ABCs of Hedging Chris Howell, Cambridge Risk Ltd

1
ABCs of HedgingChris Howell, Cambridge Risk
Ltd

• February 2008

2
Important Information

• The information and opinions contained in this
  document are not intended to be a comprehensive
  study, should not be regarded by any recipient as
  providing the basis for any investment decision
  and should not be treated as a substitute for
  specific advice concerning individual situations.
  
• Cambridge Risk Limited neither gives any warranty
  nor makes any representation as to the accuracy
  or completeness of this document and does not
  accept any liability for the consequences of any
  reliance upon any statement of any kind
  (including statements of fact and of opinion)
  contained herein.
• Cambridge Risk Limited is authorised and
  regulated by the Financial Services Authority

3
1. Introducing ABC Mining
ABC Mining plc is developing a small mine that
plans to produce gold over the next 10 years. The
plan assumes a current gold price of 940 per oz,
with variable production costs of 500 per oz.

• The underlying asset, produced by ABC Mining,
  gold, can be sold when it is produced at the spot
  price, which is the price for immediate delivery.
• Miners are exposed to market price risk, the risk
  of adverse movements in the spot price over time.
• ABC Mining could seek to mitigate price risk by
  hedging with financial derivatives. This could
  either fix the future sale price, or provide
  insurance in the case of adverse price movements.

4
2. What is a Financial Derivative?
Financial Derivative A contractual agreement
between parties to make payments between the
parties based on the price of the underlying
asset at a particular point in time. Key
Properties

• Contractual
• Details of the contract can be crucial
• May involve counterparty risk if losing party
  fails to meet commitments under the contract
• Frequently Involve Gearing
• Final losses can easily exceed any initial cash
  requirements and be material to even the largest
  listed entities
• Derivative position may constitute a substantial
  unrealised asset or liability

5
3. History of Hedging and Derivatives

• Early Commercial Contracts
• 12-13th Century traders made forward sale
  agreements. E.g Monasteries who frequently sold
  their wool up to 20 years in advance to foreign
  merchants.
• 17th Century Tulip Mania in Holland. Fortunes are
  lost in after a speculative boom in tulip futures
  burst. Futures contracts deemed non-enforceable
  in law.
• Exchanges open
• Late 17th Century, Dojima in Japan trading rice
  futures.
• Chicago Board of Trade (1848), Chicago Mercantile
  Exchange (1898) etc
• Options valuation theory develops
• 1960s - Black and Scholes work on options
  valuation
• Chicago Board of Options Exchange (1973), Liffe
  London (1982)
• Rapid increase in range and value of derivatives
  traded
• Expansion to include interest rates, stocks,
  indexes and a wide variety of metals and soft
  commodities.
• 1990s onwards - series of derivatives related
  corporate disasters - Metallgesellshaft losing
  1.5 billion on oil futures (1994) and Barings
  Collapse (1995), to Société Générale losing 4.9
  billion in Jan 2008

6
4. Who might use Financial Derivatives?

• Hedgers producers like ABC mining can use
  derivatives to reduce market risk i.e. from
  falling prices. Their derivatives positions are
  said to be covered by their physical capacity to
  produce the underlying commodity.
• Speculators take a view on which way a market
  will move, and use derivatives to increase
  exposure to their expected market movement. Their
  derivatives positions are usually uncovered or
  naked.
• Arbitrageurs Look to make series of balancing
  trades within or across markets to exploit small
  pricing differences or errors for the same or
  similar commodities.

7
5. How to enter a derivatives contract
There are several ways ABC mining could enter a
derivatives type contract

• Over the Counter Market (OTC)
• Bespoke contract with a financial institution,
  bank etc
• Very flexible contract terms e.g. quantity,
  delivery time, delivery method etc
• Higher cost, less transparent pricing
• May not require cash up front, but will price in
  credit risk of ABC Mining failing to meet
  obligations
• Exchange Traded
• Fixed contract terms
• Limited liquidity on longer expiry dates,
  especially for base metals
• Contracts are novated to the clearing house, so
  almost zero counterparty risk
• Initial margin and daily variation margin
  payments required to ensure no counterparty risks
• Commercial contracts
• Derivatives embedded within normal commercial
  contracts, e.g. off-take agreements, sale
  agreements etc
• Can be surprisingly significant for mining
  companies.

8
6. Basic Instruments
Most financial derivatives are one of three basic
types of instrument

• Forwards or Futures a commitment to sell an
  underlying commodity at some time in the future,
  at a price agreed today.
• Options the right, but not the obligation to
  buy a commodity (a call option) or sell a
  commodity (a put option) at an agreed price
  (the strike price).
• Swap an agreement to swap cashflows with a
  counterparty, e.g. swap an obligation to pay a
  fixed interest rate on a loan for an obligation
  to pay a floating interest rate over the period
  of the loan.
• There are two sides to every contract. The buyer
  of the commodity or option is said to be long,
  the seller short. For options, the seller of the
  option is said to write or grant the option.

9
7. Hedging with Forwards

• ABC Mining can use a short forward (sell forward)
  to 100 hedge market price risk.
• Consider a forward sale of one months expected
  production, e.g. Jan 09
• Assume the forward price for delivery in Jan 09
  is approx 963 per oz

10
7. Hedging with Forwards
11
8. Forwards Valuation Basics

• The forward value can be derived from todays
  spot price, the cost of carry and the financing
  costs.
• The cost of carry is the net cost or benefit of
  holding the commodity from now until the forward
  delivery time, including factors such as costs of
  warehousing, income from leasing the commodity
  and so-called convenience yields from holding
  base metals.
• If the forward price does not reflect the spot
  price and cost of carry, there will be arbitrage
  opportunities that would ultimately correct the
  price, e.g.
• Forward price too high, you could Sell forward,
  borrow cash, buy at spot, hold until delivery and
  make a risk free profit.
• Forward price too low, you could buy forward,
  borrow the underlying and sell at spot, invest
  the proceeds until the forward delivers then
  return the borrowed commodity.

12
8. Forwards Valuations for Gold

• Gold is an asset that is primarily held for
  investment.
• Implies when calculating the cost of carry that
  you can obtain a return (the lease rate) from
  lending gold, warehousing costs are negligible,
  and there will always be a supply available to
  meet short term demand.
• This results in a forward price generally higher
  than the spot price, known as a contango market.

13
8. Forwards Valuations for Gold
14
8. Forwards Valuations for Base metals

• Base metals are primarily held for consumption
• As a result of this, although warehousing costs
  may now be significant, there is a benefit to
  holding stock e.g. to avoid short term shortages,
  introducing a convenience yield to the cost of
  carry.
• As a result, forward prices for base metals tend
  to be lower than the spot price, know as a market
  in backwardation.
• This can make it very expensive to hedge base
  metals by selling forwards!

15
8. Forwards Valuations for Base metals
16
9. Hedging with Options Long put

• ABC mining could buy a put e.g. with a strike
  price of 800 per oz expiring in Jan 09, which is
  the right, but not the obligation to sell gold at
  800 per oz.
• This is an insurance policy against falling
  prices. If the spot price falls below 800 per
  oz, the option will become in the money, and
  the payoff from the option will then compensate
  for the lower sale price of gold produced.
• If the price is above 800 per oz, the option
  expires unexercised, but ABC Mining would enjoy
  the benefit of selling gold at the higher spot
  price.
• The cost of this insurance is the premium paid
  for purchasing the option

17
9. Hedging with Options Long put
18
9. Hedging with Options Short call

• ABC Mining could sell (write) a call option at
  1,200 per oz, covered by the mines expected
  production.
• If the option expires out of the money (spot
  price below 1,200), the option wouldnt be
  exercised, and ABC would just keep the premium
  paid by the buyer of the option.
• If the spot price is higher than 1,200 on
  expiry, the option will be exercised by the
  buyer, restricting ABCs revenue on gold produced
  to 1,200.

19
9. Hedging with Options Short call
20
9. 9. Hedging with Options Collars

• Why might ABC mining want to sell a call?
• As part of a collar, a combination of a long put
  at a low strike and short call at a high strike.
  This insures against significant falls in the
  gold price, paid for by forgoing the benefits of
  a significant rise in gold price.

21
9. Hedging with Options Collars
22
10. Options Valuation

• The key theory for valuing an option (i.e. the
  premium) is the Black Scholes equation, devised
  by Robert Merton, Fischer Black and Myron
  Scholes in a paper published in 1973. This was
  awarded the Nobel Prize for Economics in 1997.
  Key factors affecting the price of both puts and
  calls are
• The strike price compared to the current spot
  price. Further in the money more
  valuable/expensive
• The time to expiry. Longer till expiry more
  valuable/expensive
• The volatility of the price of the underlying.
  More volatile more valuable.
• There are several styles of options
• European options Can only be exercised on expiry
• American options Can be exercised at any point
  up to expiry, which can only help the buyer of
  the options, so tends to make them more expensive
  than European options.
• Asian options the strike price is compared to an
  average market price e.g. in the month up to
  expiry. Common in base metals, as prevents
  manipulation of the spot price near expiry. Tend
  to be lower cost as volatility of the average
  price is lower than the volatility of the spot
  price.

23
11. Stakeholder Expectations

• ABC Mining is thinking of hedging its production
  what might its stakeholders think?
• Providers of debt finance just want their money
  back. May expect or insist on hedging to protect
  repayments in the event of a fall in market price
• Shareholders have invested in a gold mine.
  Likely to expect to have a significant exposure
  to the market price of gold
• Potential for conflict between the needs of
  different stakeholders

24
12. Hedging the mining plan

• ABCs mining will result in production expected
  over a number of years, so care needs to be taken
  to match derivatives expiry and cashflows to the
  production plan.
• Hedging strategies frequently require a strip of
  options or forwards to be entered into - sets of
  options with different expiry dates, typically a
  month apart.
• One way of achieving this is a flat forward, an
  over the counter forward product that offers a
  fixed price for monthly deliveries over the
  course of the mining plan.
• Flat forward pricing for a commodity with a
  contango forward curve will include an element of
  interest and credit risk charges.

25
12. Hedging the mining plan Flat Forwards
26
13. Exotic Options

• Exotic Options are more complex instruments,
  built up from a number of basic instruments, or
  with particular conditions relating to when they
  can be exercised.
• Examples inlcude
• Barrier options like a standard option, but can
  only be exercised if a particular spot price is
  reached during the life of the option (knock-in)
  or if a particular spot price isnt reached
  (knock-out).
• Digitals effectively an option with only two
  outcomes a bet with a fixed payback.
• Frequently used to make the price of options (and
  hedging) cheaper, by excluding some opportunities
  for exercise.
• Beware! Exotics can be complex to value (i.e.
  expensive) and hard to understand (i.e. involve
  high gearing)

27
14. The Greeks

• The Greeks refer to how the value of an option
  moves with a movement in another factor such as
  time, volatility or the price of the underlying
• Most useful is the Delta of an option - how much
  the option value moves compared to movements in
  the underlying.
• For example, the delta of a put option at the
  money is -0.5, i.e. if gold increases in value by
  10, an at the money put option will decrease by
  5.
• Monitoring the overall delta of a hedging
  portfolio of derivatives can be useful to
  determine how the value of a hedging portfolio
  will change with movements in the spot price.

28
15. Conclusions

• Hedging isnt free in order to protect against
  adverse price movements, you either need to pay
  for insurance, or forgo some of the upsides
• Hedging can be a complex topic need to
  understand in detail the effects of contracts
  entered into
• Gearing can result in substantial liabilities
  being incurred for little initial outlay, so
  risks need to be carefully evaluated and monitored

29
Contact Cambridge Risk

• E-mail donald.douglas_at_cambridgerisk.co.uk
• Telephone [phone] and 44 7889 657590
• Address 15 Long Road, Cambridge CB2 8PP
• Chris Howell 44 7779 326808

30
ABCs of HedgingChris Howell, Cambridge Risk
Ltd

• February 2008