Issue 20

Quick Study... Barrier Options For Producers

For the last ten years, producers have considerably modified their hedging strategies. Traditional forward sales have lost ground to options. Where forward sales lock the price of physical sales regardless of the gold price at maturity, European put options allow producers to participate in an upside movement at maturity while still being fully protected against the downside. This upside participation is an important feature both for producers increasing their cash flows alongside with the gold price and for some shareholders expecting a good level of correlation between their shares and the gold price.

However, there is no free lunch: a premium has to be paid when purchasing such insurance. The premium for puts is traditionally paid in cash at the time of the transaction, but can also be paid in several instalments (synthetic puts) or financed by other instruments: additional sale of calls (collars), additional forward sales at a lower price than the market, gold interest rate swaps, etc. Another way of reducing this hedging cost is to use options with lower premiums, such as barrier options, part of the "path-dependent" option generation.

Barrier options

Classic European put options do not take into account possible spot movements during their lives. This is important since markets J o not necessarily move progressively in one direction, but can also retrace their steps, resulting in a small net movement. A producer holding a European put option may not have the opportunity to benefit from a sudden peak in the market, as the gold price and the strike price are only compared at the maturity date. In fact, for "static" hedgers protecting their physical sales at maturity, the life of a European option can be summarised as the conception at transaction date and the birth and death at maturity.

The life of a barrier option is significantly longer since it starts at the transaction date and stops when the barrier is triggered or at maturity.

There are two types of barrier options, also called one-touch or option with limits.

Knock-out option - has a cancellation limit. If the gold spot price trades at a predetermined level (the limit ) at any time during the life of the option, the contract is automatically cancelled.

Knock-in option - the mirror image of a knockout option. If at any time during the life of the option the gold spot price trades at a predetermined level, a defined option appears.

The premium of a barrier option is always cheaper than a European option, as there is a probability that the barrier option disappears (a knockout ) or never appears (a knock-in) . In fact, the higher this probability (measured by the barrier level vs market price), the lower the premium.

Case Study

Purchase of a knock-out put with a forward sale order.

This is the simplest and one of the most effective strategies in using barrier options. The producer is protected if the gold price slides, but still takes advantage of a price rise.

The producer purchases a knock-out put with a barrier over the strike price and simultaneously leaves an order to sell forward the same amount of gold when gold spot reacJ1cs the level of the barrier. If the barrier is triggered, the output is cancelled and the producer automatically sells forward at a higher level than the barrier. This forward sale order enables the producer to lock an attractive price, avoiding a possible forthcoming drop in the gold price.

Transaction Details

  • Transaction date: June 2000
  • Purchaser: the producer
  • Seller: the bullion bank
  • Option type: knock-output
  • Maturity: December 2001
  • Strike price: US$ 280/oz
  • Barrier level: LISS 300/oz
  • Premium: US$ 5.35/oz

This up-and -output has a 30% discount compared to a standard European US$ 280/oz put.

From the time of the transaction onward, the gold spot price is closely monitored by the bullion bank.

If the barrier is not triggered, the producer is protected by the put at maturity.

If the barrier is triggered by the gold spot price, the producer automatically sells forward for December 2001 at a higher price than the strike price of its put (barrier level + prevailing contango). At the same time, the put is cancelled (no overprotection). The producer has now fixed the sale price of his gold thanks to the forward sale.

No additional premium is paid if the barrier is triggered. The lower cost of this option and the opportunity to set the knockout level at a high gold price make this an attractive strategy.

The juxtaposition of different knock-in and knock-out options can also create strategies such as the "reset option" which allows the producer to improve his strike price with the gold price. Used in combination with other hedging instruments, these options can offer many possibilities, and their wide usage on foreign exchange or interest rate markets proves this ability.

However, whichever such path-dependent strategy is chosen, the golden rule of hedging must not be broken: the producer must initially reconcile physical production and global hedge portfolio to avoid finding himself exposed to unwanted commitments.