Gold Hedging

Gold hedging is done to safeguard oneself from volatile gold price. This page is targeted to those (customers or jewelers) who want to understand basic concept of Hedging in general and hedging of gold in particular.

Hedging Introduction

Generally, people (even jewelers) don’t know about hedging, while some of them know the meaning of hedging but don’t know how to hedge.

Hedging is about doing things that reduce your exposure to bad events. It is not about making money, it is rather about reducing risk. Hedgers use the futures market to protect themselves against the risk of fluctuating prices. It means, taking a position in futures market that is opposite to exposure in the physical market with objective of reducing or limiting risks associated with price changes.

A Future is simply a deal to trade commodity at terms (i.e. amounts and prices) decided now, but with a settlement day in the future. That means you don't have to pay up just yet (at least not in full) and the seller doesn't need to deliver you the good just yet either.

To offset the price risk, a business person can "hedge" by buying or selling a futures contract. This ensures that whenever he loses in the spot (actual, current market), he can make up in the futures market to offset the difference. However, opposite is also true, i.e. if he makes money in spot market, then it will be offset by loss in futures market.

How Hedging Works?

The long position holder (the party who will buy the commodity) attempts to lock in the lowest price that they can. The short position holder (the party who will sell the commodity) is tries to secure the highest possible price. The advantage for both parties is that the futures contract gives them both certainties relating to the price.

Futures contracts can be purchased and sold in the market through regular brokers. Contracts are created by the futures market. At the end of each day there are an equal number of sellers and buyers in each contract and the sum of all profits and all losses by all market participants is zero, i.e. a zero-sum game (unlike the stock market, where everyone can make or lose money).

Gold Hedging

The wholesalers and retailers are (or should be) concerned with earning profit from difference between "making charge" paid to jewelry manufacturers and the revenue generated from jewelry sales rather than the underlying price of gold.

High and volatile gold prices not only impact demand for gold and jewelry, but also increase the impact cost of misjudging demand due to inefficiency in buying of gold.

Most of the jewelers buy gold at market prices whenever they need to buy, irrespective of the prices. But, in today’s fast changing world this mode of working involves 2 types of risks:

• Foreign Exchange Rate Risk – Due to change in relative value of currencies.
• Gold Price Risk – Due to fluctuation in price of gold.

This article is about gold hedging, which is done to reduce risks involved due to fluctuation in gold price.

The gold futures market is used by jewelers to hedge their gold against market price fluctuations. With the below example, you will get to know that how a jeweler do gold hedging and protects himself from running into losses due to continuously surging gold price.

Let’s assume a jeweler will need to procure 100 ounces of gold in 3 months' time. The prevailing spot price for gold is USD 2000.00/oz. To hedge against a rise in gold price, the jeweler can lock in a future purchase price (say USD 2010.00/oz) by taking a long position in an equivalent number (equal to 100 ounce gold) of Gold futures contracts.

Gold hedging guarantees that the jeweler will be able to purchase 100 troy ounces of gold at USD 2010.00/oz. Let's see how this is achieved by looking at scenarios in which the price of gold makes a significant move either upwards or downwards by delivery date.

Scenario 1 - Gold Spot Price Increase by 10% to USD 2200.00/oz on Delivery Date

With the increase in gold price to USD 2200.00/oz, the jeweler will now have to pay USD 220,000 for the 100 troy ounces of gold. However, the increased purchase price will be offset by the gains he made in the futures market. How? See below…

By delivery date, the gold futures price will have converged with the gold spot price and will be equal to USD 2200.00/oz. As the long futures position (unlimited profit, unlimited risk position) was entered at a lower price of USD 2010.00/oz, jeweler will have gained USD 2200.00 - USD 2010.00 = USD 190.00 per ounce. With 100 ounces of gold, the total gain from the long futures position will be USD 19,000.

So, in the end, the higher purchase price will be offset by the gain in the gold futures market, resulting in a net payment amount of USD 220,000 - USD 19,000 = USD 201,000. This amount is equivalent to the amount payable when buying the 100 troy ounces of gold at USD 2010.00/oz.

Scenario 2 - Gold Spot Price Decrease by 10% to USD 1800.00/oz on Delivery Date

With the spot price having fallen to USD 1800.00/oz, the jeweler will only need to pay USD 180,000 for the gold. However, this savings made in spot market will be offset by the loss in the futures market. How? See below…

By delivery date, the gold futures price will have converged with the gold spot price and will be equal to USD 1800.00/oz. As the long futures position was entered at USD 2010.00/oz, jeweler will have lost USD 2010.00 - USD 1800.00 = USD 210.00 per ounce. With 100 ounces, the total loss from the long futures position will be USD 21,000.

So, the savings realized from the reduced purchase price for the gold will be offset by the loss in the gold futures market and the net amount payable will be USD 180,000 + USD 21,000 = USD 201,000. Once again, this amount is equivalent to buying 100 ounces of gold at USD 2010.00/oz.

As you can see from the above examples, the downside of the long hedge is that the jeweler would have been better off without the hedge if the price of the commodity fell. But, because price of gold is more likely to increase, the futures contract is a good way for the jeweler to protect himself from gold price rise risk.

Conclusion

Lack of awareness of gold hedging and hedging strategies has resulted in losses for those in gold trade and gold related areas. World gold council and other related agencies need to do more to spread the awareness of the need for hedging.

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