in a favourable upside gold move is greater.
Figure 6: Forward Extra with Corresponding Trigger Levels.
Across history, gold has been perceived as a safe haven during political and economic crises. Many players are active in the gold market: mining companies, central banks, consumers, investors and individuals to name just a few. During the past decade gold prices have risen dramatically and have started to correct and weaken since the peak price registered in September 2011. Over the subsequent period price volatility has increased and various market participants are looking to hedge their gold positions.
The hedging strategies suggested in this study aim to cater to various flavors, including:
- Buy only.
- Buy and sell to generate zero cost structures.
- Various derivatives (linear – forward), vanilla options and exotic options.
The derivatives market offers numerous hedging tools that could be used to mitigate this volatility. The various strategies could be tailored to suit the hedgers’ requirements and preferences. One may select the size of the premium to be paid (if any), whether to sell options or just buy, use exotic options, hedge on a specific date or an ongoing cash flow. This article has selected no more than a handful of structures, although many more hedging strategies are available.
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