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REPORT
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A REPORT
ON
Hedging through gold options and futures Cost Benefit Analysis
SUBMITTED BY
SHRUTI DROLIA
08BS0003195
SUBMITTED TO
DR. KRISHNA PRASANNA
FACULTY, IBS HYDERABAD
DECLARATION
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Hedging through gold options and futures Cost Benefit Analysis
I, Shruti Drolia hereby declare that this project report entitled ‘Hedging
me for partial fulfillment of the M.B.A. program of I.B.S. Hyderabad. This report
Faculty IBS. This project report has not been submitted to any other institution or
DATE: SIGNATURE
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Hedging through gold options and futures Cost Benefit Analysis
Dr Krishna Prasanna
Faculty IBS.
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Hedging through gold options and futures Cost Benefit Analysis
ACKNOWLEDGEMENT
It is a moment of great pleasure for me to acknowledge the help of all individuals who
helped me make this project successful.
I feel honored to have worked under the guidance of, Dr Krishna Prasanna, Faculty IBS. I
thank her for her cooperation and encouragement throughout the project.
I would like to thank all my friends who helped me directly or indirectly in the successful
completion of this project work.
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Hedging through gold options and futures Cost Benefit Analysis
Abstract:
It deals with the study of risks involved as well as the risk management techniques
employed. Risk management and price discovery are two main functions of future
market. Future markets perform risk allocation function and can be used to hedge the
prices. One of the determinants of success of future market is its hedging effectiveness.
Hedging in future market involves purchase/sale of futures in combination with another
commitment, usually with the expectation of favorable change in relative prices of spot
and future market of gold. The basic idea of hedging through future market is to
compensate loss/profit in future market by profit/loss in spot market. Various actors in
the commodity market can manage their activities in an environment of unstable and
uncertain prices through the use of the commodity futures market to assure or reduce
their risk exposure.
Indian commodity future market has been going through many ups and downs after
inception of national exchanges came into being. High growth in Indian commodity
futures markets has been accompanied by higher volatility in prices which requires a
systematic investigation of hedging effectiveness provided by these markets.
At the same time options strategies would be used for the hedging. With the help of
binomial model prices would be determined to establish the relationship between the
future and the spot prices of gold.
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Hedging through gold options and futures Cost Benefit Analysis
TABLE OF CONTENTS
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Hedging through gold options and futures Cost Benefit Analysis
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Hedging through gold options and futures Cost Benefit Analysis
1. INTRODUCTION
A broad cross-section of companies in the gold industry, from mining companies to fabricators
of finished products, can use the COMEX Division gold future and gold future option contracts
to hedge their price risk. Furthermore, gold has traditionally had a role in investment strategies,
and gold futures and gold options can be found in investors' portfolios.
Gold is an effective hedge against inflation. In addition, gold is inversely correlated to the US dollar,
making it a good currency hedge. As an asset class, gold has all the advantages of being universally
regarded as a currency, without what are all too often the disadvantages of being subject to the
economic and monetary policies of one particular country's government.
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Hedging through gold options and futures Cost Benefit Analysis
The correlation between the estimated future price and actual future and its impact
on the spot price.
1.2 Methodology:
Analysis of future and spot prices of gold.
Articles and research papers on the subject, & Online search
1.3 Limitation:
Time constraint.
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Hedging through gold options and futures Cost Benefit Analysis
2. Derivatives Market
2.1 Introduction:
The emergence of the market for derivative products, most notably forwards, futures and options,
can be traced back to the willingness of risk-averse economic agents to guard themselves against
uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets
are marked by a very high degree of volatility. Through the use of derivative products, it is
possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk
management, these generally do not influence the fluctuations in the underlying asset prices.
However, by locking-in asset prices, derivative products minimize the impact of fluctuations in
asset prices on the profitability and cash flow situation of risk-averse investors.
2.2 Definition:
Derivative is a product whose value is derived from the value of one or more basic variables,
called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying
asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish
to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a
transaction is an example of a derivative. The price of this derivative is driven by the spot price
of wheat which is the "underlying".
In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines "equity
derivative" to include –
1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security.
2. A contract, which derives its value from the prices, or index of prices, of underlying securities.
The derivatives are securities under the SC(R) A and thus the regulatory framework
under the SC(R) A governs the trading of derivatives.
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Hedging through gold options and futures Cost Benefit Analysis
A future is simply a deal to trade gold at terms (i.e. amounts and prices) decided now, but with
a settlement day in the future. That means buyer don't have to pay up just yet and the seller
doesn't need to deliver the buyer any gold just yet either. It's as easy as that.
The settlement day is the day when the actual exchange takes place - i.e. when the buyer pays,
and the seller delivers the gold. It's usually up to 3 months ahead.
Most futures traders use the delay to enable them to speculate - both ways. Their intention is to
sell anything they have bought, or to buy back anything they have sold, before reaching the
settlement day. Then they will only have to settle their gains and losses. In this way they can
trade in much larger amounts, and take bigger risks for bigger rewards, than they would be able
to if they had to settle their trades as soon as dealt.
Trading gold futures securities happens primarily on paper: most of the gold bought or sold in
the futures market never moves. Gold futures are typically traded by "speculators," investors
who buy or sell gold futures but aren't interested in the physical gold, versus "hedgers," who do
value the gold itself as an investment. Additionally, those wanting primarily to invest in
physical gold might opt to invest in gold bullion.
Delaying the settlement creates the need for margin, which is one of the most important aspects
of buying (or selling) a gold future.
Margin is required because delaying settlement makes the seller nervous that if the gold price
falls the buyer will walk away from the deal which has been struck, while at the same time the
buyer is nervous that if the gold price rises the seller will similarly walk away.
Margin is the down payment usually lodged with an independent central clearer which protects
the other party from your temptation to walk away. So in order to deal with the gold futures one
needs to pay margin, and depending on current market conditions it might be anything from 2%
to 20% of the total value of what dealt.
Now we will see how futures provide leverage, sometimes known as gearing.
For example, suppose we had $5,000 to invest. If we buy gold bullion and settle we can only
buy $5,000 worth. But we can probably buy $100,000 of gold futures! That's because our
margin on a $100,000 future will probably be about 5% - i.e. $5,000.
If the underlying gold price goes up 10% we would make $500 from gold bullion, but $10,000
from gold futures.
Sounds good, but don't forget the flip side. If the price of gold falls 10% we'll lose just $500
with bullion and our investment will be intact to earn us money if gold resumes its steady
upwards trend.
But the same 10% fall will cost us $10,000 with futures, which is $5,000 more than we invested
in the first place. We will probably have been persuaded to deposit the extra $5,000 as a margin
top-up, and the pain of a $10,000 loss will force us to close our position, so our money is lost.
If we refused to top-up our margin we will be closed out by our broker, and our original $5,000
will be lost on a minor intra-day adjustment - a downwards blip in the long-term upward trend
in gold prices.
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Hedging through gold options and futures Cost Benefit Analysis
We can see why futures are dangerous for people who get carried away with their own
certainties. The large majority of people who trade futures lose their money. That's a fact. They
lose even when they are right in the medium term, because futures are fatal to our wealth on an
unpredicted and temporary price blip.
Big professional traders invent the contractual terms of their futures trading on an ad-hoc basis
and trade directly with each other. This is called 'Over The Counter' trading (or OTC for
short).
In a standardized contract the exchange itself decides the settlement date, the contract amount,
the delivery conditions etc. We can make up the size of our overall investment by buying
several of these standard contracts.
Dealing standard contracts on a financial futures exchange gives two big advantages:-
Firstly there will be deeper liquidity than with an OTC future - enabling us to sell our future
when we like, and to anybody else. That is not usually possible with an OTC future.
Secondly there will be a central clearer who will guarantee the trade against default. The central
clearer is responsible (among other things) for looking after margin calculations and collecting
and holding the margin for both the buyer and the seller.
• There is a psychological pressure involved in owning gold futures for a long time.
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Hedging through gold options and futures Cost Benefit Analysis
• As a futures contract ends - usually every quarter - an investor who wants to keep the
position open must re-contract in the new period by 'rolling-over'. This ‘roll-over’ has a marked
psychological effect on most investors.
• Having taken the relatively difficult step of taking a position in gold futures investors
are required to make repeated decisions to spend money. There is no ‘do nothing’ option, like
there is with a bullion investment and rolling over requires the investor to pay-up, while
simultaneously giving the opportunity to cut and run.
• The harsh fact of life is that if investors are being whip-lashed by the regular volatility
which appears at the death of a futures contract many of them will cut their losses. Alternatively
they might attempt to trade cleverly into the next period, or decide to take a breather from the
action for a few days. Unfortunately every quarter lots of investors will fail the psychological
examination and close their position. Many will not return. The futures markets tend to expel
people at the time of maximum personal disadvantage.
This problem is mitigated by "margin". Margin is money futures investors deposit at the demand
of the clearer who seeks to prevent the risk of default from growing too big. It is calculated by
comparing the original deal to the current market value of what was traded. The process is called
marking-to-market and it results in a margin call to the person who has speculated badly, while
a margin surplus grows at the account of the successful trader. The margin is collected and
managed by a clearer on behalf of the exchange.
Margin deposited only needs to cover the likely potential loss on the trade which could occur in
the time it would take for the clearer to collect more margin. So, for example, on a $400 gold
price it might be thought that $20 was the largest likely intra-day move, and that margin could be
collected before the next trading day. So to keep off risk the clearer would require the investor to
put up margin of 20/400, i.e. about 5% of the contracted deal size.
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Hedging through gold options and futures Cost Benefit Analysis
In practice the margin calculation will vary from exchange to exchange and from clearer to
clearer. It is ultimately up to each firm to decide how it implements a margin policy and it's
always a compromise between risk and the attractiveness of the product to the client. At any rate,
the result is that speculators only have to pay a fraction of the value of the contract’s amount - as
a variable down-payment. Provided they close their position before expiry they will never have
to put up the rest of the money.
This means that the aggressive speculator can 'gear-up' his position by trading many times more
gold than he could ever afford to pay for, and this makes futures very popular with people who
have an appetite for bigger risks.
Usually investors only have to deposit about 2% of the full value of gold they want to buy, but
their broker will retain the right to close them out without instruction if the market moves
viciously against them. Meanwhile on a daily basis investors must quickly top up margin if the
market has moved a little against them.
That is the simple basis of futures trading. It is not particularly complicated and need not be
risky, but there are some points which deserve special mention.
When a number of big open positions want to close out near to the trading deadline of a quarterly
futures contract the prices frequently can start to behave irrationally and with wild gyrations
down and up.
This is inevitable where 99 out of every 100 investors want to trade before the end of the day - to
close a position which if it is not closed will end up in them having to take delivery of metal and
pay 50 times as much as the 2% margin as they have deposited.
The volume is usually so large that the tail of the futures market wags the dog of the spot market,
where volumes are much smaller. The market becomes a high stakes game of "chicken" and it is
far from unusual to see the price maintained by a big player at a particular rate, only to swerve
violently immediately after the contract terms expire. It can make for some frightening action for
the uninitiated - and they usually lose out.
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Hedging through gold options and futures Cost Benefit Analysis
Gold is bought as the ultimate defensive investment. Many people buying gold hope to make
large profits from a global economic shock which might be disastrous to many other people.
Indeed many gold investors fear financial meltdown occurring as a result of the over-extended
global credit base - a significant part of which is derivatives.
The paradox in investing in gold futures is that a future is itself a 'derivative' instrument
constructed on about 95% pure credit. There are many speculators involved in the commodities
market and any rapid movement in the gold price is likely to be reflecting financial carnage
somewhere else.
Both the clearer and the exchange could theoretically find themselves unable to collect vital
margin on open positions of all kinds of commodities, so a gold investor might make enormous
book profits which could not be paid as busted participants defaulted in such numbers that
individual clearers and even the exchange itself were unable to make good the losses.
The futures exchanges we see around us today are those whose appetite for risk has most
accurately trodden the fine line between aggressive risk taking and occasional appropriate
caution. There is no guarantee that the next management step will not be just a bit too brave.
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Hedging through gold options and futures Cost Benefit Analysis
1. Gold is cheap, while stocks are expensive. In January of 1980, both the Dow Industrials and
the price of gold were at the same level: 800. Now, nearly 24 years later, the Dow is near 10,000,
while gold is less than half its January 1980 value.
2. Governments will make our money worth less to pay off their record debts. Governments can
print money to pay off their debts. But they can’t create gold. The supply of paper money can be
infinite. But the supply of gold is extremely limited. And it’s difficult to extract. Bill Gates could
buy all the gold mined in the world in a year from his checkbook.
3. Gold should do well in major international conflicts. The price of gold was fixed during World
War I and World War II. But silver, for example, rose by over 100% in both world wars. It’s
been rising for the duration of the War on Terrorism. It all comes back to point 2, above
governments ultimately print money to pay for wars.
4. Gold should do well in extreme bear markets. Silver more than doubled in value from 1932 to
1936 during the Great Depression (the price of gold was fixed by the government). The next long
bear market was 1968-1980. Silver rose from around $2 in 1968 to a peak near $50 in 1980.
5. Gold stock will rise during inflation, and during deflation. Investing in gold is good inflation
protection gold rises as the value of the dollar falls. But what many people don’t understand is
that gold stocks will do even better during deflation, as the government lowers interest rates
significantly and wildly prints money (creating inflation) to offset that deflation, leading to
substantially higher gold prices. This is where we are now, and gold has done what it’s supposed
to do.
6. When we buy gold investments, we lower risk in our investment portfolio. In the past, gold
has tended to do the opposite of stock, sit skyrocketed in the 1970s, when stocks did horribly.
Then in the 1980s and 1990s, when stocks soared, gold lost over half its value. Now in the new
millennium gold has soared while stocks are still below their year 2000 highs. Holding a portion
of our portfolio in gold stock will smooth out our portfolio fluctuations.
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Hedging through gold options and futures Cost Benefit Analysis
We can make 500% in gold stocks or 50% in raw gold. We can even make thousands of percent
in futures and options-or we can lose it all. Let’s cover the various gold investing options, and
the risks and rewards associated with each, starting with the most risky:
Yes we can make thousands of percent in these in a gold bull market. And yes we can lose all
our money, and then some (in the case of futures).
Phew…these are much too risky for my blood as well. They say only one in 10,000 exploration
companies will find a mine and bring it into production. For the lucky one that’s found the
average cost of finding and developing a gold mine in Canada, for example, is $100 million. But
they can and do rise many hundreds of percent in a gold bull market.
I’m finally comfortable here with blue chip mining stocks. These are cash-creating businesses.
They generally have many mines operating, generating cash earnings. They plow those cash
earnings back into the business by buying out junior mining companies that have made a
discovery. Why bother doing the exploration ourselves? Just buy the juniors after a discovery.
That’s basically what they do. These include names like Newmont (NEM) and Barrick (ABX).
This is probably the smartest and best way to invest in gold. Chances are, one is not an expert in
analyzing assay results. That’s okay. Guys like Frank Holmes at U.S. Global funds know how to
find the winners. His World Precious Minerals Fund is up 68%, and his Global Resources Fund
is up 75% year-to-date-the best performer in its sector by far.
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Hedging through gold options and futures Cost Benefit Analysis
I consider these to be the best opportunity right now. While gold stocks are up nearly 500%,
investment grade gold coins (those that carry a grading of Mint State (MS) 63 or higher from the
grading agencies PCGS or NGC) are ‘only’ up 70%. These coins peaked in value in 1989. They
subsequently fell by 85%, bottoming in 2001. There is still 100% upside on the table here, and
downside is limited. I prefer the least expensive of these with the highest gold content, like the
$20 Saint Gaudens.
To own gold directly, we can buy common gold coins or small bars of gold. Common gold coins
are known as ‘bullion’ coins. These include popular coins like Krugerrands or Canadian Maple
Leafs, and they cost just a few dollars more than the current price of gold. These don’t have
extraordinary upside or downside – they simply move with the price of gold. But after the huge
run-up in mining shares, we may prefer to have the limited downside risk of these.
Gold options are option contracts in which the underlying asset is a gold futures contract. The
holder of a gold option possesses the right (but not the obligation) to assume a long position (in
the case of a call option) or a short position (in the case of a put option) in the underlying gold
futures at the strike price. This right will cease to exist when the option expire after market close
on expiration date.
Gold option contracts are available for trading at New York Mercantile Exchange (NYMEX) and
Tokyo Commodity Exchange (TOCOM).
NYMEX Gold option prices are quoted in dollars and cents per ounce and their underlying
futures are traded in lots of 100 troy ounces of gold.
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Hedging through gold options and futures Cost Benefit Analysis
TOCOM Gold options are traded in contract sizes of 1000 grams (32.15 troy ounces) and their
prices are quoted in yen per gram.
With gold futures contracts, investors contract to buy or sell gold at a certain quantity for a
specific, pre-set price at a planned future date. Gold futures are relatively liquid because they are
standardized this way.
The "option" part of gold futures options means that the buyer of the option may buy or sell the
underlying futures contract within a specified time period (up to the expiration date) for a
specified price, called the "strike price." If bought at an at-the-money strike price, the option is
purchased with a strike price equivalent to the current market price of the gold futures contract.
With the trading of gold futures options, an investor is essentially betting on the future price of
gold. If the investor expects the price of gold futures to go up, he or she can buy a "call" option.
Call options offer the buyer the chance to buy the futures contract later at a set price, ideally
below that of the current futures market.
If the investor expects the price of gold futures to fall, he or she can buy a "put" option. Put
options give investors the optional right to sell the futures contract to the buyers, ideally at a
premium price.
7.2 Buying Gold Call Options to Profit from a Rise in Gold Prices:
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Hedging through gold options and futures Cost Benefit Analysis
If a person is bullish on gold, he/she can profit from a rise in gold price by buying (going long)
gold call options.
Example: Long Gold Call Option
We observed that the near-month TOCOM Gold futures contract is trading at the price of JPY
2,518 per gram. A TOCOM Gold call option with the same expiration month and a nearby strike
price of JPY 2,500 is being priced at JPY 168.00/gm. Since each underlying TOCOM Gold
futures contract represents 1000 grams of gold, the premium we need to pay to own the call
option is JPY 168,000.
Assuming that by option expiration day, the price of the underlying gold futures has risen by
15% and is now trading at JPY 2,896 per gram. At this price, our call option is now in the
money.
Gain from Call Option Exercise
By exercising our call option now, we get to assume a long position in the underlying gold
futures at the strike price of JPY 2,500. This means that we get to buy the underlying gold at
only JPY 2,500/gm on delivery day.
To take profit, we enter an offsetting short futures position in one contract of the underlying gold
futures at the market price of JPY 2,896 per gram, resulting in a gain of JPY 396.00/gm. Since
each TOCOM Gold call option covers 1000 grams of gold, gain from the long call position is
JPY 396,000. Deducting the initial premium of JPY 168,000 we paid to buy the call option, our
net profit from the long call strategy will come to JPY 228,000.
Long Gold Call Option Strategy
Gain from Option Exercise = (Market price of Underlying Futures-Option Strike Price)*
Contract Size
= (JPY 2,896/gm - JPY 2,500/gm) x 1000 gm
= JPY 396,000
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Hedging through gold options and futures Cost Benefit Analysis
= JPY 228,000
7.3 Buying Gold Put Options to Profit from a fall in Gold Prices
If a person is bearish on gold, he/she can profit from a fall in gold price by buying (going long)
gold put options.
Example: Long Gold Put Option
We observed that the near-month TOCOM Gold futures contract is trading at the price of JPY
2,518 per gram. A TOCOM Gold put option with the same expiration month and a nearby strike
price of JPY 2,500 is being priced at JPY 168.00/gm. Since each underlying TOCOM Gold
futures contract represents 1,000 grams of gold, the premium we need to pay to own the put
option is JPY 168,000.
Assuming that by option expiration day, the price of the underlying gold futures has fallen by
15% and is now trading at JPY 2,140 per gram. At this price, our put option is now in the money.
Gain from Put Option Exercise
By exercising our put option now, we get to assume a short position in the underlying gold
futures at the strike price of JPY 2,500. In other words, it also means that we get to sell 1,000
grams of gold at JPY 2,500/gm on delivery day.
To take profit, we enter an offsetting long futures position in one contract of the underlying gold
futures at the market price of JPY 2,140 per gram, resulting in a gain of JPY 360.00/gm. Since
each TOCOM Gold put option covers 1,000 grams of gold, gain from the long put position is
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Hedging through gold options and futures Cost Benefit Analysis
JPY 360,000. Deducting the initial premium of JPY 168,000 we paid to purchase the put option,
our net profit from the long put strategy will come to JPY 192,000.
Long Gold Put Option Strategy
Gain from Option Exercise = (Option Strike Price - Market Price of Underlying Futures)
x Contract Size
= (JPY 2,500/gm - JPY 2,140/gm) x 1000 gm
= JPY 360,000
Gold futures options lose value over time as the expiration date approaches. The gold futures
option price depends on:
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Hedging through gold options and futures Cost Benefit Analysis
how much time remains for the buyer to take the option
the difference between the strike price and the price of the current gold futures market
Trading Hours (All times are New York time): Open outcry trading is conducted from
8:30AM. Until 1:30 pm. After-hours electronic trading begins at 2:00 PM on Mondays
through Fridays and concludes at 8:00 AM the following day, with the exception of Friday's
session which concludes at 4:30 PM that same day. On Sundays, the session begins at 7:00
PM and concludes at 8:00 AM the following day.
Trading Months: Gold futures trading is conducted for delivery during the current calendar
month; the next two calendar months; any February, April, August, and October falling within
a 23-month period; and any June and December falling within a 60-month period beginning
with the current month.
Minimum Price Fluctuation: $0.10 (10¢) per troy ounce ($10.00 per contract).
Maximum Daily Price Fluctuation: Initial price limit, based upon the preceding day's
settlement price, is $75.00 per ounce. Two minutes after either of the two most active month’s
trades at the limit, trades in all months of gold futures and options will cease for a 15-minute
period.
Last Trading Day: Trading terminates at the close of business on the third to last business
day of the maturing delivery month.
Delivery: Gold delivered against the gold futures contract must bear a serial number and
identifying stamp of a refiner approved and listed by the Exchange. Delivery must be made
from a depository licensed by the Exchange.
Delivery Period: The first delivery day is the first business day of the delivery month; the
last delivery day is the last business day of the delivery month.
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Hedging through gold options and futures Cost Benefit Analysis
Exchange of Futures for Physicals (EFP): The buyer or seller may exchange a gold
futures position for a physical position of equal quantity. EFPs may be used to either initiate
or liquidate a gold futures position.
Margin Requirements: Margins are required for open gold futures positions.
Trading Symbol: GC
The terms "gold futures contracts" and "gold futures options" can be confusing. Options always
have a contract underlying them. In a gold futures contract, each holder must fulfill the contract
to buy or sell gold by the delivery date, unless the contract is offset. In the trading of a gold
futures option, it's at the buyer's discretion to inherit the contract commitment, called the
position, attached to the option up to the expiration date of the option. Compared to the outright
purchase of the underlying gold futures, gold options offer advantages such as additional
leverage as well as the ability to limit potential losses. However, they are also wasting assets that
have the potential to expire worthless.
Additional Leverage:
Compared to taking a position on the underlying gold futures outright, the buyer of a gold option
gains additional leverage since the premium payable is typically lower than the margin
requirement needed to open a position in the underlying gold futures.
Limit Potential Losses:
As gold options only grant the right but not the obligation to assume the underlying gold futures
position, potential losses are limited to only the premium paid to purchase the option.
Flexibility:
Using options alone, or in combination with futures, a wide range of strategies can be
implemented to cater to specific risk profile, investment time horizon, cost consideration and
outlook on underlying volatility.
Time Decay:
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Hedging through gold options and futures Cost Benefit Analysis
Options have a limited lifespan and are subjected to the effects of time decay. The value of a
gold option, specifically the time value, gets eroded away as time passes. However, since trading
is a zero sum game, time decay can be turned into an ally if one chooses to be a seller of options
instead of buying them.
When traders participate in both commodity and derivatives markets they must choose a hedging
strategy that reflects their individual goals and attitudes towards risk. At the same time, optimal
portfolio management depends not only on the fundamental and technological analysis in
maximizing returns, but it also encompasses diversification techniques in unsystematic risk.
Nevertheless, systematic risk can be effectively eliminated by futures contracts.
In portfolio theory, hedging with futures can be considered as a portfolio selection problem in
which futures can be used as one of the assets in the portfolio to minimize the overall risk and
optimizing profitability. Hedging with futures contracts involves purchase/sale of futures in
combination with another commitment, usually with the expectation of favorable change in
relative prices of spot and futures market. The basic idea of hedging through futures market is to
compensate loss/ profit in futures market by profit/loss in spot markets.
The optimal hedge ratio is defined as the ratio of the size of position taken in the futures market
to the size of the physical position which minimizes the total risk of portfolio.
Hedging strategies
• Principle: Hedging reduces the risk associated with one asset by holding a second asset such
that, together, the payoffs cancel out across states of the world.
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Hedging through gold options and futures Cost Benefit Analysis
Consider a world with two states (labeled 1 and 2) and two assets (labeled A and B) with payoffs
as follows:
Asset A Asset B
State 1 −2 6
State 2 3 −4
Assets A and B are risky: their returns differ across states. But any strategy that holds A and B in
the ratio 2:1 result in a payoff that is identical across states, thereby eliminating risk. Thus asset
A could be used as a perfect hedge for asset B, and conversely.
In a perfect hedge the risk component is zero that means the whole of the underlying is perfectly
hedged and return is optimistic.
A firm plans to sell oil 11 months from today but price on the delivery date is unknown.
In hedging, you can hedge your whole portfolio or some portion of it. The hedge ratio is the size
of the paper (Derivative) contract relative to the physical transaction. The basic aim of optimal
hedge ratio is to minimize risk and optimize profitability. It is not always optimal to hedge the
whole physical underlying. This method gives an idea as to how much to hedge against the
physical transaction.
According to this method the hedge ratio can be found out as follows:
The more the correlation between the physical & paper index closer to 1 and larger the standard
deviation of the physical index, the more you hedge. On the other hand, larger the standard
deviation of the paper index the lesser you hedge. It is even possible that, Hedge Ratio greater
than 1 that is the optimum hedging quantity is more than the physical.
This method is called as Minimum Variance Method because; the hedge ratio minimizes the
variance of the hedger’s position. Minimizing the variance ensures that there will be less risk
using futures with an underlying asset. The following graph shows the hedge ratio where the
variance is minimum.
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Hedging through gold options and futures Cost Benefit Analysis
Minimum Variance
The physical transactions are done on spot prices and to hedge such risk we are taking positions
in futures market. The indices in which we buy papers are of future month. Thus Minimum
Variance Method minimizes the variance (Risk) in spot and futures prices by ensuring an
optimum hedge ratio.
The “H” calculated (Refer to the above graph) minimizes the variance of
∆S – H*∆F
H = Hedge Ratio
If ρ=1 (Completed correlated) and S (Standard deviation of the Spot price) = F (Standard
deviation of the future price) then H=1. In this case futures prices mimics the spot price. And if
ρ=1 and F = S then H=0.5. This follows since future prices changes twice the spot price.
Optimal hedge ratio is the slope of best fit regression line when ∆S is regressed against ∆F. We
expect there to be a linear relationship between them. Following is the regression of change in
spot price against change in future price.
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Hedging through gold options and futures Cost Benefit Analysis
The hedge ratios are calculated for the portfolios (pair of Physical & Paper indices) entity wise
by using Minimum Variance Hedge Method (MVH).
We will take a Hedge ratio (from the above table) between Gold physical & Gold paper for the
calendar year 2009-2010 and try to understand what does it signify. Here, Hedge Ratio (H) =
1.0770193
This signifies that if you have a physical transaction of 100,000 troy ounces of Gold then the
optimum quantity that need to be hedged in derivatives market is (H*100,000) troy ounces.
For calculating the payoffs a portfolio of physical and one month future prices of gold as paper
index and the respective hedge ratio calculated by Minimum Variance Hedge is taken. The
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Hedging through gold options and futures Cost Benefit Analysis
payoffs are calculated since Jan 2009 to Dec 2009. The payoffs are calculated on a monthly basis
for the hedged and unhedged portfolios. The payoffs can be calculated as follows:
Payoff (Unhedged) = S0 – S1
The future price is taken as price after 30 days. The after 30 days prices are compared with the
spot prices both for physical and paper indices and the payoffs are calculated on a daily basis.
The payoffs signify how much gain or loss is made on the basis of the price movements during
that period. This is shown in the following table.
S0 S1 F0 F1 H (S0-SI)-H(F0-F1) (S0-S1)
month spot Physical 1 Spot Paper 1 MVH HEDGED UNHEDGED
physical day forward Paper day forward Hedge ratio Payoff Payoff
JAN 858.21 941.46 807.30 892.00 1.077 7.968 -83.25
FEB 941.46 925.13 892.00 889.10 1.077 13.209 16.33
MAR 925.13 891.43 889.10 867.40 1.077 10.329 33.70
APR 891.43 927.75 867.40 888.20 1.077 -13.917 -36.32
MAY 927.75 946.74 888.2 920.6 1.077 15.906 -18.99
JUN 946.74 934.25 920.60 909.30 1.077 0.319 12.49
JUL 934.25 949.44 909.3 934.3 1.077 11.735 -15.19
AUG 949.44 996.52 934.3 955.2 1.077 -24.568 -47.08
SEP 996.52 1043.34 955.20 999.50 1.077 0.893 -46.82
OCT 1043.34 1126.58 999.50 1054.00 1.077 -24.546 -83.24
NOV 1126.58 1133.42 1054.00 1086.00 1.077 27.625 -6.84
DEC 1133.42 1086.00
The negative payoffs are shown in red color with minus sign. From the table in the month of Jan
the payoff from the unhedged portfolio is -83.25 i.e. suffered a loss of 83.25. On the other hand
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Hedging through gold options and futures Cost Benefit Analysis
the same portfolio which is hedged gained 7.968 (Hedge ratio as per Minimum variance Hedge
Method).
In all most all the months it is observed that the payoffs for hedged portfolios are more than the
unhedged portfolios. The hedge ratio (calculated by Minimum variance Hedge) used to calculate
payoffs. The huge fluctuations in the gold market make it riskier for traders if the physical
transaction is not hedged. The month of Jan2009 showed a loss of 83.25, but when it hedged it
showed a profit of 7.968. So hedging minimizes risk at same time optimizes profitability.
HEDGED UNHEDGED
Total Pay- off 24.957 -275.208
From the above table the total payoff for the unhedged portfolio is significantly lower than the
hedged portfolios. The total payoff is negative for the unhedged portfolio; this shows the amount
of risk involved if the portfolio is unhedged.
Hence, to conclude we can say that if we hedge our portfolio it reduces the probability of loss i.e. it
minimizes the risk and optimizes the return.
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Hedging through gold options and futures Cost Benefit Analysis
References
Websites:
www.mcx-india.com
www.sebi.gov.in
www.google.com
www.investopedia.com
www.moneycontrol.com
www.economictimes.indiatimes.com
www.derivativesindia.com
Books:
Options, Futures and other Derivatives by John C Hull
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