Gold Derivatives: The Market View

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The information presented here has come from the publication:
Gold Derivatives: The Market View: PDF File
Interest rates refer throughout this chapter to dollar or local currency interest rates as opposed to gold lease rates.
THE PRODUCTS


5.1 THE FORWARDS
5.1.1  The fixed forward
5.1.2  The floating gold rate forward
5.1.3  The floating forward
5.1.4  The spot deferred
5.1.5  The participating forward
5.1.6  The advance premium forward
5.1.7  The short-term averaging forward
5.2 THE OPTIONS
5.2.1  The put option
5.2.2  The call option
5.2.3  The cap and collar or the min-max
5.2.4  The up and in barrier option (kick/knock-in)
5.2.5  The down and out barrier option (knock out)
5.2.6  The convertible ‘forward'
5.3 The basic lease rate swap

5.1. THE FORWARDS



5.1.1 The fixed forward
Definition:The most basic forward contract that allows the seller to deliver an agreed volume of gold for an agreed price at a future agreed date.

UNDERLYING FINANCIAL PARAMETERS:
Price: Fixed based on spot at execution.
US$ (local) interest rate: Fixed – compounded annually.
Gold lease rate: Fixed – compounded annually.
Contango: Calculated from the above two parameters and fixed.
Maturity: Fixed.

Application and usage: Best selected when interest rates are high and not likely to rise further or could even fall during the life of the contract. Best selected when gold lease rates are low and are unlikely to fall further but could actually rise during the life of the contract. The two situations will yield the optimal level of contango. From the miner's point of view best selected when delivery of metal is guaranteed.

Advantages to the user: Offers guaranteed contango and price protection in the event of declining gold prices. All financial parameters associated with the contract are known. Does not require active management after it is executed unless the miner elects to restructure. Can be unwound before delivery.

Disadvantages to the user: Inflexible delivery dates. The user cannot put into practice any specific views on either the lease rate or interest rates. Can lock in unfavourable contango if the lease rates and/or interest rates move against the hedger. For fixed forwards beyond 12 months, the executing bank quotes for a period beyond which gold borrowing can readily be hedged; a factor which is ultimately reflected in the price. Can incur an opportunity cost should the market price consolidate at levels higher than the contract price (including contango).

IMPACT ON THE PRICE OF GOLD:
Immediate impact: 100% - the executing bank borrows the equivalent amount of gold and sells it immediately into the market.
Subsequent impact: On delivery, the executing bank unwinds the short position and delivers gold back to the original lender.

Cost to the user: Bank commission and any cost of restructuring. Potential opportunity costs as described above.
 
 

5.1.2 The floating gold rate forward
Definition: Standard forward contract in which the gold price and interest rates are pre-agreed and locked-in. The gold lease rate is allowed to float and is calculated at maturity based on its performance during the life of the contract. It is most common for the three-month lease rate to be used.

UNDERLYING FINANCIAL PARAMETERS:
Price: Fixed based on spot at execution.
US$ (local) interest rate: Fixed – compounded annually.
Gold lease rate: Floating – calculated on maturity.
Renewal date is flexible but usually done quarterly or bi-annually.
Contango: Calculated from the above two parameters at maturity.
Maturity: Fixed.

Application and usage: Best selected when interest rates are high and not likely to rise further or could even fall during the life of the contract. Best selected when gold lease rates are high and could fall during the life of the contract. The two situations will yield the optimal level of contango. From the miner's point of view best selected when delivery of metal is guaranteed.

Advantages to the user: Offers guaranteed contango and price protection in the event of declining gold prices. More flexible than the fixed forward with respect to the user's views on future lease rates. Does not require active management after it is executed unless the miner elects to restructure. Can be unwound before delivery. Three-month lease rates appear more cost effective than other rates. Allows greater flexibility than the fixed forward in that interest rates can be locked-in but lease rates float. Beyond 12 months, the problem associated with the fixed forward is overcome as the gold lease rates are quoted for periods shorter than the contract life.

Disadvantages to the user: Inflexible delivery dates. The user cannot put into practice any specific views on future interest rates. Can lock-in unfavourable contango if the interest rates move against the hedger. If the lease rates rise during the life of the contract, the cash adjustment is payable by the hedger. Settlement is payable on maturity. Final contango is confirmed only on maturity. Can incur an opportunity cost should the market price consolidate at levels higher than the contract price (including contango).

IMPACT ON THE PRICE OF GOLD:
Immediate impact: 100% - the executing bank borrows the equivalent amount of gold and sells it immediately into the market.
Subsequent impact: On delivery, the executing bank unwinds the short position and delivers gold back to the original lender.

Cost to the user: Bank commission and any cost of restructuring. Potential opportunity costs as described above.
 
 

5.1.3 The floating forward
Definition: Forward contract in which the gold price is pre-agreed but the interest rates and gold lease rates are allowed to float and are calculated at maturity based on their performance during the life of the contract.

UNDERLYING FINANCIAL PARAMETERS:
Price: Fixed based on spot at execution.
US$ (local) interest rate: Floating – calculated on maturity.
Renewal date is flexible but usually done quarterly or bi-annually.
Gold lease rate: Floating – calculated on maturity.
Renewal date is flexible but usually done quarterly or bi-annually.
Contango: Calculated from the above two parameters at maturity.
Maturity: Fixed.

Application and usage: Best selected when interest rates are likely to rise further and gold lease rates are likely to fall during the life of the contract. The two situations will yield the optimal level of contango. From the miner's point of view best selected when delivery of metal is guaranteed.

Advantages to the user: Offers guaranteed contango and price protection in the event of declining gold prices. Allows user to put into practice specific views with respect to future lease rates and interest rates. Does not require active management after it is executed unless the miner elects to restructure. Can be unwound before delivery. Allows greater flexibility than preceding forwards in that interest rates and lease rates float. Beyond 12 months, the problem associated with the fixed forward is overcome as the gold lease rates are quoted for periods shorter than the contract life.

Disadvantages to the user: Inflexible delivery dates. Can lock-in unfavourable contango if the interests rates and/or lease rates move against the hedger. Slightly more after-execution attention is required with respect to interest rate and lease rate renewals. Settlement is payable on maturity. Final contango is confirmed on maturity. Can incur an opportunity cost should the market price consolidate at levels higher than the contract price (including contango).

IMPACT ON THE PRICE OF GOLD:
Immediate impact: 100% - the executing bank borrows the equivalent amount of gold and sells it immediately into the market.
Subsequent impact: On delivery, the executing bank unwinds the short position and delivers gold back to the original lender.

Cost to the user: Bank commission and any cost of restructuring. Potential opportunity costs as described above.
 
 

5.1.4 The spot deferred
Definition: Forward contract in which the gold price is pre-agreed; interest rates and gold lease rates are allowed to float. The maturity date is deferrable.

UNDERLYING FINANCIAL PARAMETERS:
Price: Fixed based on spot at execution.
US$ (local) interest rate: Floating – calculated on maturity.
Renewal date is flexible but usually done quarterly or bi-annually.
Gold lease rate: Floating – calculated on maturity.
Renewal date is flexible but usually done quarterly or bi-annually.
Contango: Calculated from the above two parameters at maturity.
Varies with each roll over or deferral.
Maturity: Flexible with indefinite deferral subject to a pre-agreed notice period, commonly 45 days. Notice is usually one full interest period.

Application and usage: Best selected when interest rates are likely to rise further and gold lease rates are likely to fall during the life of the contract. Best selected when delivery of metal is not guaranteed.

Advantages to the user: Offers guaranteed contango and price protection in the event of declining gold prices. Can be unwound before delivery. Allows the user to put into practice specific views with respect to future lease rates and interest rates. No fixed delivery date and metal can be delivered on or before maturity or deferred indefinitely. Flexible delivery reduces loss of upside participation into a price rally. If spot prices exceed the contract price (including contango), delivery is deferred.

Disadvantages to the user: Executing bank can eventually request delivery and serve notice. The bank might serve notice if the mine is in default on other contracts, exceeds credit limits or operates at a substantial loss. Slightly more after-execution attention is required with respect to interest rate and lease rate renewals. Settlement is payable on maturity.

IMPACT ON THE PRICE OF GOLD:
Immediate impact: 100% - the executing bank borrows the equivalent amount of gold and sells it immediately into the market.
Subsequent impact: On delivery, the executing bank unwinds the short position and delivers gold back to the original lender.

Cost to the user: Bank commission plus the cost of any restructuring. The more regular the renewal period, the greater the cost of deferral and the shorter the delivery notice.
 
 

5.1.5 The participating forward
Definition: Forward contract with a purchased call option attached.

UNDERLYING FINANCIAL PARAMETERS:
Price: Fixed based on spot at execution.
US$ (local) interest rate: Fixed – compounded annually.
Gold lease rate: Fixed – compounded annually.
Contango: Calculated from the above two parameters and fixed.
Maturity: Fixed.
Option strike price: Pre-agreed – depending on potential forward contango and intended volume of options.
Option maturity: Pre-agreed usually matched to forward maturity.

Application and usage: Best used when the potential loss of upside participation is a major concern. Used mostly during periods of high price volatility. Best selected when interest rates are high and when gold lease rates are low. The two situations will yield the optimal level of contango. From the miner's point of view best selected when delivery of metal is guaranteed.

Advantages to the user: Offers guaranteed price protection in the event of declining gold prices. All financial parameters associated with the contract are known. Does not require active management after it is executed unless the miner elects to restructure. Can be unwound before delivery. Loss of upside participation is reduced by the call option which is exercised if the spot price on maturity exceeds option strike price. Most contracts offer the ability to re-write the contract thus locking-in higher prices as the spot rallies which is an advantage over min-max (collars) strategies.

Disadvantages to the user: Inflexible delivery dates. No contango is earned since the contango pays for the call options. Slightly more after-execution attention required if the option is to be exercised. The option is exercisable only if it is in-the-money. If the spot price exceeds the contract price but the options are out-of-the-money the option expires worthless and the contango is lost. On using the rewriting facility, the upside participation is reduced. There is an opportunity cost if the gold lease rates fall and/or the interest rates rise during the life of the contract since the option buying power is reduced.

IMPACT ON THE PRICE OF GOLD:
Immediate impact: 100% of the forward leg of the contract - the executing bank borrows the equivalent amount of gold and sells it immediately into the market. The call option writer is initially a buyer of gold depending on the delta.
Subsequent impact: On delivery, the executing bank unwinds the short position and delivers gold back to the original lender. The call option writer becomes a subsequent buyer of gold if the gold price rises and a seller if the gold price falls depending on the delta. The delta hedging against the options cannot be greater than 100% of the underlying volume of gold associated with the options (not necessarily equal to the volume associated with the forwards).

Cost to the user: Bank commission and cost of any restructuring. Price of the options (forgone contango). Cost of the rewrite facilities.
 
 

5.1.6 The advance premium forward
Definition: A forward contract in which the contango is partly payable in advance. Also known as the flat rate forward or the stablised contango.

UNDERLYING FINANCIAL PARAMETERS:
Price: Fixed based on spot at execution.
US$ (local) interest rate: Fixed – compounded annually.
Gold lease rate: Variable.
Contango: Calculated from the above two parameters.
Maturity: Fixed.

Application and usage: Best selected when interest rates are high and not likely to rise further or could even fall during the life of the contract. Best selected when gold lease rates are high and could fall during the life of the contract. The two situations will yield the optimal level of contango. From the miner's point of view best selected when delivery of metal is of no concern. Best used in the early years of a project when the greater contango can coincide with cash flow requirements. Most effective for long-term hedging.

Advantages to the user: Offers guaranteed contango and price protection in the event of declining gold prices. Contango paid upfront has cash flow advantages. Conversion of a standard forward into an advance premium forward allows for early realisation of hedging profits. Does not require active management after it is executed unless the miner elects to restructure. Can be unwound before delivery.

Disadvantages to the user: Inflexible delivery dates. Can lock-in unfavourable contango if the interests rates move against the hedger. Settlement is payable on maturity. Slightly more after execution attention required because of contango payments. The early payment of the contango is at the expense of yield in the later years of the contract. Can incur an opportunity cost should the market price consolidate at levels higher than the contract price (including contango).

IMPACT ON THE PRICE OF GOLD:
Immediate impact: 100% - the executing bank borrows the equivalent amount of gold and sells it immediately into the market.
Subsequent impact: On delivery, the executing bank unwinds the short position and delivers gold back to the original lender.

Cost to the user: Bank commission plus the cost of any restructuring. Opportunity costs as described above.
 
 

5.1.7 The short-term averaging forward
Definition: A forward contract locking in an average, not the spot price.

UNDERLYING FINANCIAL PARAMETERS:
Price: Average of the am/pm London gold fixes over a pre-selected period.
US$ (local) interest rate: Fixed – compounded annually.
Gold lease rate: Variable.
Contango: Calculated from the above two parameters.
Maturity: Fixed.

Application and usage: Best selected when maximising revenue from short-term production. Best selected when interest rates are high and not likely to rise further or could even fall during the life of the contract. Best selected when gold lease rates are high and could fall during the life of the contract. The two situations will yield the optimal level of contango.

Advantages to the user: Offers guaranteed contango and price protection in the event of declining gold prices. Does not require active management after it is executed unless the miner elects to restructure. Can be unwound before delivery. Reduces the probability of the contract price being the low for the period. With the contango, the achieved price is guaranteed to exceed the average of the London fixes for the duration of the contract. Averaging slightly reduces the opportunity costs incurred with other forward products if the market prices stabilises above the contract price (including contango).

Disadvantages to the user: Inflexible delivery dates. Can lock-in unfavourable contango if the interest rates move against the hedger. Possible opportunity cost incurred in averaging rather than attempting to lock-in the highs.

IMPACT ON THE PRICE OF GOLD:
Immediate impact: 100% - the executing bank borrows the equivalent amount of gold and sells it immediately into the market.
Subsequent impact: On delivery, the executing bank unwinds the short position and delivers gold back to the original lender.

Cost to the user: Bank commission plus the cost of any restructuring. Opportunity costs as described above.
 

5.2. THE OPTIONS
5.2.1 The put option
Definition: A contract that gives the buyer the right but not the obligation to sell gold at a pre-agreed price at an agreed date. There is an obligation on the part of the option writer to take delivery of gold at the agreed price on the agreed date should the option be exercised.

UNDERLYING FINANCIAL PARAMETERS:
Strike price: Pre-agreed at the time of execution.
US$ (local) interest rate: Pre-agreed at the time of execution.
Gold lease rate: Pre-agreed at the time of execution.
Maturity: Pre-agreed at the time of execution.
Implied price volatility: Quoted by the option writer.

Application and usage: Widely bought by the mining industry since the put offers price protection on the downside at finite cost without limiting upside participation in any rally in the gold price.

Advantages to the user: Costs of the hedge are limited to the premium paid for the option. Since the product offers price protection on the downside without limiting potential participation in a price rally, it is a mechanism that is clearly more acceptable than forwards to many shareholders and boards.

Disadvantages to the user: Price of options can be high depending on how close to the money they are at the time of writing. Price protection has to be paid for without the earning of any contango as in a forward.

IMPACT ON THE PRICE OF GOLD:
Immediate impact: Put option buyers will tend not to delta hedge any of the exposure. The writer (the commercial banks) will initially be a seller depending on the delta. Primary delta hedging is normally around 40-45% of the underlying volume.
Subsequent impact: The bank will remain a seller into any price declines but will become a buyer into any price rises depending on the delta. The delta hedging against the options cannot be greater than 100% of the underlying volume of gold.

Cost to the user: Initial premium and any cost associated with restructuring.
 
 

5.2.2 The call option
Definition: A contract that gives the buyer the right but not the obligation to buy gold at a pre-agreed price at an agreed date. There is an obligation on the part of the option writer to deliver gold at the agreed price on the agreed date should the option be exercised.

UNDERLYING FINANCIAL PARAMETERS:
Strike price: Pre-agreed at the time of execution.
US$ (local) interest rate: Pre-agreed at the time of execution.
Gold lease rate: Pre-agreed at the time of execution.
Maturity: Pre-agreed at the time of execution.
Implied price volatility: Quoted by the commercial bank generating the calls.

Application and usage: Widely written by the mining industry in order to earn a premium. Also written by a number of central banks. The premium either pays for put options bought or enhances average realised prices of the balance of the hedging (in the case of the miners) or renders gold holdings income bearing (in the case of the official sector). The calls are left naked to maximise the premium earned.

Advantages to the user: Offers additional revenue particularly if the hedger is of the opinion that the spot price will not exceed the strike price of the calls. The hedger (especially the central banks) may be willing to deliver against the calls should they be exercised.

Disadvantages to the user: Since these options are sold by the hedger although created by the commercial banks, the potential loss should the price move against the contract is unlimited. Loss of upside participation emerges once the market price exceeds the option strike price.

IMPACT ON THE PRICE OF GOLD:
Immediate impact: Calls written by the hedger are deliberately left naked and thus the hedger does not delta hedge this position in any way. The executing bank as the call option buyer, is initially a seller depending on the delta.
Subsequent impact: The bank will be a seller into any price rises and will become a buyer into any price falls depending on the delta. The delta hedging against the options cannot be greater than 100% of the underlying volume of gold.

Cost to the user: Initially nothing to the option granter since the calls written generate income. Subsequently, any restructuring may incur a cost depending on the nature of the transaction.
 
 

5.2.3 The cap and collar or the min-max
Definition: An option strategy in which the user buys put options and writes call options.

UNDERLYING FINANCIAL PARAMETERS:
Strike prices: Pre-agreed at the time of execution.
US$ (local) interest rate: Pre-agreed at the time of execution.
Gold lease rate: Pre-agreed at the time of execution.
Maturity: Pre-agreed at the time of execution.
Implied price volatility: Quoted by the issuing commercial bank.

Application and usage: Widely used by the mining companies to secure downside protection in the gold price (via put options) but to offset the cost of that protection via the granting of call options. The premium earned by the calls pays either in part or totally for the puts options bought. The calls are left naked to maximise the premium earned.

Advantages to the user: Offers price protection at either no or greatly reduced costs. The miner can stipulate the levels at which the call options are written. The ratio of put options bought to call options written is usually 1:3.

Disadvantages to the user: Since the call options are written by the miner, the potential loss should the price move against the contract is unlimited. Loss of upside participation when the market price exceeds the call option strike price. The further out-of-the-money the call options are written the lower the premium paid and hence the greater volumes that have to written to secure the desired cost saving. The closer into-the-money the calls are written, the greater the premium earned but the greater the possibility of them being exercised.

IMPACT ON THE PRICE OF GOLD:
Immediate impact: The miner or user does not delta hedge either the put options bought or the calls options written. With respect to the put options written and the call options bought, the executing bank is an initial seller.
Subsequent impact: The bank's subsequent delta hedging will be as follows:
With respect to the calls bought: a seller into a price rise and a buyer into price falls;
With respect to the puts written: a buyer into a price rise and a seller into price falls.

The delta hedging against the options cannot be greater than 100% of the underlying volume of gold.

Cost to the user: Initially, either nothing or minimal since the calls are written with the express intention of funding the puts. Costs incurred in any subsequent restructuring depending on the transaction. Unlimited loss potential via call option writing.
 
 

5.2.4 The up and in barrier option (kick/knock-in)
Definition: An option strategy in which the options (either calls or puts) are triggered and come into being if a pre-agreed price level is broken at any stage of the contract life. Up and in put options have little use to the mining industry.

UNDERLYING FINANCIAL PARAMETERS:
Trigger prices (knock-in) boundary:Pre-agreed at the time of execution.
US$ (local) interest rate: Pre-agreed at the time of execution.
Gold lease rate: Pre-agreed at the time of execution.
Maturity: Pre-agreed at the time of execution.
Implied price volatility: Quoted by the issuing commercial bank.

Application and usage: Most commonly up and in call options are written by the mining industry with trigger prices at intervals above spot at the time of the transaction. The calls then only come into being once the spot price hits the trigger price. The kick-ins are usually bought in conjunction with other option strategies, commonly put options in which case the calls offer some upside participation in a price rally but only until the trigger price.

Advantages to the user: Affords the mining industry upside participation in the gold price between any put option strike price (existing price protection) and the trigger price of the kick-ins.

Disadvantages to the user: Upside participation into a price rally is limited only through to the trigger beyond which the calls come into being. The premium earned is less than that earned by writing a vanilla call since the buyer forfeits some time value. Very commonly the trigger is valid only for a certain usually limited period throughout the option life which in turn can limit the window of opportunity during which the options can be brought into existence.

IMPACT ON THE PRICE OF GOLD:
Immediate impact: The option buyer (in this case the commercial bank) will be an initial delta hedge seller.
Subsequent impact: The option buyer will then remain a delta hedge seller into a rising gold price but a delta hedge buyer into price declines. The level of delta hedging increases very sharply as the spot price approaches the trigger price especially if the contract is close to maturity. Thus the delta hedging against these options can and often does greatly exceed 100% of the underlying volume. Deltas of 150-200% are commonplace. Once the trigger price is breached, all the delta hedge selling that has been done is then suddenly reversed and the option buyer will buy back all the delta hedge selling that has taken place. This can have a marked impact on short-term price movements if the options exist in sufficient volume at specific price levels.

Cost: The proximity of the kick-in boundary to the spot price and the strike price at the time of writing greatly affects the price of the option. The further away the boundary, the less the probability of kick-in therefore the more the cost will resemble a vanilla option. Kick-ins tend to be cheaper than ordinary options since the buyer is potentially giving up time value.
 
 

5.2.5 The down and out barrier option (knock out)
Definition: An option strategy (can be either calls or puts) in which the options cease to exist if a pre-agreed price level is broken at any stage of the contract life. A rebate is usually payable if the option is knocked-out, the amount depending on the remaining life of the contract. Down and in options also exist but have little application of the mining industry.

UNDERLYING FINANCIAL PARAMETERS:
Knock-out boundary: Pre-agreed at the time of execution.
US$ (local) interest rate: Pre-agreed at the time of execution.
Gold lease rate: Pre-agreed at the time of execution.
Maturity: Pre-agreed at the time of execution.
Implied price volatility: Quoted by the generating bank.

Application and usage: Calls are used by the mining industry to generate a premium to pay for put options. Put knock-out boundary is usually substantially higher than put strike and spot prices. Most barrier options are priced more on contango rather than spot price.

Advantages to the user: Call options that can cease to exist if the spot price falls. Put options which cease to exist with the spot price rises substantially above the boundary or trigger level.

Disadvantages to the user: Less premium is earned by the writer compared with writing vanilla calls. Very commonly the trigger is valid only for a certain usually limited period throughout the option life which in turns limits the window of opportunity during which the options can be knocked-out.

IMPACT ON THE PRICE OF GOLD:
Immediate impact:
With respect to calls: if the mining industry has written the calls, the buyer (the commercial bank) will be an initial seller depending on the delta.
With respect to puts: if the mining industry has bought the puts, then the buyer (the commercial bank) will be an initial seller depending on the delta.

Subsequent impact:
With respect to the calls as written above: the commercial bank will remain a delta hedge seller into a price rise but will turn a delta hedge buyer into a price fall.
With respect to the puts as written above: the commercial bank will become a delta hedge buyer into a price rally but will turn a delta hedge seller into a price decline.

The level of delta hedging increases very sharply as the spot price approaches the trigger price especially if the contract is close to maturity. Thus the delta hedging against these options can and often does greatly exceed 100% of the underlying volume. Deltas of 150-200% are commonplace. Once the trigger price is breached, all the delta hedge selling (buying) that has been done is then suddenly reversed and the option buyer will buy (sell) back all the delta hedge selling (buying) that has taken place. This can have a marked effect on short-term price movements if the options exist in sufficient volume at specific price levels.

Cost: The proximity of the knock-out boundary to the spot price and the strike price at the time of writing greatly affects the price of the option. The further away the boundary, the less the probability of knock-out and therefore the more the cost will resemble a vanilla option. Knock-outs tend to be cheaper than ordinary options since the buyer is potentially giving up time value.
 
 

5.2.6 The convertible ‘forward'
Definition: This in fact is not a forward at all but an option strategy that involves the mining industry in buying a vanilla put option and selling a kick-in call option. A feature of this strategy is that the options have the same strike price. A variant of this product is the purchase of the vanilla put with the writing of a knock-out call at a trigger level that is substantially below the option strike price.

UNDERLYING FINANCIAL PARAMETERS:
Strike price: Pre-agreed at the time of execution.
US$ (local) interest rate: Pre-agreed at the time of execution.
Gold lease rate: Pre-agreed at the time of execution.
Maturity: Pre-agreed at the time of execution.
Trigger price: Pre-agreed at the time of execution.
Implied price volatility: Quoted by the generating bank.

Application and usage: A complex structure that mimics a forward transaction but offers added (although perhaps limited) flexibility where loss of upside participation is considered an issue.

Advantages to the user: Offers the miners the standard price protection via the put option. It generates a premium via the calls options that in turn offer participation into a price rally to the point at which the option kicks in. Put options can be converted into a forward.

Disadvantages to the user: Upside participation is limited to the trigger point. Window of opportunity is usually limited to a period of the entire option life.

IMPACT ON THE PRICE OF GOLD:
Immediate impact:
The mining company leaves both the puts bought and the calls written unhedged.
The counterparty hedges the strategy as follows:
The puts: an initial seller depending on the delta
The calls: an initial seller depending on the delta

Subsequent impact:
With respect to the puts: The counterparty buys into a price rise and continues to sell into a price fall. Given that the puts are vanilla the total delta hedging cannot exceed 100% of the underlying volume;
With respect to the calls: The counterparty remains a seller into price rises but turns a buyer into a decline in the price. The level of delta hedging increases very sharply as the spot price approaches the trigger price especially if the contract is close to maturity. Thus delta hedging of 150-200% of the volume of the underlying is commonplace. Once the trigger price is breached, all the delta hedge selling that has been done is then suddenly reversed and the option buyer will buy back all the delta hedge selling that has taken place. This can have a marked affect on short-term price movements if the options exist in sufficient volume at specific price levels.

Cost to the user: Bank commission plus cost of any restructuring. Cost of the put options. Probably less cost effective than a forward sale.
 
 

5.3. The basic lease rate swap
Definition: A basic agreement in which gold is lent at a pre-agreed lease rate for a pre-agreed period (usually 3 months). At the end of the period the average lease rate is compared to the contract rate and the differential is paid by the party in debit. The contract is then usually rolled for a further period.

UNDERLYING FINANCIAL PARAMETERS:
Volume: Pre-agreed at the time of execution.
Gold lease rate: Pre-agreed at the time of execution.
Maturity: Pre-agreed at the time of execution.

Application and usage: Used increasingly by the official sector for the purposes of lending gold.

Advantages to the user: Allows roll over of short term lending. Overcomes the tenure mismatch experienced by the bullion banks between their gold on deposit and the length out to which the miners wish to hedge.

Disadvantages to the user: Possible cost incurred if the lease rate moves against the swap during the contract life.

IMPACT ON THE PRICE OF GOLD:
No direct impact on the gold price per se. But has considerable implications for the lending market since the swap allows the official sector to begin taking a longer-term view with respect to their lending policies.
 
 
 
 



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