A combination of emotion, lack of knowledge and unclear planning can lead a hedge manager to enter a strategy that may be entirely unsuitable risk wise. Or a strategy may fit within the hedging criteria at the outset but, with a change in the volatility and/or direction of market prices, its nature may alter so significantly that over time it no longer is able to meet the hedger's goals. Using a back-to-basics risk management approach would provide integrity to a hedging program in each instance.

The metals market of 2001 is a very different animal to that of the middle to late '90s. The appetite of mining companies, refiners, central banks and bullion banks alike for risk has changed dramatically. In general terms, the clear trend has become well entrenched - in fact, the occasional pockets of extreme positive price action are symptomatic of such a trend. These occasions provide crystal clear examples of how exotic derivative-based hedge strategies can increase the risk to the underlying price rather than mitigate it.

Each and every product listed above has its place in a hedge portfolio - the keyword here is portfolio. We believe a portfolio approach to risk management is paramount. Vanilla options are the building blocks we will focus on.

The term leverage - to influence people or events - can conjure up all manner of negative thoughts, but a simple bought put option provides just that. In the current climate, we recommend the purchase of a strip of put options with standard deliveries, which will guarantee a minimum buffer over cash costs. The combination of a known worst-case scenario and an evenly spread maturity profile provides the hedge manager with flexibility and an implied positive mindset. Unlike selling a strip of calls, the market price can move through the option strike without materially impacting the hedge manager's decision-making process.

Costs and Approaches

What does it cost? Like any insurance cover, there is a premium attached, a cost that many hedge managers in the past have been reluctant to pay. This payment can be deferred to the option expiry date or dates, thereby matching the delivery schedule.

But nothing comes for free. The granting of call options to fund the purchase of put options (for zero cost) decreases the hedge manager's participation in a rising market and creates uncertainty over whether the sold call will get stuck in the market.

  • We recognise that the above is the simplest of approaches; however, simplicity can lead to success. Let's explore the original goals and expectations highlighted earlier:
  • We have established that risk appetite may well be lower in the current environment. Buying put options at a known cost immediately identify a worst-case scenario for the hedge manager.
  • Owning a 'floor' on the underlying asset price suggests that everything else is an upside - that is, full participation in a rising market.
  • In the current environment, business and management cycles are shorter than in the past. When coupled with the ongoing credit-assessment process, the benefit of insurance cover is two-fold: bought puts guarantee downside protection and enable the hedge manager to evaluate risk (market and systemic) in a more impartial manner. Looking ahead, we expect the average maturity profile of hedge books to be less than five years.
  • It's all well and good for a hedge strategy to be a 'fit' at inception, however, in certain market conditions the hedge profile may change dramatically. For example, the hedge manager might boy a gold put, and For zero cost sell a gold call at the same strike that knocks-in at a price higher than current spot (intriguingly termed a smart forward). This may be quite appropriate in a flat-to-weaker price cycle, but in a Washington Agreement scenario, the hedge manager is left with additional out-of-the-money hedging.
  • It is not unusual for liquidity in the exotic derivatives market to decrease in a volatile price environment. This may materially impact the hedge - manager's ability to exit from the strategy.
  • There is no doubt risk management systems do not in any way resemble their predecessors of the last decade. Having said that, any strategy must begin and end with the right hedging philosophy. The hedge manager must have a thorough understanding of the behaviour of the strategy and its ramifications over a range of prices.

In summary, today's low but fickle gold price environment requires a pragmatic and controlled approach to risk management. Hedge managers can do well to deploy derivative tools which protect them from downside risk without committing them either to unlimited loss of upside potential or to a tenor which exceeds the reduced parameters of our modern clay business cycle.

The success of any investment or risk management decision is inextricably linked to its appropriateness at the outset. The key is to tailor any strategy around the hedger's goals and expectations with specific regard to the following:

  • Appetite for risk
  • Expected returns and participation levels
  • Time horizon
  • Liquidity - How easily can the hedger exit from the strategy undertaken?
  • Systems and infrastructure - Can the hedger properly value and account for risk?
  • Knowledge - Does the hedger fully understand the strategy?

The Hedger's Tools

Hedgers have the following tools at their disposal to manage the price risk of an underlying commodity?

  • Forward sale
  • Commodity loan
  • Derivatives - including vanilla put/call options, exotic options and interest rate swap.