Risk Management in Gold Mining Industry

Created by Mbaakoh Longinu, Coventry University
Dedication
To my dear father and mother Mr & Mrs Longinu Fombi
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Acknowledgement
I am extremely grateful to Mr Robert Evans of the Coventry Business School for

inspiring and guiding me through this dissertation. His perspective and guidance
have been invaluable. Thank you to Mr Azoh-mbi Solomon and Mr Akonde John
Best for their words of encouragement and support. This study has also
benefited immeasurably from the comments and suggestions of Ijeoma, Karen
and Agnese. Finally special thanks to Amanpreet for reading through the first
draft. Her suggestions were extremely helpful and insightful.
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Table of Contents
Dedication.............................................................................................................1
Acknowledgement.................................................................................................1
Table of Contents..................................................................................................3
Abstract.................................................................................................................5
List of Tables ........................................................................................................7
List of Figures .......................................................................................................8
1.0 Introduction .....................................................................................................9
1.1 Research Question .................................................................................................. 12
1.2 Research Objectives................................................................................................ 14
2.0 Literature Review ..........................................................................................15
2.1 Risk Management Theories .................................................................................... 16
2.11 Financial Distress Model .................................................................................. 16
2.12 Tax Incentives and Hedging ............................................................................. 17
2.13 Management Incentives and Risk Aversion ..................................................... 19
2.14 The Underinvestment Problem ......................................................................... 20
2.15 Financial Sophistication Hypothesis................................................................. 21
2.2 Empirical Evidence on the Determinants of Corporate Risk Management............ 21
2.21 Empirical Evidence from Surveys ........................................................................ 22
2.22 Empirical Evidence from Cross Sectional Studies ........................................... 22
2.3 Empirical Evidence in the Gold Mining Industry................................................... 25
3.0 Research Methodology .................................................................................26
3.1 Research Perspective .............................................................................................. 27
3.2 Research Approach ................................................................................................. 28
3.3 Research Design...................................................................................................... 29
3.4 Data Collection Methods ........................................................................................ 31
3.5 Sample Description................................................................................................. 32
3.61 Measuring Financial distress............................................................................. 34
3.62 Measuring Investment Opportunity .................................................................. 34
3.63 Measuring Tax Convexity................................................................................. 35
3.64 Alternatives to Risk Management..................................................................... 35
3.7 Construction of the dependent variable .................................................................. 37
4.0 Data Analysis ................................................................................................41
4.1 Univariate Analysis................................................................................................. 42
4.2 Regression Analysis................................................................................................ 44
4.3 Presenting Regression Results ................................................................................ 46
4.31 Results of Financial Distress Variables ............................................................ 47
4.32 Results of Investment Opportunity Variables................................................... 49
4.33 Results of Firm Size.......................................................................................... 49
4.34 Results of Taxation ........................................................................................... 50
5.0 Conclusions ..................................................................................................51
Appendixes 1 Global Positions in OTC derivative market...................................55
Appendix 2 Calculations of Independent Variables.............................................55
Appendix 3 Company year end derivative positions ...........................................57
Appendix 4 Determination of Portfolio delta........................................................58
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Appendix 5 Summary of Pooled Data .................................................................61

List of References and Links...............................................................................62
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Abstract
Purpose – In the last two decades a number of studies have examined the risk
management practices within the gold mining industry. For instance some
studies report on the use of derivatives in the North American Gold mining
companies. Yet, another group of researchers have investigated the
determinants of corporate hedging policies. This and other studies of similar
focus have made important contributions to the literature. This dissertation uses
four mining companies including one based in South African to shed light on
some determinants of corporate hedging. The determinants examined include
financial distress hypothesis, the Underinvestment Problem and the Tax
Incentives to hedging. Furthermore the report investigates the existence of
alternatives to risk management.
Design/methodology/Approach- This dissertation presents the results of case
study of four companies: Barrick Gold, AngloGold Ashanti, Kinross Gold
Corporation and Agnico-Eagle Ltd. Using the linear regression model the work
focuses on testing for statistical significance some of the theoretical determinants
of corporate hedging decisions. Furthermore, it investigates the extent to which
the results are consistent or inconsistent with previous empirical works.
Findings- The results indicate that companies with high leverage are more likely
to hedge consistent with the financial distress model. However the results also
indicate an inverse significant relationship between cash costs and hedging. That
is over the period examined companies’ reduced hedging activity despite
increases in production contrary to popular theory. The results also show that
larger firms are likely to hedge than smaller firms. Large firms benefit from scale
economies and that information and transaction considerations have more
influence on hedging activities than the cost of raising capital. Other effects
measured such taxes, investment opportunity and cash balance found little
evidence supporting the theoretical models underpinning them.
Research Limitations - As with any case study, the small sample size severely
limits the power of generalisation. Furthermore, the researcher could not verify if
the linear regression model was the most appropriate for data analysis. Further
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research could improve the power of the tests by including more detailed
variables, different time spans and larger sample size.
Originality/Value – To highlight the determinants of corporate risk management
in the gold mining industry using four cases in environment of rising gold prices.
Paper type - Dissertation
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List of Tables
Table 1 10 Year gold price history in US $ per ounce……………………………11
Table 2 Firm yearly gold production……………………………………………….32
Table 2 Summary of variables……………………………………………………..35
Table 4 Sample data on Barrick Gold risk management activity……………….37
Table 5 Portfolio delta calculation of Barrick Gold……………………………….38
Table 6 Descriptive Statistics of Pooled data…………………………………….45
Table 7 Determinant of degree to which gold mining firms engage in price risk
management using financial derivatives……………………………….46
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List of Figures
Figure 1 Firms facing concave and convex tax schedule………………………17
Figure 2 Firm yearly gold productions…………………………………………….32
Figure 3 Percentage gold production hedged by firms………………………….41
Figure 4 Firm sizes as measured by total assets………………………………..42
Figure 5 Relationship between Leverage, Cash balance and Hedging Factor.43
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1.0 Introduction
The corporate use of derivative products for risk management has grown rapidly
over the last two decades. In 2004, the notional value of all over the counter
(OTC) derivatives traded in domestic and international markets exceeded US
$221 trillion, an increase of more than 1100% on the 1996 figure of US$20
trillion. Corporate risk management is thought to be an important element of the
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overall business strategy both in financial and non financial institutions (El-Masry
2006). However, despite serious managerial and public policy implications, the
rationales behind firm hedging decisions have remained unconvincing and
mixed. Firms facing the same exposure have adopted different approaches to
financial risk management through the use of derivatives.
Derivatives have generally been used to manage three financial risks

♦ Commodity Price risks
♦ Interest rate risks
♦ Foreign exchange risk
Commodity price risk forms part of business risk. It can be readily defined as risk
faced by a business due the possibility of adverse changes in the price of
commodities (Stephens 2001). Commodities are divided into three broad
categories. The first category is agricultural products, the second category is
metals and the third category is energy.
Interest rate risk represents the companies’ exposure to fluctuations in interest

rates. The debt structure of firms will possess different maturities of debt,
different interest structures (such as fixed versus floating) and different
currencies of denominations. Interest rates are currency –specific. Hence the
multi currency dimension of interest rate risk is of serious concern to firms.
Similarly foreign exchange risk is the risk faced by a business due variability in
exchange rates. These risks could severely impact a firm’s financial stability.
Several financial instruments have been developed over the years to manage
these exposures. Hedging is the ‘taking of position, acquiring a cash flow, an
asset or a contract that will rise (fall) in value and offset a fall (rise) in the value of
an existing position (Moffett, Stonehill & Eiteman 2004:199)’. Hedging therefore
protects the owner of an existing asset from loss. However it also eliminates any
gain from an increase in value of the asset depending on the instrument
employed. A brief review of the more widely instruments are presented below.
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Forward market (contract)

The forward market is an over the counter trade involving contracting today for
the future purchase or sale of a commodity or exchange rate. It is an agreement
between a buyer and a seller for delivery of specified quantity and quality product
at an agreed upon place and date in the future, in return for payment of an
agreed upon price. They are not exchange traded and can be tailor-made to suit
both parties. This feature distinguishes it from futures contracts, which are
standardized contracts traded on an exchange. However commodity forward
market does have some disadvantages such as credit risk to both parties. The
use of forwards is associated with linear strategy of risk management as this
eliminates all exposures the pay off is certain.
Options
An option is contract giving the owner the right, but not the obligation, to buy or
sell a given quantity of an asset against a premium at a specified price (strike
price) at some time in the future. There are two basic types of options namely
calls and puts. An option to buy the underlying asset is a call, and an option to
sell the underlying asset is a put. Because the option holder does not have to
exercise the option if it is to his disadvantage, the option has a price, or premium.
Swaps
A swap is an agreement between two parties to exchange a periodic stream of
benefits payment over a prearranged period. The payments could be based on
the market value of an underlying asset. The two parties to the contract are
called the counterparties. Swaps are mostly used to manage interest rate
exposure. Other derivative products commonly employed in financial risk
management include futures, spot deferred contracts and synthetic products
such as collars and floors. These products are used differently depending on the
industry and type of risk faced. This research will seek to examine some of the
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theoretical rational for hedging in the gold mining industry in the context of an
increasing gold price trend.
1.1 Research Question

There are several reasons to examine this industry:
♦ There is only one major source of risk- the risk of a fall in the price of gold.
Table 1 illustrates the gold price movement over the last decade.
Table 1
10 Year gold price history in US $ per ounce
www.goldprice.org
Table 1 shows the movement of gold price over the last decade. The 1990s saw
gold prices averaging US$300. Prices picked up in early 2002 and have
maintained the upward trend. A second reason for studying the gold mining
industry is that
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♦ There exist liquid markets for derivatives based on gold and so there are
hedging vehicles available to hedge the risks.
♦ Gold mining firms provide detail information on their hedging activities

(more so than most other industries, as they provide details of their
hedging activities in their quarterly reports).
♦ Even though many gold producers hedge the price risk, some do not,
leading to strongly opposing views among mining firms on the desirability
of hedging.
♦ Gold is a unique commodity, and the factors that influence its price make
for an interesting analysis of the advantages and disadvantages of
hedging
A substantial amount of research has been carried to test the various corporate
theories on risk management in the gold industry with mixed results. Theorists
continue to advance new rationales for corporate risk management while
researchers seeking to test these theories have been held back by the lack of
reliable data (Tufano 1996). Furthermore the studies carried so far do not cut one
way or the other. Several theoretical rationales have been advanced for why
companies hedge. They include the financial distress theory which states
businesses with high debt levels tend to hedge more. Secondly the
underinvestment theory posits that businesses with investment opportunity
would hedge more so as to secure financing while the tax convexity explanation
suggest businesses facing a convex tax shield tend to hedge more to lower the
average tax bill. The three hypotheses constitute the shareholder maximisation
rational for hedging. Dionne and Garand (2002) and Allayannis and Weston
(2001) found evidence shareholder maximization hypothesis. On the contrary,
Tufano (1996) found little evidence in the gold mining industry. The second
rational for hedging developed by Smith and Stulz (1985) is concerned with
managerial incentives and risk aversion. Once again there is empirical evidence
is mixed. This dissertation will highlight the aspects of the shareholder
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maximization rational by seeking the answer the following questions using four
gold mining firms.
1. What is the extent of hedging in the gold mining firms?
2. What firm characteristics significantly impact on hedging decision?
3. Why do some firms’ hedge and others do not?
4. Are there alternatives to hedging?
1.2 Research Objectives

The questions discussed above constitute the basis on which the following
objectives will be studied.
♦ Examine for statistical significance the financial distress theory
♦ Testing of the Underinvestment theory in the pooled data
♦ Investigate the significance tax shield on the hedging variable
♦ Examine the use of alternative strategies to risk management
This research is divided into five chapters. Chapter 1 introduces the concepts
corporate risk management by identifying the different types of exposures
faced by firms and the nature of the instruments used for its management.
Additionally, discussion on the research questions and objective is examined.
Chapter 2 highlights the dominant theories of why companies hedge including
an evaluation key empirical studies and literature on hedging. This is followed
by examination of the evidence in the gold mining industry. In the light of the
discussion in chapter 2, chapter 3 describes the methodology to be applied.
This is carried out by reviewing the firm characteristics (variables) that theory
would use to explain the cross sectional disparity in risk management
choices. Chapter 4 examines using poled data variation financial risk
management practices. This is undertaken by testing for significance the
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several firm characteristics when regressed against the extent of hedging as

measured by firm delta. The results are evaluated in evaluated in the context
of other studies. The last chapter concludes the research with a discussion on
the implications of the findings for current theory and subsequent research on
risk management. In addition, a detailed appendix depicting on the
computations used in this research is provided.
2.0 Literature Review
Hedging with financial derivatives is an integral part of most risk management

structures. However the debate about its merit has been the subject of numerous
academic discussion with both proponents and detractors coming to separate
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conclusions. Two main groups of financial theory on hedging theory exist, most
of which arrive at optimal hedging policies by introducing some friction to the
classic Modigliani and Miller model. The first group assumes that managers
hedge to maximise firm value while the second group predicts managers hedge
for personal diversification purposes, or to maximise their personal utility (Stulz
1984 & Tufano 1996). According to Miller and Modigliani paradigm, risk
management is irrelevant to the firm. Shareholders can do it on their own, for
example, by holding well diversified portfolios. An extension of the shareholder
maximisation theory is examined by Bartraun, Brown and Fehle (2004) who
suggest that firm’s hedge after acquiring a certain level of financial sophistication.
This section looks the theoretical motivations of hedging including the factors that
might lead to more or less hedging. This followed by a review of some seminal
works on hedging. The chapter ends with a discussion on the empirical evidence
on hedging in the gold mining industry.
2.1 Risk Management Theories

Corporate risk management is underlined by number theoretical underpinnings
such as the financial distress models, Underinvestment theory, Tax incentives,
financial sophistication and managerial incentive and risk aversion. These
theories have been the subject extensive research in both financial and non
financial firms.
2.11 Financial Distress Model

Volatilities in cash flows can lead firms into situations where available liquidity is
insufficient to meet fixed payment objectives such as wages, and interest rate
payments especially for firms with huge amount debt. High leverage firms are
most likely to face difficulties servicing debt in a falling gold price environment
because of the debt covenants (Smith and Stulz 1985). Financial risk
management can reduce the probability of such occurrences and thus lower the
expected value of costs associated with expected financial distress by lowering
cash flow variability (Smith & Stulz 1985). These costs include bankruptcy,
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reorganisation or liquidation and situations in which the firm faces direct legal
costs. Warner (1997) finds that these direct costs of financial distress are less
proportional to firm size, implying that small firms are more likely to hedge. On
the hand Block and Gallagher (1986) and Booth, Smith and Stulz (1984) argue
that hedging programs exhibit informational economies of scale and that larger
firms are likely to employ managers with specialized information to manage a
hedging program. Therefore the relation between firm size and hedging remains
an empirical question.
2.12 Tax Incentives and Hedging

The structure of the tax code can make it beneficial for companies to hedge and
therefore maintain some level of cash flow predictability. If a firm faces convex
tax function, then hedging that reduces the volatility of taxable income reduces
the firm’s expected tax liability (Smith and Stulz 1985). Graham and Smith (1998)
and Mayers and Smith (1982) argue that for firm facing some form of tax
progressivity, when taxable income is low, its effective marginal tax rate will be
low. But when income is high, its tax rate will be high. If such a firm hedged, the
tax increase in circumstances where income would have been low is smaller than
the tax reduction in circumstances where income would have been high thus
lowering expected taxes. From their analysis of 80000 firm observations, they
found in approximately 50% of the case, corporations face convex effective tax
functions and thus an incentive to hedge. In approximately 25% of the cases,
firms face linear tax functions. The remaining firms face concave tax functions.
Firms are most likely to face convex tax functions when:

1. Their expected taxable income is near zero
2. Their income are volatile
3. Their income exhibit negative serial correlation (hence the firm is likely to
shift between profits and losses).
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Much of the convexity is induced by the asymmetric treatment of profits and

losses in the tax code. That is a zero tax rate on negative income, moderate
progressivity and constant rate thereafter. The convex region is extended by tax
preference items like investment tax credits and deferred taxation. Figure 1 and
1a illustrates the tax liability for firm facing either a convex or concave tax shield
Figure 1
Firm facing concave and convex tax schedule
Adapted from (Smith & Stulz 1985: 293)
Figure 1a illustrates firm facing concave tax shield and figure 1b depicts the firm
facing convex tax shield. This simplistic illustration highlights the benefits of
hedging when firm is facing a convex tax schedule. The tax liability T1 for convex
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schedule is less than for concave schedule leading tax savings. In fact Graham
and Smith found that among firms facing convex functions, average tax savings
from five percent reduction in volatility of taxable income were about 5.4 percent
of expected tax liabilities. In extreme cases these savings exceeded 40 percent.
2.13 Management Incentives and Risk Aversion

Managerial attitude to risk has been found in some studies to be a significant
factor in determining the extent of hedging in some firms (Merton 1973 and
Tufano 1996). Stulz (1984) and Smith and Stulz (1985) argue that managers are
often unable to diversify firm specific risks. Most senior managers derive
substantial wealth from the firm and consequently their financial position is highly
undiversified. Consequently risk aversion may cause some managers to deviate
from acting in the best interests of shareholders by allocating resources to hedge
diversifiable risk (Stulz, Mayers & Smith 1985). They argue that unless managers
are faced with proper incentives they will not maximise shareholder wealth.
When a risk adverse manager owns a large number of the firm shares, his
expected wealth is significantly affected by variations in the firms expected
profits. Hedging changes the distribution of the firm’s payoffs locking in an
expected cash flow, and therefore changes the managers expected utility. These
arguments imply that, all else been equal, managers with more wealth in firm’s
equity will have a greater incentive to hedge the firm’s risks.(Christopher, Minton
& Catherine 1997: 1326).Thus firms that are closely held will be more likely to
use derivatives. Consequently Smith and Stulz (1984) predict a positive relation
between managerial wealth invested in the firm and the use of derivatives as the
managers’ end of period wealth is more a linear function of the value of the firm.
In support of the managerial ownership hypothesis Tufano (1996) contends that
not only the level of management’s equity ownership, but also the form by which
that equity stake is held, is related to firm’s risk management choices. Firms
whose managers own more options tend to hedge less than those with equity
ownership. This is so because as long as managers hold options, they are
sheltered from downside risks. Therefore firms whose managers hold large
number of shares of stock may be willing to hedge than those holding options on
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the shares. Hence Smith and Stulz (1985) predict negative correlation between
option holdings and derivative usage.
This has serious implications for managerial compensation scheme because by

increasing equity component of managerial compensation, firms can align
managers’ incentives more closely with those of other shareholders. This
alignment enables optimal investment decisions to be taken.
2.14 The Underinvestment Problem

The investment and financing policies of a firm can be harmonized and
integrated by risk management to increase shareholder value (Froot, Scharfstein,
and Stein, 1993). They argue without risk management, firms will be forced
reject potential investment project; projects with positive Net Present Value.
Firms may underinvest because of expensive external cost of capital. When the
firms’ cash flow is low, obtaining additional financing is very costly inducing firms
to make suboptimal investment decisions. In this case derivatives can be used to
lower the cost of capital through the financing and investing decisions (Bartaum,
Brown & Fehle 2004). When leverage is high underinvestment problem can
occur. Establishing sound risk management policy can limit the underinvestment
costs by reducing the volatility of firm cash flow and firm value (Allayannis and
Weston 2001). Admittedly firms facing significant growth and investment
opportunities are likely to be plagued by the underinvestment problem (Bartraum,
Brown & Fehle 2004). Hence Froot, Scharfstein, and Stein’s (1993) theory
suggest that firms with key planned investment programs and costly external
financing would be inclined to use risk management to avert the need to access
costly external financing to continue these programs. They also argue that
smaller firms are likely to hedge more to avoid the expensive costs of external
financing. Various measures such as market to book ratio, research and
development expenses to sales ratio, capital expenditure to sales, net assets
from acquisitions to size are used for testing the underinvestment hypothesis.
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2.15 Financial Sophistication Hypothesis

Bartraun, Brown and Fehle (2004) propose this alternative theory after
examining empirical evidence on the theoretical motivations of firm use of
derivatives. They suggest that because of ambiguous results on theoretical
motivation for hedging, firms that hedge do so because of their ability to do so,
regardless of other firm characteristics. Financial sophisticated companies
described as firms with multiple industry segments, mature treasury and foreign
equity listings. It follows then larger firms are more likely to fulfil these
characteristics and are expected to hedge more than smaller firms. Their findings
are in contrast to Warner (1997) who suggested that from a financing perspective
small firms are expected to hedge more.
2.2 Empirical Evidence on the Determinants of Corporate Risk

Management
Early research on the use of financial derivatives as risk management tool has
been inconclusive. The motivations and instruments used vary across industry
and geographic presence. This led to hypothesis put forward by Bartraum, Brown
and Fehle that firms simply hedge once a certain level of financial sophistication
is reached (2004).
Most empirical studies have followed the neoclassical work of Modigliani and
Miller (1958) where financial risk management at the firm level create
shareholder value when in inefficiencies in the capital market give rise to
deadweight costs born by the shareholders. In addition early studies test hedging
motives of firms on the basis of survey data. For instance, Bodnar et al. (1995);
Bodnar et al. (1996); Javlilvand et al (2002) surveyed derivative usage among
non financial firms.
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2.21 Empirical Evidence from Surveys

Bodnar et al (1996). Survey 530 US non financial firms about the use of financial
derivatives. Their findings indicate that large firms tend to use over the counter
(OTC) products, while small firms tend to use a mixture of OTC and exchange
traded-products. They also find that 80 percent of firms use derivatives to hedge
firm commitments, and 44 percent of firms use derivatives to hedge the balance
sheet. One of the key goals of hedging with derivatives is to minimise cash flow
fluctuations. Similar survey evidence undertaken by Alkebaeck and Hagelin
(1999) on Swedish non financial firms found the use of derivatives to be more
common among larger than smaller firms and that the principal use of derivatives
is for hedging purposes consistent with Bodnar et al (1996). However Bodnar
and Gebhardt (1999) found distinctive differences between German and US non
financial firms including the primary goal of hedging firms, firms’ choices of
hedging instruments and the influence of market view when taking derivative
positions. The choice of instruments varies across industries. Based on
evidence for a global sample, non financial firms mostly use forwards (36
percent) to manage foreign exchange risk, while swaps (11 percent) and options
(10 percent) are less popular (Bartraum, et al, 2003). For interest rate
management, swaps are more frequently (29 percent); interest rate options are
used as well, but less often (7 percent). Commodity price derivatives are
generally used less frequently, and there are few differences across different
instruments (3 percent for futures; 2 percent for options) with some variation
across industry.
2.22 Empirical Evidence from Cross Sectional Studies

The majority of theoretical models of corporate risk management indicate that
derivatives use increases with leverage, the existence of tax losses, the
proportion of shares held by directors, and the pay out ratio. On the other hand,
the extent of hedging decreases with the interest coverage and liquidity (Smith &
Stulz, 1985; Froot et al, 1993; Nance et al., 1993).
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However, empirical studies find only weak and at times ambiguous evidence
consistent with theory. Mian (1996) finds that there is empirical evidence on the
determinants of corporate hedging decisions. Based on non survey data for a
sample of 3002 firms the study provides evidence, which emphasize that hedging
is desirable because it lowers contracting costs, financial distress costs (Mayers
& Smith 1982; Smith & Stulz 1987) and external financing costs associated with
capital market imperfections (Froot, Scharfstein & Stein 1993). The evidence is
strong with respect to financial distress theory but weak in respect of
underinvestment and tax models. However evidence is supportive of the
hypothesis that hedging activities exhibit economics of scale.
Grezy, Minton and Schrand (1997) analysed a sample of 372 Fortune 500 non
financial firms in the United States. They find that firms with greater growth
opportunities and tighter financial constraints are more likely to use derivatives to
reduce the variation in cash flows or earnings that might otherwise preclude firms
from investing in valuable growth opportunities. The evidence is in line with
underinvestment theory (Shapiro & Titman, 1986; Froot, Scharfstein and Stein
1993). The underinvestment cost explanation for optimal hedging suggests
without hedging firms are likely to pursue suboptimal investment projects. Hence
derivatives may provide a valuable benefit to firms that use them rationally
(Allayannis and Weston 2001).
Graham and Smith (1999) and Graham and Rogers (2002) using simulation
model investigate the tax incentive to hedge that a firm facing a convex tax
function, hedging that reduces the volatility of the taxable income reduces the
firm’s expected tax liability
Among firms facing convex tax functions, average tax savings from a five percent
reduction in volatility are about 5.4 percent of expected tax liabilities; in extreme
cases, these savings exceed 40 percent. However they point out any such
program must be compared to the cost of hedging. In addition for firms with
convex effective tax functions, the tax savings of hedging are not mutually
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exclusive from hedging the benefits of controlling the underinvestment problems,

increased debt capacity. In contrast Haushalter (2004) in a study of oil and gas
producers using the Tobit regression model found no conclusive evidence
between firm’s risk management policy and tax function. These results highlight
the difficulty in correctly capturing tax save due to hedging. Both the
measurement and analysis of the variable involve substantial statistical
challenges. Furthermore the complexities of certain tax code present an added
dimension to the problem.
Some studies focused on specific industries or individual firms benefit from the
availability of detailed data on exposure and corporate hedging activities.
Admittedly these data ensure the calculation of more precise measures of the
extent of hedging. In a study of a sample of 100 oil and producers in the US
Haushalter (2000) finds evidence of a positive correlation between the extent of
hedging and financial leverage supporting the theory that corporate risk
management is used to alleviate financing costs. Secondly a positive correlation
was observed between the decision to hedge and the total asset. This is
consistent with the notion that companies can face significant economies of scale
in hedging, particularly in setting up a hedging program and therefore increases
firm value. Contrasting these findings Jin and Jorion (2006) found no relationship
between derivative activities and firm value in the US oil and gas industry.
Similarly, Brown (2001) undertakes a clinical study of a US based manufacturers’
use of FX derivatives and finds little support for the financial distress or other
primary theories of risk management and instead proposes that earnings
management, competitive factors in the product market, or contracting efficiency
gains motivate hedging.
Clearly statistical support for popular theories of derivative use is mixed.

However Bartraum, Brown and Fehle found evidence supporting a ‘naïve’
hypothesis that firms simply hedge once a certain level of financial sophistication
is reached. Their study examines the use of derivatives by 7319 firms in 50
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countries that together comprise 80 percent of the global market capitalisation on

non financial companies. Their results are supportive of the theory that derivative
use increases firm value especially for firms using interest rate derivatives.
2.3 Empirical Evidence in the Gold Mining Industry

In this industry commodity price exposure is transparent and easy to hedge by
investors. Theory might predict that no firms manage gold price risk since
investors can diversify the way the risks. On the contrary risk management is
practised by over 85 percent of the firm in the industry (Tufano, 1996). Though
faced with identical price exposure gold mining firms have adopted very different
approaches to risk management. Hedging policy has been extensive studied in
the gold mining industry but the results have been at best weak and inconclusive.
Tufano, (1996) examined 48 North American firms and finds risk management
practices are consistent with some extant theory. He finds virtually no
relationship between risk management firm characteristics that value maximising
risk management theories would predict. In contrast managerial risk aversion
seems particularly relevant bearing out Smith and Stulz (1985) prediction that
firms whose managers own more stock options manage less gold price risk, and
those whose managers have wealth invested in common stock manage more
gold price risk. Another study of 44 North American gold firms from 1991 to 2000
Jin and Jorion (2006) found no relationship between hedging activities and firm
values as measured by Tobin’s Q. The Tobin Q is defined as the ratio of the
market value of the firm to the replacement cost of the assets, evaluated at the
end of the fiscal year. However, the findings of Dionne and Garand show that
seven variables (deferred taxation, tax save, production cost, dividend pay out
ratio, preferred shares, and firm size) related to maximizing the firm’s value
significantly affect the decision to hedge the price gold (2000). They considered
hedging decisions based on quarterly data and extended analysis over longer
period.
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Arguably empirical tests on the determinants of corporate hedging policy have

yield mixed results. The results are significantly influenced in some cases by the
sample size, complexity of variables measured and analytical model applied. In
the light of the mixed results it is important for further research to be conducted
especially in environment of higher gold prices. This research will be limited to
testing the financial distress, underinvestment and tax incentive theories.
3.0 Research Methodology
Research methodology involves a description of the process, variables to be

measured and analytical tools. It examines the relevance and appropriateness
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research design to objective. This section examines the perspective, approach

and research design adopted. Issues about sampling and data collection
methods are also explored. The latter part looks at different firm characteristics
and their relevance to the objective. Firm characteristics will be measured by the
construction of six explanatory variables and one dependent variable. These
explanatory variables will then be pooled and regressed against the extent of
hedging given by hedge ratio.
3.1 Research Perspective

Two research perspective; positivist and interpretivist are widely associated with
management research (Collis and Hussey 2005). The positivist approach seeks
the facts or causes of social phenomena, with little regard to the subjective state
of the individual. Furthermore the researcher assumes the role of an objective
analyst, making interpretations about data that have been collected in justifiable
manner (Saunders, Lewis & Thornhill 2003). As a result the positivist perspective
emphasises on a highly structured methodology to facilitate replication and
quantifiable observations that lend themselves to statistical analysis.
Critics of positivism argue that the social world of business and management is
far too complex to be defined by laws in the same way as the physical sciences
(Saunders et al 2003). They are argue that important insights into this complex
world is lost if such complexity is reduced to a series of law-like generalisations.
Interpretivism stresses the importance of complexity and uniqueness of business
situations (Bryman and Bell 2003). The approach emphasises the importance of
making sense of the world through our own experiences. It argues that if
businesses are unique and the business environment is always changing then
there is little value in law-like generalisations (Saunders et al 2003).
The positivist perspective will dominate the research as much of the variables
under investigation are easily quantifiable such as leverage ratio, quick ratio, and
27
portfolio deltas. However the use of simple linear regression model to evaluate
the relation severely limits the generaliasability of the results. On the other hand
the research will involve four companies in a particular context involving variables
influenced by people, economic and social factors. This can be seen as
interpretivist perspective. Hence both perspectives will guide the research
approach.
3.2 Research Approach

Research projects also involve the use of theory and the extent to which theory is
explicit in the design of the project raises important questions about the approach
being adopted. Two approaches have identified in literature: deductive and
inductive. The deductive approach entails development of a theory or hypothesis,
and designing a research strategy to test the hypothesis. On the other in
inductive approach theory is developed out of the data analysis.
The deductive approach involves the development of a theory that is subjected to

rigorous test. It owes much to the thinking of scientific research and positivism
(Saunders et al 2003). There are several important characteristics of deductive
approach. First, there is the search to explain the causal relationships between
variables. These variables must be quantifiable and hence quantitative data is
paramount to any analysis. In order to ascertain causality controls are introduced
to allow testing of hypothesis (Bryman and Bell). The controls would ensure the
direction of causality is ascertained. The final characteristic of deductive
approach is generalisation. However in order to generalise observations it is
necessary to select sample of sufficient numerical size.
Induction or theory building is the alternative approach to deduction. This

involves the data collection, analysis and as end result the formulation of theory.
One of the criticisms of deductive approach is that it enabled cause-effect link to
make between particular variable without an understanding of the way in which
humans interpret their social world (Saunders et al 2003). Developing such an
28
understanding is one of the strengths of deductive research. Research using

deductive approach would be particularly concerned with the context in which
events are taking place and involves the collection of qualitative data. This
approach owes much to interpretivism.
The deductive approach has been the dominant approach in research on the
corporate risk management. This can justified in the sense that the data is readily
available and empirical evidence on cause-link between variables are easier to
measure (Bryman and Bell 2003). However the mixed nature of evidence
suggests lack of detail understanding of the context and interaction among
variables which an inductive approach might shed light on.
For the purpose of this dissertation, the deductive approach will be applied for
number of reasons. First, time constraints does not permit elaborate data
collection needed to conduct inductive research. Secondly the data to be used is
readily available for analysis making it less risky than otherwise would be with
questionnaires and interviews associated with inductive approach.
3.3 Research Design

Research design can take several forms (Saunders et al 2003)
• Experimental design
• Cross sectional
• Longitudinal design
• Case study design
• Comparative design
• Survey
Early studies on hedging in the gold industry were based on survey literature
(Bodnar et al 1995; Alkebaeck and Hagelin 1999 Bailey, N. 1985). Tufano 1996
works on the practices of risk management in the gold industry focused on cross
sectional data among 48 North American Gold mining firms. Other cross
29
sectional studies includes Adam, Fernando & Salas 2007; Dionne, & Garand
2000).
This research will bear elements of case study design and cross sectional
design. Collis and Hussey (2003) define a case study as ‘an extensive
examination of a single instance of a phenomenon of interest.’ The importance of
context is essential as it focuses on understanding the dynamics present within a
particular setting. Yin (1994) identifies the following characteristics of case study
research:
The research aims not only to explore certain phenomena, but to

understand them within a particular context
The research does not commence with a set a of questions and notions
about the limits within which the case study will take place
The research uses multiple methods for collecting data which may be
quantitative and qualitative.
However these characteristics are open to debate (Collis and Hussey 2005).
They argue that if one is taking a more positivist approach one might wish to
commence with strong theoretical foundation and specific research questions as
is the case with this dissertation. Saunders contends that case study design often
uses multi- cases to explore phenomena and is for a particular purpose.
Some elements of cross sectional design will be introduced into this research.
Cross sectional design ‘entails the collection of data on more than one case at a
point in time in order to collect a body of quantitative or quantifiable data in
connection with two or more variables, which are then examined to detect
patterns of association’ (Bryman & Bell 2003: 48). Cross sectional design permits
the examination of the relation between variables. Though establishing the
directional of causality is problematic, useful inferences can deduce using
appropriate statistical package.
30
One major criticism of the case study and cross sectional design is that
generalisation is difficult. This research seeks to test some of the theories on
hedging within among four selected companies. Clearly the results might not
generaliasable but important conclusions could be drawn.
3.4 Data Collection Methods

There are two main approaches to data collection: quantitative and qualitative
and each present a mixture of advantages and disadvantages. One of the main
advantages of quantitative approach to data collection is the relative ease and
speed with which collection can occur. However the analytical and predictive
power which can be gained from statistical analysis must be set against the
issues of sample representativeness, errors in measurement and quantification
Collins and Hussey (2005).
Qualitative data collection methods can be extensive and time consuming

although it can be argued that qualitative data in business research provides a
more ‘real’ basis for analysis and interpretation (Bryman and Bell 2003).
Moreover qualitative approach presents problems relating to rigour and
subjectivity. Data collected for this dissertation is mostly quantitative. There exist
several ways to collect data for research purposes. These include:
Using secondary data

Through observation
Using interviews
Using questionnaires (Saunders, M 2003)
This research involves analysis of pooled data over a five year period for four
companies. Consequently secondary data has been extensive used. The main
sources of data are company annual reports Form 10k disclosures and Form
31
20F. Other sources include yahoo finance, financial times and Edgar-online
database.
3.5 Sample Description

Selecting a sample is a fundamental element of a positivist study. The sample
size can determine the extent to which results are representative of the
population. Several sampling methods exist some of which include:
Random sampling
Systematic sampling
Stratified sampling
Quota sampling
Cluster sampling etc (Collis & Hussey 2005)
Among the methods quota sampling will be employed in this research. The aim
of quota sampling is to produce a sample that reflects the industry in terms size.
Most of theories on hedging in the gold industry have an element of firm size.
Consequently size will be the key factor in the selection of the four companies.
Size will measured in terms of average production per year over the last five
years as well as the total assets. Large firms are considered as producing more
than two million ounces per year. Average production per year has been used as
close substitute for market capitalisation; the industry measure of firm size
(Tufano1996). Table 2 and figure 2 illustrate the company’s gold production in
million of ounces over five years.
Table 2
Firm yearly gold production
2002/m 2003/m 2004/m 2005/m 2006/m
ounces ounces ounces ounces ounces
32
Barrick 5.695 5.51 4.958 5.46 8.643

Gold
AngloGold 6.161 6.639 6.182
6.516 6.765
Ashanti
Kinross 0.888634 1.653784 1.608805 1.476329
1.62041
Agnico- 0.26 0.236653 0.271567 0.241807 0.245826
Eagles ltd
Data collected from annual reports

Figure 2
Gold Production
10
8 2002
Production 6 2003
(million/Oz) 4
2004
2
2005
0
Barrick Kinross Agnico- AngloGold 2006
Eagles Anshanti
From Table 2 and figure 2 Barrick gold and AngloGold Anshanti are considered
large firms while Kinross and Agnico- Eagles are termed small firms. All firms
considered in the sample use derivatives as part of risk management strategy.
3.6 Construction of independent variables

This research is concerned with examining the significance of three of the major
determinants often cited to justify risk management activities all of which were
reviewed in chapter 2. It also seeks to test the existence of alternatives to risk
management. The determinants include
♦ Reduction in expected costs of financial distress;
33
♦ Increase investment opportunities or the underinvestment problem
♦ Reduction in expected tax payments
These outcomes are measured by constructing variables to capture their

likelihood. A summary description of the variables is shown in Table 3.
3.61 Measuring Financial distress

Gold mining firms face financial distress if the price of gold falls below their costs
of production often termed cash-costs. Cash costs is used on the basis that firms
with high production costs are less efficient and more prone to financial failure.
Additionally they are more likely to pay higher premiums to their partners. To
measure the relative likelihood of financial distress data is collected on the firm
cash costs. Another variable used to measure costs of financial distress is long
term debt weighted according to market value (Tufano 1996; Dionne & Garand
2000). Measuring cash costs is more closely related to the probability of financial
distress, whereas leverage has more to do with costs resulting from financial
distress, supposing such costs are proportional to the face value (Dionne &
Garand 2002). In this research long term debt is weighted according to total
assets because this value was readily available. Theory predicts positive
relationship between delta percentage and both cash costs and leverage. The
data on cash cost and leverage for the companies is presented in Appendix 2.
3.62 Measuring Investment Opportunity

Scharfstein and Stein (1987) theory predicts that firms with key planned
investment programs and costly external financing would be inclined to use risk
management to mitigate the need to access costly external financing to continue
these programs. A decline in the price of gold could severely obstruct the
investment programs of mining firms: exploration and acquisition. To measure
the significance and importance of these activities, information is collected on the
34
firms’ annual exploration expenditure and net cash acquisition activities from both
income and cash flow statements. Here again it scaled by total assets instead of
market value. If risk management is used to protect the continued funding of
these programs, theory predicts a positive relationship between these measures
and the delta percentages.
Similarly it is reasonable to suggest that transaction costs and information

asymmetries for smaller firms are greater than for larger firms; at least for
financing activities (Tufano 1996). Hence theory suggests from a financing
perspective an inverse relationship between firm size and delta percentage. That
is smaller firms might actively adopt risk management so as to avoid to seek
costly external financing. For this research firm size is measured by total assets
as shown in appendix 2. However reserves are common measure of firm size in
the gold industry.
3.63 Measuring Tax Convexity

Firms facing convex tax structure may lower average taxes through reducing
fluctuations in earnings. The complex nature of tax structure has meant that no
obvious variables have been agreed by researchers as appropriate for
measuring the convexity of the tax structure (Dionne & Garand 2000). Graham
and Smith (1999) formulated an equation allowing the computation of taxes
saved as a result of risk management. This variable should have a positive effect
on hedging. However for this research that used by Dionne and Garand (deferred
income tax) will be employed. Tax credits for losses reduce deferred income thus
the ratio measures the inverse of the tax function’s convexity. So a negative sign
is predicted. The data is shown in Appendix 2
3.64 Alternatives to Risk Management

Some firms pursue alternative activities that substitute for financial risk
management strategies. Diversification could be undertaken instead of hedging
35
or they could adopt conservative financial policies such as carrying a large cash
balance or maintaining a low leverage. Consequently firms that pursue this
strategy should be associated with less financial risk management and lower
delta percentage. However these do not represent explanations for financial risk
management, but rather controls for substitute forms of risk management. To
measure the existence of these alternatives information is collected on firm cash
balances and firm leverage as shown in appendix 2. The quick ratio represents
the degree of available cash balance in excess of current needs. This ratio is
given determined by (cash and cash equivalents + receivable) dividend by
current liabilities (McKenzie 2003).
Table 3
Summary of Variables
Delta %
The delta is the variation in the value of the portfolio of the derivative products for
every $1 variation in the price of gold. The aggregate value of the portfolio,
calculated yearly is then divided by the firm’s gold production over the same
period. The delta measures the level of derivatives used, that is the degree of
risk management
Cash Cost
Average Cost to produce an ounce of gold. The cash cost is used to capture the
likelihood of financial distress. When the price of gold decreases less efficient
firms will be may be unable to pay current expenses. A positive sign is predicted.
The annual value is used in this research.
Total Assets
Book Value of total assets is used as substitute for market value
Long term Debt/ Total assets
The book value of long term debt divided by the book value of the firm’s total
assets. Debt generates obligatory interest payments. If the firm is unable to make
its interests payments, it will get into financial hardship. This ratio therefore
captures financial distress factor. A positive sign is predicted
36
Exploration Expenditures/ Total Assets

The net cash payments for acquisitions divided total assets. This variable is
collected on an annual basis. This variable captures the growth opportunities
factor to the extent that exploration efforts are profitable. A non significant
relationship is expected, since the correlation between investment opportunities
and cash flows is positive in the gold mining industry. That is gold mining
companies benefit from natural hedging.
Acquisitions/ Total Assets
The net cash payments due to acquisition activities divided by total assets. A non
significant relationship is presumed, since correlation between investment
opportunities and cash flow is positive in the gold industry.
Deferred Income Tax/Total Assets
The deferred Income item of the statement divided by total assets.
Cash balance (Quick Ratio)
Cash plus cash equivalent divided by current liabilities (McKenzie 2003). Liquidity
can act as a cushion for financial disasters. They are thus substitute for risk
management and a negative sign is predicted
3.7 Construction of the dependent variable

The extent of risk management for each firm is determined by calculating the
effective amount of ounces of gold that each firm has hedged, or sold forward
denoted by delta. Rather than analyse each financial contract separately, the
portfolio delta is calculated. Portfolio delta gives a measure of reported financial
risk management activity and is regarded as the industry measure of investment
portfolio. The delta represents the change in the price of the portfolio with respect
to a small change in the price of the underlying asset (Hull 2003). Table 4
illustrates the risk management activities of Barrick Gold as reported in the
annual report. As of 2002, the firm had committed to sell 365000 ounces of gold
under forward sales commitments at an average price of $365. It had purchased
put options expiring before the end of 2002 with an average strike price of
$297/ounce on 160,000 ounces. Finally, it wrote call options on gold at a price of
37
$330/ounce on1330, 000 ounce, expiring before the end of 1991.The data for the
three others is shown in appendix 3. Table 5 displays the determination of
portfolio delta for Barrick Gold. For forward sales or spot deferred contracts, the
delta is equal to -1 because there is no uncertainty that the transaction will occur;
but for firms that hold options an effective portfolio delta must be calculated using
the Black and Scholes formula (see Table 5) which takes into the account that
the option will be exercised. Finally the firm’s total is calculated by dividing the
sum of ounces whose price is covered over the same period by the total
production for that year. Hence delta expresses the equivalent number of
ounces (3564880 in 2002) that the firm would need to hold in a replicating
portfolio to their hedged positions. In other words the firm had a gross short
position in gold equal to 3564880 ounces of gold sold. In aggregate for 2002, for
a $1 drop in the gold price, the market value of the firm’s gold portfolio should
rise by $3564880. Although quarterly data for instruments would be more
appropriate yearly data is collected because of time constraint. The portfolio delta
calculations for rest of the companies are shown in Appendix 4.
Table 4
Sample Data on Barrick Gold Risk Management Activity
2002 2003 2004 2005 2006

Ounces Price/US$ Ounces Price Ounces Price Ounces Price Ounces Price
Forward 2800 365 2800 340 1350 345 1550 335 1540 338
Put sold 1600 297 250 344 300 310 300 317 250 332
Call
options
sold 1330 303 425 363 570 328 550 336 1460 362
Table 4 shows the risk management activity of Barrick gold. All prices are in US$
and contracts are in thousands of ounces.
Table 5
Delta of Barrick Gold Derivative Portfolio
38
Calculation
of Portfolio
Year Delta
2002 Ounces/ Delta Equivalent Ounces
Forward 2800000 -1 -2800000
Put sold 160000 -0.325 -52000
call sold 1330000 -0.536 -712880
Equivalent ounces 3564880
production 5695000
Delta percentage 62.59666
2003 Forward 2800000 -1 -2800000

Put sold 250000 -0.309 -77250
call sold 425000 -0.622 -264350
production 5510000
2004 Forward 1350000 -1 -1350000

Put sold 300000 -0.108 -32400
call sold 570000 -0.849 -483930
production 4958000
2005 Forward 1550000 -1 -1550000

Put sold 300000 -0.076 -22800
call sold 550000 -.889 488950
production 5460000
2006 Forward 1540000 -1 -1540000

Put sold 250000 -0.11 -27500
call sold 1460000 -0.974 -1422040
production 8643000
39
Black Scholes formula

ln( S / K ) + ( r − δ + σ 2 / 2)T
Call delta = ∆c = N ( d 1) e −δT where d 1 =
σ T
Put delta =∆p = - N ( − d 1 )
S = Stock price
K = Strike price
T = time to maturity assumed to be a year
r = risk free rate ( average 10 year US Treasury note rate 5.1%
σ = Volatility of gold (average return standard deviation of annual gold returns
over the past 30 years; 30.13%
δ = Annual Gold lease rate of 0.39%
(Nitzsche & Cuthberston 2003: 270)
Table 5 is a sample illustration of the portfolio delta of Barrick Gold at the end of
year. The calculations assume that the options expire at the end of the year. The
average spot prices for 2002, 2003, 2004, 2005 and 2006 are taken to be 310,
364, 410, 445 and 604 US$ respectively. The same methodology is used for all
four firms to enable consistent results. The consistency of approach ensures the
data collected is reliable and valid conclusions can be drawn. The variables
measured are recognised industry benchmarks and have been used by Tufano
(1996). However it might difficult to generalise conclusions from a case study
especially given the fact that only four companies are studied. To attempt to
overcome this factor the data will be pooled to obtain 20 observations as shown
in Appendix 5.
The calculated variables will be used in the next section to undertake univariate
analysis with further examination using the linear regression model. Regression
analysis will allow for the study of relation among variables including their
strength and significance.
40
4.0 Data Analysis

This section involves the analysis and presentation of data. The first part
presents a summary of the key findings univariate results including descriptive
statistics. Any observable trend will be highlighted and further examined using
41
the simple linear regression model. The linear regression model allows
statistically significant observations to identify through the use of P value test.
The results of the regression will then be evaluated against the theoretical
models and previous empirical studies in the Gold industry.
4.1 Univariate Analysis

The univariate analysis uses five year averages of firm characteristics for all four
companies. Figure 3 below displays the extent of hedging among the companies
as measured by the percentage of production hedged.
Figure 3
Percentage production Hedged
50.00
42.37
40.00
30.00 28.05
Delta Percentage
20.00 14.54
10.00
1.07
0.00
Barrick AngloGoldKinross Agnico
Figure 3 illustrates the five year averages of percentage of total production

hedged as measured by the hedging factor delta. The Y axis shows the values of
the delta values while the companies are shown on X axis. The results show that
Barrick Gold and AngloGold Ashanti are more active users of derivative as
corporate risk management strategy while the remaining two companies have
been less reliant on derivatives with Agnico- Eagles selling almost all of its entire
production on the spot market. Secondly it could be argued from larger firms’
hedge more than smaller firms. Figure 4 displays the firm size values as
measured by total assets.
42
Figure 4
Firm Size as measured by Total Assets

A quick look at figure 2 and 3 appear to show larger firms end to hedge more
than
10000
8000
6000
U$ thousands Total Assets
4000
2000
0
Barrick AngloGold Kinross Agnico
It appears to show larger firms hedge more than smaller firms. This observation
will need further examination using the simple linear regression model.
Another variable that merits discussion from univariate analysis is the apparent
relationship between hedging and the company long debt. Leverage has been
used to measure the company debt position over the years. Figure 5 presents
five yearly averages for leverage and cash balances measured against the
hedging factor given by the delta percentage.
Figure 5
43
Relationship between Leverage, Cash balance

And hedging factor
Agnico
Kinross Quick Ratio

Leverage
AngloGold Delta Percentage
Barrick
0.00 10.00 20.00 30.00 40.00 50.00

Percentage
The figure above show that firms employing little risk management are barely
distinguishable from those employing moderate to high levels of risk
management, apart from carrying higher cash balances as predicted by theory.
Analyses of the other variables do not yield substantial variations.
Given the correlations among the different firm characteristics, these univariate
tests do not reveal significant differences in firm traits, holding other attributes
firm attributes constant. Thus multivariate tests would be appropriate. However
this work the linear regression model will be employed.
4.2 Regression Analysis

Regression analysis is used primarily for the purpose of prediction. The goal in
regression analysis is to develop a statistical model that can be used to predict
the values of dependent variable or response variable based on the values of at
least on explanatory variable or independent variable (Berenson, Livine &
Krehbiel 2002). The nature of the relationship between variables can take many
forms ranging from simple to extremely complicated mathematical functions. In
this research the linear model will be applied. The relationship between the
variables could be positive linear in which case as the independent variable
increases the dependent also increases while a negative linear relationship will
44
involve one variable increasing while the other decreases. The sign coefficient of
regression given by the slope of the regression line is indicative of the nature of
the relationship. A positive coefficient relates to positive linear relationship and
vice versa. To examine the ability of the independent variable to predict the
dependent variable in the statistical model, several measures of variation have
been developed. One of the measures is the coefficient of determination. It
measures the proportion of variation of the dependent variable that is explained
by the independent variable in the regression model. For example of 91% implies
91% of the dependent variable can be explained by the variability independent
variable. This is an example of a strong positive linear between the two variables.
To test for the significance of the relationship the t Test for the slope is employed.
By setting a level of significance of 0.05, any p value < 0.05 is regarded as
significant. However for regression analysis to hold three assumptions have to be
satisfied
♦ Normality of Error
♦ Homoscedasticity
♦ Independence of Errors
The first assumption, normality, requires that the error around the line of
regression be normally distributed at each value of the independent variable (X).
The second assumption homoscedasticity requires that the variation around the
line of regression be constant for all values of X. This means that the errors vary
the same amount when X is a low value as when X is a high value. The third
assumption, independence of error, requires that the errors around the
regression line be independent of each value of X. This assumption is particularly
important when data is collected over a period of time. In such situations the
errors for a specific time period are often correlated with those of the previous
time period.
With these assumptions in mind the hedging factor is regressed against the firm
characteristics in order to create a regression equation that can used to generate
45
the strength of relationships among variables. The signs of coefficient indicate

nature of the relationship while the p value determines the significance. For this
research p = 0.05.This implies that all p < 0.05 is regarded as significant.
4.3 Presenting Regression Results
In order to regress the variables the data five year observations for each
company was pooled to produce a sample of 20 observations.
Table6
Descriptive Statistics of Pooled Data
Minimu Maximu
N m m Mean Std. Deviation
Delta percentage 20 .0 62.6 21.401 18.9741
Cash cost ($US/oz 20 177 690 274.05 112.659
Leverage % 20 9.17 43.89 31.1283 10.89632
Exploration
20 .45 2.56 1.2549 .69873
activities( %
Acquisition
20 .02 222.85 24.8427 48.47892
activities (%)
Deferred Taxation
20 .55 14.77 6.2420 4.34859
(%)
Quick Ratio 20 .53 8.51 2.7238 2.25439
Total assets 21373.0 4763.39
20 593.81 4993.28998
0 65
Valid N (listwise ) 20
Table 6 illustrates the descriptive statistics of the pooled data. Average the firms
hedged 21.4% of production over the period under observation. The standard
deviation of 18.97% is indicative of high degree of dispersion among the firms
into active and moderate hedgers.
The results of regressing annual percentage delta against the firm characteristics
described in table 3 are shown in the table below.
46
Table 7
Determinants of the degree to which Gold Mining Firms Engage in Price
Risk Management Using Financial Derivatives.
INSTRUMENT COEFFICIENT R2 P VALUE

VARIABLE
Cash Costs ($/Oz) -0.077 21.2% 0.0406
Leverage (%) 0.8334 22.9% 0.03278
Exploration 7.520 7.6% 0.2371
Activities
Acquisition -.0.03125 0.6% 0.7379
Activities
Deferred Taxation 0.3025 0.48% 0.7714
Quick Ratio -2.855 11.5% 0.1433
Firm Size 0.0016 19.9% 0.0481
The dependent variable for each firm year observation is the delta percentage,
the percentage of estimated production that has effectively been sold short
through financial contracts. The independent variables are defined in Table 3.
The second column gives the regression coefficient while R 2 represents the
coefficient of determination. The P value indicates the desired level of
significance. P values less than 0.05 are shown in bold face type.
4.31 Results of Financial Distress Variables

Table four suggests that the notions of corporate risk management on tendency
of financial distress have some predictive power among firms in the gold mining
industry. There negative sign for coefficient for cash suggest an inverse
relationship between cost of production as measured using cash costs and
hedging factor. This is contrary dominant theory dominant theory of a positive
relationship. A p-value of 0.0406 suggests this relationship is statistically
significant. In other words increases in production cost over the period of
observation have been followed by decrease in hedging activity not increase.
This result is contrary to Tufano (1996) who found no significant relationship
47
between cash costs and Dionne and Garand (2000) who found significant
positive relationship. Many factors can be attributed for the inverse relationship
ship among which is the consolidation in the gold mining industry. Previous
research was carried over periods when the gold mining industry was fragmented
and the disparity between efficient and non efficient firms was great. Cash costs
as measure probability of financial distress is based on the premise that less
efficient firms are more likely to face financial difficulties. But the spate of
mergers and acquisitions activities in the industry coupled with increasing gold
price trend could account for the inverse relationship. That is the companies have
tended to less hedge less though cash costs have been increasing. Similarly it
could be argued that because gold prices have been rising over the last five
years less efficient mines have been brought on board raising the average cost
of production sustained by the increased revenue from sale on the spot market.
In terms the of likelihood of financial distress as measured by the leverage

scaled by total assets the results as shown in figure 5 are consistent with theory .
A positive relationship is predicted and obtained in the results. This result is
statistically significant with a p value of 0.03278. This result is in line Dionne &
Garand (2000) and Haushalter (2000) who found a significant positive
relationship between hedging and leverage. That is higher levered firms tend to
hedge more than low levered firms. On the hand the results are contrary (Tufano
1996) Jin & Jorion (2006). Tufano (1996) argues that financial distress may be
less of a rational of risk management in the gold mining industry because
deadweight costs of bankruptcy may be small. As opposed to many other
companies gold mines own tangible assets the produce an ‘unbranded’
commodity product with no after market price, leading to little loss of franchise
value in terms of financial distress (Tufano 1996).
48
4.32 Results of Investment Opportunity Variables

The investment opportunities as measured by exploration and acquisition
activities show no statistical significant observation. This result is consistent with
Dionne and Garand 2002 but contrary to Allayannis and Weston (2001). Theory
predicts positive sign for both exploration and investment activities. A positive
relationship emerges for exploration activities and negative for acquisition
activities. The non significance of the results is therefore contrary to the notion to
that firms set up risk management programs to protect large on going investment
programs. However these results might have been influenced the values of the
acquisition figures used which represented the net cash figure shown in the cash
flow statements. Tufano (1996) used the dollar value of attempted acquisitions
from the acquisition and mergers database but found no significant relation
between hedging and acquisition activities.
4.33 Results of Firm Size

Total assets has been used a close substitute for firm size for the research.
Theory predicts an inverse relationship between firm size and hedging at least
from a financing perspective. As a rule, the largest firms have greater negotiation
power and thus low financing costs, which reduces the need to hedge. However,
most empirical research shows that larger firms tend to hedge more than smaller
firms in support of the financial sophistication hypothesis. From Table 6 a positive
significant relationship exists between firm size and use of financial derivatives.
This result strengthens the univariate observation that Barrick tended to hedge
more than Agnico- Eagle ltd. This positive association between firm size and
hedging suggests that the relationship between size and hedging is more
strongly influenced by economies of scale in risk management activities rather
than financial distress models or costs associated with raising capital (Allayannis
and Weston 2001)
49
4.34 Results of Taxation

The complex nature of the tax structure implies no consistent variables and
results have been maintained for the extent of taxes on corporate hedging
activities. Generally theory predicts an inverse relationship between firm’s
deferred taxes and hedging. Deferred taxes measure the inverse of convexity.
That is firms facing convex tax structure may lower average taxes by reducing
fluctuations in earnings. The results from table 5 show no significant relationship
between amount of deferred taxes and the extent of hedging. This implies the
value taxation cannot be used to predict the extent of hedging by firms. Previous
empirical research has found no consistent relationship between measures of tax
– schedules and degree of derivative use. Nance, Smith, and Smithson (1993)
find a positive relationship, but Grezy, Minton and Schrand (1995) do not.
Generally the predictive power of the tax save function has been difficult to
quantify with accuracy because of the complex nature of the tax system across
countries. This has serious limited the ability of research work into tax incentive
hypothesis to hedging.
4.35 Results of Cash balances (Quick Ratio)

Some firms pursue alternative activities as a substitute for financial risk
management. High cash balance can be used as buffer against adverse
movement in prices. Univariate analysis showed firms with higher cash balances
engaged less in risk management. This results appears be borne out after
regressing the quick ratio against the hedging variable. A negative sign emerges
as predicted that as firms accumulated high cash reserves they tend to hedge
less. This appears to be the case for Barrick Gold which has substantial reduced
its level of hedging with an increasingly high cash balance. That notwithstanding
a p value > 0.05 makes the not statistically significant.
50
5.0 Conclusions
This paper studies the hedging activities of 4 gold mining companies between
2002 and 2006 and examines the relationship between gold hedging and three of
shareholder maximization theories which include the financial distress models,
underinvestment problem and tax save incentive. Pooling the data over the
period generated 20 observations on which regression was done.
The unique aspects of the study are:

♦ Use of financial statement footnotes to derive information on corporate
hedging decisions, instead of survey data as is typical of most previous
work on hedging
♦ Use of case study approach focuses on just four companies and unlike
previous works focusing on mostly North American Mining firms this paper
includes AngloGold Ashanti a South African based gold mining firm.
♦ This dissertation is among the few studies that have been carried out in
environment of rising gold prices and should shed considerable light on
the light on the validity of theoretical underpinnings of hedging in the gold
mining industry.
Out of the four companies two are classified as large firm and the remaining two
small firms based on their totals assets and yearly gold production. As far as the
empirical tests of the determinants of hedging are concern, the relevant question
is whether there is any statistical significance between firm characteristics (cash
costs, leverage, investment activities, exploration activities, taxes, size, and cash
balance) defined in this research as independent variable and the extent of
hedging as defined by the percentage of yearly production that has effectively
been shorted, delta.
The evidence is mixed is with respect to models of hedging emphasising the

likelihood of financial distress and determinant of hedging. Financial distress as
51
measured by the cash costs has a significant inverse relationship with extent of
hedging. Cash cost is used as measure of likelihood of financial distress with the
assumption that less efficient firms (high production cost) are more likely to
encounter financial difficulties and hence hedge more. However on the evidence
of this work as cash costs are rising hedging has reducing. This evidence is
contrary most works done in the gold mining industry including those of (Tufano
1996) who found positive but insignificant relations between cash cost and
hedging among North American firms and Dionne and Garand who revealed a
positive significant relationship between the two variables. Possible explanations
for this result could be the correlation between the price of gold and hedging. In
this sample the price of gold is inversely proportional to changes in delta
hedging. In other words as the companies have tended to hedge less as prices
have increased. Another explanation still related to price of gold could be as
prices of gold have risen less efficient mines have been brought on stream
leading to high average production cost of gold to rise.
The second variable used to measure financial distress leverage with a p value
of was found to be significantly positively correlated with hedging variable. The
result show firms with high debt are more likely to hedge consistent with the
works Stulz and Smith (1985) but at variance with Tufano who found no
significant relation. The mixed nature of the findings highlight the issues
associated with measuring an effect such financial distress.
Another important observation is the strong positive correlation between firm size
and hedging. This report supports the theory that larger firms are more likely to
hedge than smaller firms. Large firms benefit from scale economies and that
information and transaction considerations have more influence on hedging
activities than the cost of raising capital. The result contradicts Warner (1997)
external finance hypothesis that smaller firms are likely to hedge to avoid costly
external finance.
52
The underinvestment hypothesis is not supported in this dissertation as the

report found little evidence in its favour. These findings could have been
influenced however by the fact the value of acquisitions and exploration activities
were net cash positions report on the cash flow statements and not the gross
values.
This report also finds little evidence that hedging strategies are motivated by tax
saving strategies. Deferred Taxation which measures the inverse of tax convexity
yielded no significant result. However as discussed earlier the documented
problems associated with selecting a variable and different tax structures among
the companies impacted the results. The evidence in this study suggest that not
all aspects of the shareholder maximisation theory are valid hence the mixed
results.
Clearly the dissertation being a case study limits the generalization of results but
presents a fresh perspective on the debate on the merits and rational for risk
management. One major shortcoming of the project was the linear regression
method used. A more appropriate would have been multivariate analysis which
permits the interaction between variables to be isolated.
There exist correlations between the variables and some of were strong enough
to have influenced the results. Formal interpretations of these correlations require
specifications of a simultaneous equations framework. This report did not
examine the managerial aversion incentive to hedging which was found by
Tufano (1996) to be more significant influence on hedging decisions than the
concept of shareholder maximization. Further investigation of these issues is
suggested as a line for future research. Additionally most studies in the gold
mining industry have concentrated on north American mining firms more
research should carried including mines from other parts of the globe to improve
generalization of the results. This report makes that attempt by including South
53
African based mining company. Subsequent work might increase the power of
the tests used in this dissertation:
♦ Use of more data
♦ Use of continuous measure of hedging activity
♦ More effective separation and description of variables.
54
Appendixes 1 Global Positions in OTC derivative market
Appendix 1
http://www.bis.org/triennial.htm
Appendix 2 Calculations of Independent Variables

Barrick Gold
2002 2003 2004 2005 2006
Production/million (m) 5.695 5.51 4.958 5.46 8.643
Financial Distress
Cash costs/US $ 177 189 214 227 282
long-term debt/ ‘000’ 1927 1864 2711 3012 7173
Total assets/’000’ 5261 5358 6274 6862 21373
Leverage 36.628017 34.7891 43.21007332 43.89391 33.56103495
Investment opportunity
Exploration/US $ million 104 137 141 141 171
Exploration/total asset 1.9768105 2.556924 2.247370099 2.054795 0.800074861
Acquisition/US$ million 58 334 821 1180 1593
55
Acquisition/total asset 1.102452 6.233669 13.08575072 17.19615 7.453328966

Taxation
Deferred Income
tax/US$m 155 230 139 114 798
Deferred/Tax 2.9462079 4.292647 2.215492509 1.661323 3.733682684
Quick Ratio 2.373 3.308 4.18 2.403 2.087
AngloGold Ashanti
2002 2003 2004 2005 2006
Financial Distress
Cash costs/US$ 213 225 268 277 308
long-term debt/’000’ 1886 2009 3516 3815 3397
Leverage 43.35632184 37.60059891 37.42018 41.86327225 35.70903
Investment
opportunity
Exploration/$ 28 40 44 45 61
Acquisition/US$ million 305 11907 4640 4355 80
Taxation
Deferred Income
tax/m$ 505 789 1158 1152 1275
Total assets/’000’ 4350 5343 9396 9113 9513
Deferred/total asset 11.6091954 14.76698484 12.32439 12.64128169 13.40271
Production/kg 184722 174668 188223 191783 175263
Quick Ratio 1.738 0.951 0.802 0.639 0.544
Kinross
2002 2003 2004 2005 2006
Financial Distress
Cash costs/US$ 201 222 243 275 319
long-term debt/m 92.4 164.5 533.4 607.6 570.6
Total assets/m 598 1794.5 1834.2 1698.1 2053.5
Leverage 15.45151 9.166899 29.0808 35.78117 27.78670562
Exploration/m 2.7 24.3 25.8 26.6 39.4
Acquisition/m 0.1 81.9 442.3 257 257
Production/m ounce 0.888634 1.62041 1.653784 1.608805 1.476329
Taxation
Deferred Income
tax/million 3.3 54.1 119.9 129.6 114.4
56
Quick Ratio 2.81 1.954 0.526 0.712 0.932
Agnico-Eagle Mines Ltd

2002 2003 2004 2005 2006
Financial Distress
Cash costs/US$ 182 269 56 43 690
long-term debt/’000’ 175.02 199.975 213.446 267.45 197.148
Total Assets/’000’ 593.807 637.101 718.164 976.069 1521.488
Leverage 29.47422 31.38827 29.72107 27.40073 12.95758
Production/ounce 260000 236653 271567 241807 245826
0.26 0.236653 0.271567 0.241807 0.245826
Exploration/m 3.766 5.975 3.584 16.581 30.414
Acquisition/million 66.609 105.907 94.832 66.539 299.723
Deferred Income tax 20.899 29.378 17.684 52.5 90.793
Quick Ratio 8.511 4.19 4.8 3.455 7.56
Appendix 3 Company year end derivative positions

Barrick Gold
2002 2003 2004 2005 2006
Ounces/’000’ Price/$ Ounces Price Ounces Price Ounces Price Ounces Price
Forward 2800 365 2800 340 1350 345 1550 335 1540 338
Put sold 1600 297 250 344 300 310 300 317 250 332
call options sold 1330 303 425 363 570 328 550 336 1460 362
AngloGold Ashanti Derivative Position

2002 2003 2004 2005 2006
kg price ounces price ounces price ounces price ounces price

Forward 61.727 299 15.289 307 18.056 313 34.021 315 30.428 333
Put purchased 10.238 312 5.808 352 796 291 757 291 563 291
put sold 3.732 273 12.752 307 7.466 317 6.21 397 4.354 339
call purchased 24.535 338 4.555 351 0.572 360 9.88 340 3.03 351
call sold 24.584 340 18.83 332 5.829 330 29.49 322 18.017 329
57
Kinross Gold Corporation

2002 2003 2004 2005 2006
Ounces price Ounces price Ounces price Ounces price Ounces Price
Forward 113 271 137.5 278 137.5 278 200 452
Calls 50 340 100 320 50 340 225 522
Put options
bought 150 250 150 250 150 250
Agnico Eagle
2002 2003 2004 2005 2006
ounces price ounces price ounces price ounces price ounces price
Put options
bought 136.644 260 190.2 260 152 260
Appendix 4 Determination of Portfolio delta

AngloGold
Ashanti
2002 kg Delta Equivalent Ounces

Forward 61727 -1 -61727
Put purchased 10238 -0.386 -3951.868
Put sold 3732 -0.232 -865.824
Call purchased 24532 -0.506 -12413.192
Call sold 24584 -0.499 -12267.416
Equivalent ounces -91225.3
Production 184722
2003 Forward 15289 -1 -15289

Put purchased 5808 -0.337 -1957.296
Put sold 12752 -0.19 -2422.88
Call purchased 4555 -0.663 -3019.965
Call sold 18830 -0.727 -13689.41
Production 174668
2004 Forward 18056 -1 -18056

Put purchased 796 -0.074 -58.904
Put sold 7466 -0.122 -910.852
Call purchased 572 -0.874 -499.928
Call sold 5829 -0.845 -4925.505
58

Production 188223
Kinross Gold Corporation

Calculation of Portfolio Delta Kinross
Ounces Delta Equivalent Ounces
2002 Forward 113000 -1 -113000
calls 50000 -0.498 -24900
Aggregate equivalent portfolio (ounces) -137900
Production 2002 (ounces) 888634
2003 Forward 273000 -1 -273000

Calls 100000 0.766 -76600
delta percentage 21.57478663
2004 Forward 137500 -1 -137500

Calls 50000 0.82 -41000
Put bought 150000 -0.0257 -3855
2005 Forward 200000 -1 -200000

Put bought 150000 0.01314 -1971
Production 1608805
2006 calls 225000 0.78257 -176078.25

puts bought 150000 0.010876803 -1631.52044
Aggregate equivalent portfolio (ounces) -177709.7704
Production 1476329
Calculation of Portfolio Delta Agnico-Eagles Mines Ltd

Ounces Delta Equivalent Ounces
2004 puts 136644 0.0344 -4700.5536
production 271567
Delta 1.7309
2005 puts 190200 0.0182 -3461.64
59

production 241807
Delta 1.431571
2006 puts 152340 0.00094 -143.1996

production 245826
Delta 0.058252
Black Scholes formula

ln( S / K ) + ( r − δ + σ 2 / 2)T
Call delta = ∆c = N (d 1)e −δT where d 1 =
σ T
Put delta =∆p = - N ( − d1 )
S = Stock price
K = Strike price
T = time to maturity assumed to be a year
r = risk free rate ( average 10 year US Treasury note rate 5.1%
σ = Volatility of gold (average return standard deviation of annual gold returns
over the past 30 years; 30.13%
δ = Annual Gold lease rate of 0.39%
60
Appendix 5 Summary of Pooled Data
Cash Exploration Acquisition Deferred

Stock Delta cost Leverage activities( activities Taxation Quick Total
Ticker Year percentage ($US/oz % % (%) (%) Ratio assets
ABX 2002 62.60 177.00 36.63 1.98 1.10 2.95 2.37 5,261.00
ABX 2003 57.20 189.00 34.79 2.56 6.23 4.29 3.31 5,358.00
ABX 2004 37.64 214.00 43.21 2.25 13.09 2.22 4.18 6,274.00
ABX 2005 19.85 227.00 43.89 2.05 17.20 1.66 2.40 6,862.00
ABX 2006 34.57 282.00 33.56 0.80 7.45 3.73 2.09 21,373.00
AU 2002 49.39 213.00 43.36 0.64 7.01 11.61 1.74 4,350.00
AU 2003 20.83 225.00 37.60 0.75 222.85 14.77 0.95 5,343.00
AU 2004 12.99 268.00 37.42 0.47 49.38 12.32 0.80 9,396.00
AU 2005 27.79 277.00 41.86 0.49 47.79 12.64 0.64 9,113.00
AU 2006 29.24 308.00 35.71 0.64 0.84 13.40 0.54 9,513.00
KGC 2002 15.52 201.00 15.45 0.45 0.02 0.55 2.81 598.00
KGC 2003 21.57 222.00 9.17 1.35 4.56 3.01 1.95 1,794.50
KGC 2004 11.03 243.00 29.08 1.41 24.11 6.54 0.53 1,834.20
KGC 2005 12.55 275.00 35.78 1.57 15.13 7.63 0.71 1,698.10
KGC 2006 12.04 319.00 27.79 1.92 12.52 5.57 0.93 2,053.50
AEM 2002 0.00 182.00 15.45 0.63 11.22 3.52 8.51 593.81
AEM 2003 0.00 269.00 9.17 0.94 16.62 4.61 4.19 637.10
AEM 2004 1.73 290.00 29.08 0.50 13.20 2.46 4.80 718.16
AEM 2005 1.43 410.00 35.78 1.70 6.82 5.38 3.46 976.07
AEM 2006 0.06 690.00 27.79 2.00 19.70 5.97 7.56 1,521.49
61
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http://www.anglogold.com
http://www.barrick.com/
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Risk Management in Gold Mining Industry

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Created by Mbaakoh Longinu, Coventry University

To my dear father and mother Mr & Mrs Longinu Fombi

I am extremely grateful to Mr Robert Evans of the Coventry Business School for

Appendix 5 Summary of Pooled Data .................................................................61

Derivatives have generally been used to manage three financial risks

Interest rate risk represents the companies’ exposure to fluctuations in interest

Forward market (contract)

1.1 Research Question

♦ Gold mining firms provide detail information on their hedging activities

1. What is the extent of hedging in the gold mining firms?

2. What firm characteristics significantly impact on hedging decision?

3. Why do some firms’ hedge and others do not?

4. Are there alternatives to hedging?

1.2 Research Objectives

♦ Examine for statistical significance the financial distress theory

♦ Testing of the Underinvestment theory in the pooled data

♦ Investigate the significance tax shield on the hedging variable

♦ Examine the use of alternative strategies to risk management

several firm characteristics when regressed against the extent of hedging as

2.0 Literature Review

Hedging with financial derivatives is an integral part of most risk management

2.1 Risk Management Theories

2.11 Financial Distress Model

2.12 Tax Incentives and Hedging

Firms are most likely to face convex tax functions when:

Much of the convexity is induced by the asymmetric treatment of profits and

Adapted from (Smith & Stulz 1985: 293)

2.13 Management Incentives and Risk Aversion

This has serious implications for managerial compensation scheme because by

2.14 The Underinvestment Problem

2.15 Financial Sophistication Hypothesis

2.2 Empirical Evidence on the Determinants of Corporate Risk

2.21 Empirical Evidence from Surveys

2.22 Empirical Evidence from Cross Sectional Studies

exclusive from hedging the benefits of controlling the underinvestment problems,

Clearly statistical support for popular theories of derivative use is mixed.

countries that together comprise 80 percent of the global market capitalisation on

2.3 Empirical Evidence in the Gold Mining Industry

Arguably empirical tests on the determinants of corporate hedging policy have

3.0 Research Methodology

Research methodology involves a description of the process, variables to be

research design to objective. This section examines the perspective, approach

3.1 Research Perspective

3.2 Research Approach

The deductive approach involves the development of a theory that is subjected to

Induction or theory building is the alternative approach to deduction. This

understanding is one of the strengths of deductive research. Research using

3.3 Research Design

The research aims not only to explore certain phenomena, but to

3.4 Data Collection Methods

Qualitative data collection methods can be extensive and time consuming

Using secondary data

3.5 Sample Description

Barrick 5.695 5.51 4.958 5.46 8.643

Data collected from annual reports

3.6 Construction of independent variables

♦ Reduction in expected costs of financial distress;

♦ Increase investment opportunities or the underinvestment problem

♦ Reduction in expected tax payments

These outcomes are measured by constructing variables to capture their

3.61 Measuring Financial distress

3.62 Measuring Investment Opportunity