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A New Zealand company produces 20,000 ounces of gold per year. It uses 30% of its...

A New Zealand company produces 20,000 ounces of gold per year. It uses 30% of its production for making gold jewelry sold at a fixed price through stores in Australia and New Zealand, and the rest is sold on the market, where the gold price is determined in US dollars. Australia’s profits are repatriated to New Zealand. The company’s CEO wants to use futures contractc to hedge the entire production. He calls you to seeks your opinion. Recommend a seinsble hedge stragtegy that would be in line with the CEO’s wishes (assume x is the quantity used for making gold jewelry in the New Zealand)

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Expert Solution

The best strategy is Gold Futures Short hedge strategy.

A gold company has just entered into a contract to sell X ounces of gold to be delivered in 3 months' time(Example). The sale price is agreed to be based on the market price of gold on the day of delivery to customer. At the time of signing the agreement, spot price for gold is USD 1002/oz (Example)while the price of gold futures for delivery in 3 months' time is USD 1000/oz.

To lock in the selling price at USD 1000.00/oz, the gold company can enter a short position in an appropriate number futures contracts.

The effect of putting in place the hedge should guarantee that the gold company will be able to sell the x troy ounces of gold at USD 1000.00/oz Let's see how this is achieved by looking at scenarios in which the price of gold makes a significant move either upwards or downwards.

1)If gold price falls by 10 percent : USD – 901.8. As per the sales contract, the gold mining company will have to sell the gold at only USD 901.8/oz, resulting in a net sales proceeds of USD 901.8X

The gold futures price will have converged with the gold spot price and will be equal to USD 901.8/oz. As the short futures position was entered at USD 1000/oz, it will have gained USD 1000- USD 901.8 = USD 98.2 per ounce. The fall in the spot price will not impact the company as the company is in short position.

2) If gold price increase by 10 percent : USD – 1102.2

With the increase in gold price to USD 1102.2, the gold producer will be able to sell the X ounces of gold for a higher net sales proceeds of USD 1102.2 x

However, as the short futures position was entered at a lower price of USD 1000.00/oz, it will have lost USD 1102.2 - USD 1000 = USD 102.2 per ounce. But physical Gold price will increase to 1102.2 so the net amount will be as per $1000.

.This hedging strategy will avoid the loss if the gold price fells.

jeff jeffy answered 2 years ago
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