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American Barrick Resources Corporation
How Sensitive Would Barrick Stock Be to Changes in Gold Price in the Absence of Risk
Management?
Pre-tax earnings(Exhibit 2)
223m
Reduction in earnings ifgold sold at spot 1,280m oz.X(422-345)Exhibits 2 and 12
(99m)
Proforma pre-tax earnings 124m
Taxes21% tax rate, exhibit 2
(26m)
After-tax earnings 98m
Elasticity of Earnings and Profits for 1% Change in Gold Price
1% change in gold price $3.45
Number of ounces 1,280m
Additional pre-tax profits $4.4m
Additional after-tax profits $3.5
Additional profits as % of earnings 3.5%
Cash flow = Earnings + Noncash charges
= 98m + 69m = 167m
Additional profits as % of cash flow 2.1%
What is Barrick’s Risk Management Program?
Guidelines
• Fully protected against price declines for 3 years output.
• 20-25% for next decade.
Why Manage Gold Price Exposures?
Arguments
• Pure bet on operational efficiencies for investors.– Do they want that or do they want gold?
• Have funds available to invest when external financing is costly.
• Eliminating deadweight costs of distress.
• Tax arguments: If net income is negative, lose use of tax shields.
Ownership and Risk Management
• If managers have large stake in firm, they don’t want the risk.
• Eliminating hedgeable risks makes it possible to have concentrated ownership.
• Barrick management owns 29.6% of Barrick for a value of $900m.
• Let’s look at the other firms: Exhibit 3.
What Instruments Did They Use to Manage Risks?
Gold Financing of Acquisitions
• Cullaton gold trust:– 3% of mine output when gold price was below
$399 per ounce.– Rising to 10% when gold price was at $1,000
per ounce.
• How to value this?
Tricky: Nonlinear
• Fraction paid:
Min[(0.03 + 0.07*Max((P - 400)/600),0), 0.1]
Example: 600, 0.03 +0.07*0.33 = 0.053.• Payoff:
Min[(0.03 + 0.07*Max((P - 400)/600),0), 0.1]*P
Example: 0.03*600 + 0.053*600 = 32.
Gold price
Payoff
200 400 600 800 1000 1200
20
40
60
80
100
120
Gold Loans
• Gold loan is equivalent to risk-free loan plus forward sale of gold.
Forward Price and Contango
• To get gold at future date:
• Solution one: Invest at risk-free rate + Long forward.
• Solution two: Buy gold today.
• Twist: Since you don’t need gold until future date, you can lend it and earn gold lease rate.
Example: Exhibit 9• Interest rate is 16.83%; lease rate 2%.
• Cost of forward strategy for one year: F/1.1683
• Cost of spot strategy. Since you gain 2% by leasing, you need 1/1.02 units of gold to get one at maturity: S/1.02
• F = S*1.1683/1.02 = S*1.1545or forward exceeds spot by 15.45%
Collars
• Barrick was willing to use options, but only in the form of costless collars.
• Buy put and sell call so that premium of put equals premium of call.
• Example: One year, gold at $333, LIBOR at 4%, gold lease rate at 1.8%, and volatility of gold at 7%.
Examples
• Put at $300 strike, premium is $0.30.
• Call at $350 strike, premium is $5.44.
• To create a costless collar, sell 0.055 call for each put.
• If call is at $370 strike instead, premium is $1.29. You have to sell 0.23 calls.
Spot Deferred Contracts
• What are they?
Spot at t = 0 is $300, LIBOR is 6% and lease rate is 2%
t = 0 t = 1 t = 2 t = 3
Production 200 oz. 200 oz.
Forward at t=0 $312
Case 1: Hedge With Forwards, Spot Is at $500 at t = 1
• Value of production sold at forward:
200 x 312 = $62,400.
• Value of production sold at spot:
200 x 500 = $100,000.
• Value of forward contract just before t=1:
-$37,600
Case 2: SDC contracts
• At t = 0, Barrick enters in contract to sell either at t = 1 or at t = 2.
• If at t = 1, it chooses not to deliver on contracts, it sells on spot market at $500.
• The price set so that “both parties are indifferent between rolling over the contract for another year or closing out the SDC contract and initiating a new one-year forward contract”
Setting the Price
• Keep LIBOR and gold lease rate constant.
• Forward at t=1 is then:
500 x (1+ 0.06 - 0.02) = 520
• Barrick made a loss of $188 that has to be carried forward at 6%.
• So, new price is 520 - $188 x (1.06) = $320.72
Did Barrick Follow Its Policy?
No.
• Stopped writing options in 1990 and used only spot deferred.
• By 1992, historical low for gold and gold volatilities.
• In 1992, it could insure against gold prices falling below $330 at $4.8 an ounce. With a collar, it had to give up 88% of upside above $350. Refused to do so.
• In 1992, could have sold forward at $340 for cash costs of $205.
• Was not willing to do so.
• So, Barrick’s risk management involved substantial speculation.
Who Uses Derivatives?
• Many surveys. Let’s look at the 1998 Wharton/CIBC survey.
• Sent out to 1,928 firms. 399 responded.• 50% use derivatives.• 42% have increased usage since previous
year; 46% kept constant.• Users: 83% of large firms; 45% of medium
size companies; 12% of small firms.
Most commonly managed risks for users
• FX, 96%.
• Interest rate, 76%.
• Commodity, 56%.
• Equity, 34%.
Concerns
• Accounting treatment (high concern for 37%).• Market risk (31%).• Monitoring/evaluating hedging results (29%).• Credit risk (25%).• Liquidity (21%).• SEC disclosure (21%).• Reaction by analysts, investors (18%).
Which FX hedging
• Balance sheet commitments (frequently for 54%; average exposure hedged, 49%).
• Off balance sheet commitments (24%; 23%).• Anticipated transactions less than 1 yr (46%; 42%).• Anticipated transactions more than 1 yr (12%;
16%).• Hedge competitive exposure (11%; 7%).• Hedge translation (14%; 12%).
Maturity effect for FX hedging
0%10%20%30%40%50%60%70%80%90%
1-90days
91-180days
181days -1 year
1 - 3years
3+years
0%1-25%26-50%51-75%75-100%
Maturity of exposure
Percentageof respondingfirms
Does market view matter?
• 49% sometimes alter timing of hedges and 51% sometimes alter size according to market view.
• 6% frequently take positions, 26% do so sometimes, to exploit market view.
Interest rate derivatives
• Almost all firms using interest rate derivatives report swapping from floating to fixed.
Options
• 68% of firms use options; 44% use FX options.
• 42% use European, 38% use American, 19% use average rate, 9% use basket, 13% use barrier.
• 47% of FX derivatives users use basket options, 39% use average rate, and 69% use barrier!
Reporting and valuation
• 4% report to directors monthly, 23% quarterly, and 17% annually.
• 19% value daily; 9% weekly; 27% monthly.
• 40% want risk management to decrease volatility; 22% want increased profit.
• 60% of those who do not use do so because lack of exposure.
Tufano’s analysis
• Looks at gold industry.
• Advantage: Detailed data on exposures and hedges.
• Disadvantage: One industry.
• Key result: Managerial options and ownership are important.
Why the Spectacular Success of Derivatives?
• They enable you to alter risk.
• Derivatives can allow you to take risks that are advantageous.
• Derivatives make it possible for you to shed risks that are costly.
• It is only recently that finance figured out how to do all this well.