Standard Bank Group Precious Metals
Financing And Hedging Techniques For
The Gold Jewellery Industry
Dubai, 21st February 2005
Jeffrey Rhodes
Agenda
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What Is Hedging?
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Why Hedge?
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How To Hedge?
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Futures
Forwards
Options
OTC Products
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Gold Loans
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Some Lessons
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A Glimpse Into The Future
What is Hedging?
Some simple, and not so simple, definitions are:
‘Any technique designed to reduce or eliminate financial risk; for example, taking two
positions that will offset each other if prices change’
‘A hedging transaction is a purchase or sale of a financial product, having as its purpose the
elimination of loss arising from price fluctuations. With regards to currency transactions
it would protect one against fluctuations in the foreign exchange rate’
‘A strategy designed to reduce investment risk using call options, put options, short selling
or futures contracts. A hedge can help lock in existing profits. Examples include a
position in a futures market to offset the position held in a cash market, holding a
security and selling that security short and a call option against a shorted stock. A
perfect hedge eliminates the possibility for a future gain or loss. An imperfect hedge
insures against a portion of the loss’
The focus of today’s presentation is the hedging of physical gold holdings to protect
merchants against adverse movements in the underlying gold price
Why Hedge?
In today’s world of gold a crucial fact to note is that the amount of newly mined gold each
year is virtually matched by gold jewellery consumption.
In 2003 new mine production was 2,593 tonnes, according to GFMS, compared to annual
jewellery fabrication demand of 2,531 tonnes. In other words the gold jewellery industry
underpins the global gold market
The wholesalers and retailers that make up this market are, or should be, more concerned
with generating profit from the difference between ‘the making charge’ they pay to
jewellery manufacturers and revenue generated from jewellery sales rather than the
underlying price of gold bullion
It is crucial for physical merchants to minimise their exposure to the inherent speculative
elements of the international gold market so that they can ensure their business
remains healthy in all market conditions and is not hurt by excessive volatility in the
international gold price caused by factors completely outside of their control
In my view a physical gold merchant that does not hedge the value of inventory held
is a in fact a speculator
How to Hedge?
There are a number of traditional hedging techniques that are used by
international gold bullion and jewellery traders and merchants to safeguard, or
insure, the underlying value of their physical gold assets using a variety of
financial markets and instruments. These include:
Futures
Forwards
Options
OTC products such as the metal trading facility or unfixed accounts,
specifically designed for the physical gold market.
Futures
There are a number of International Futures Exchanges which offer gold futures contracts
the major one being the COMEX Division of the New York Mercantile Exchange, while in
India there are two relatively new but flourishing regional exchanges, MCX and NCDEX.
The use of futures as a hedging tool is popular, however as with anything there are
arguments for and against
PROS
CONS
Price transparency
Liquidity can be poor
Well regulated
Transaction costs
Low credit risk
Inflexible maturities
Low original margin
Lack of confidentiality
Small size tickets
Price volatility
Forwards
Forwards are used by both producers and consumers, products include
Swaps, Fixed or Outright Forwards, Floating Forwards, Spot Deferred Contracts,
Forward Rate Agreements
Gold fabricators, principally the gold jewellery industry, can match their purchases of
physical gold with their production schedules
Gold jewellery demand is seasonal, peaking at certain times of the year, such as prior to
Diwali, Wedding Seasons, Christmas, Chinese New Year, Eid Holidays, the circumcision
season in Turkey. Instead of waiting until the metal is needed and risking having to pay
higher gold prices, the jeweller can buy for forward dates that match their fabrication
plans if the spot price falls to what is considered to be an attractively cheap level
While having obvious benefits in ‘normal markets’, this hedging practice can prove costly if
demand does not match expectations due for example to an unexpected downturn in
regional economies, an increase in geo-political tensions, or simply a change in fashion
Options
Options are often misunderstood as speculative instruments that help to cause unnecessary and
unwanted price volatility, however the truth is that an option is a form of price insurance and is a
crucial tool in managing price risk and exposure
Options can be traded on an ‘Over The Counter’ basis with a bullion bank, or on a futures market such as
the COMEX
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Exchange traded options are typically American style
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OTC options are usually European style, can be Asian
Buying a Call gives the option purchaser the right, but not the obligation, to buy a specified quantity of
metal at a previously agreed upon price (strike price) at a previously agreed upon date (expiry date).
By paying a premium, the buyer controls the upside risk, while retaining advantages of a downward
price move
Selling a Put - In exchange for collecting premium, the put seller has a contingent obligation to buy a
specified quantity of metal at a previously agreed upon price (strike) at a previously agreed upon
date (expiry). A consumer with a buying target below the market could sell puts struck at that target
price and will collect premium regardless of whether that level is reached
Over The Counter Products
The Metal Trading Facility is the classic, tailor made OTC product that was developed specifically to meet
the needs of the physical gold markets of the Middle East and South East Asia
The product is also known as a Deferred Settlement Facility or Margin Trading Account, and can be
regarded as an undated forward which eliminates the need to roll positions forward each day. In
Dubai it is called an ‘Unfixed Account’
It is effectively an exchange of assets with the gold merchant buying gold from a bullion bank, paying the
currency equivalent of the gold plus an an agreed margin to protect against adverse market moves,
but not actually fixing the final price to be be paid. The client’s currency account with the bank is
credited with the money paid in and simultaneously the client’s gold account is debited with the
ounce equivalent
This short paper position perfectly hedges the physical metal held until such time as the merchant sells at
which point the hedge is lifted, I.e. the client’s currency account is debited and gold credited
While the MTF position is open with the bank the client receives interest on his credit currency balance
and is charged interest on the debit gold balance
Gold Loans
Probably the most straight forward and commonsense method of financing that
simultaneously hedges gold price exposure for a physical gold merchant
Simply by borrowing gold rather than cash to finance the growth of his business the gold
merchant creates a paper liability that equally matches the physical assets held either in
the form of jewellery, bullion or scrap. The monetary value of both sides of the balance
sheet will rise and fall in equal proportion
In order to maintain the hedge the physical merchant should replenish stocks as sales are
made or certainly within a very short period of time in order to avoid creating an
exposure to the gold price
Gold loan rates should be cheaper than currency borrowings – over a ten year period the
three months gold LIBOR rate has averaged just under 1% per annum
A potential problem is margin calls on the paper liability from merchant’s bank, however a
flexible financial institution will understand that their client’s liquidity is held in the form of
gold rather than cash and should be willing to accept gold bullion or jewellery as call
margin
Some lessons ……
Hedging of physical gold holdings means protecting against adverse
movements in the underlying gold price
There are a wide range of simple hedging products available to physical
gold merchants
Make more use of options, view them as an insurance not a speculative
product
Adopt the ‘Unfixed Account’ approach, gives flexibility
Remember that a physical gold merchant that does not hedge the
value of inventory held is a in fact a speculator
A Glimpse Into The Future ……
Imagine a financing product for the gold jewellery industry that:
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Eliminates exposure to the international gold price
Requires no original cash margin
Is not subject to variation or call margin
Reduces financing costs
Reduces making charges
Frees up capital
Allows complete flexibility of supply
Is highly relevant to Dubai’s Gold Souk but has global potential
A pipedream or could it be a reality?
The answer is a reality, the solution has arrived.
Standard Bank has partnered with key players in Dubai’s vibrant gold market to develop an
innovative gold jewellery financing tool, based on new technology, that has these
attributes and we plan to roll out the product to the market over the next few months.
Thank you - Questions Please?
About Standard Bank
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