Apollo Gold Case Study

Fred LeggettMadelyn Puente

14 December 2007

• Apollo Gold (AMEX: AMT) is a gold mining company that has entered into an agreement with streetTRACKS Gold Trust (NYSEArca: GLD), the largest gold ETF, to supply $2,000,000 worth of gold (equivalent to 25 future contracts) for April delivery

• As of October 30, 2007, GCJ8 Futures (April 2008 delivery) is $800.30 per ounce, with 100 ounces per contract

• With new mining ventures and increasingly efficient operations that are continually reducing throughput time, Apollo Gold is reaping the benefits of record Gold prices.

• Apollo applauds its team for landing such a lucrative contract; however, it seems that the company may have acted brashly given the current market conditions and streetTRACKS strong, bullish views (consequently discussed).

Business ProblemApollo Gold and streetTRACKS

From Apollo Gold 10-Q, 3Q 2007:

4th Quarter Forecast: With the completion of the primary crusher project in October 2007, we anticipate that improvement in ore throughput will be achieved and there will be a respective increase in metal productions. As a result, we believe that in the fourth quarter 2007, the Mine should achieve its best operational results of 2007.

• Total Exposure Value: $2,000,000

• Apollo Gold is short as it has already entered into the agreement with streetTRACKS

• The company has an established risk loss limit: only a 5% chance of losing more than $100,000 or 5%

• 5% loss probability associated with +/- 1.65 standard deviations

Position Summary: -25F

Market Outlook• Economic environment, including lower interest rates and

a weakened US dollar, puts upward pressure on Gold prices as investors seek Gold as a safe haven

• US Dollar and oil prices are key drivers of the price of Gold

• Gold is used as an inflationary hedge, and inflationary pressures continue to rise with the price of oil

• Both the value of the dollar and the price of oil are largely political, making the commodity’s price even more volatile

• Over the past 6 months we see:

Source: I-Net; CSSS; Credit Suisse Analyst Report- 30 October 2007

Gold has risen by 19% Oil has risen in price by 35%US $ has weakened by

8% against the Euro

CLH8Price 87.99Call Implied Vol. 26.7530 D Hist. Vol. 26.13

Market Outlook: Volatility

A one-cent change USD/EUR

exchange rate drives the gold

price by US $8/oz

Source: I-Net; CSSS; Credit Suisse Analyst Report- 30 October 2007

Gold Prices sensitive to USD/EUR Movement…

… As well as Oil

US$ and oil volatility are becoming increasingly important drivers of gold. Gold has also displayed seasonality between December and March. As Apollo’s contract is for April, it could be affected by seasonal trend or the decline in the seasonal trend, again affecting volatility

Source: GFMS: World Gold Council; Credit Suisse Standard Securities Estimates, 10-30-2007

Market Outlook: Direction• The forecasted upward trend in Gold prices is largely driven by supply and demand• Global gold production declines as new reserves fail to replace the number of

dying mines• Significant inflation rates (see previous slides) accelerate this decline• Once the current deficit exceeds 500 tons there will be a significant and lasting

increase in the price of gold• An additional 6,679 tons are needed to supply the demand through 2015

Net Deficit

Conclusion:

Market forces of Supply and Demand are invariably pushing the gold price UP

• Direction: We see the price of gold going up, based on:– Supply and Demand market

forces– Rising oil prices– Gold’s role as a safe haven

against rising inflation

• Volatility: We estimate higher volatility than the market’s implied 21.85% volatility based on:– Strong correlations with

uncertainty in both oil prices and the dollar exchange rate

– Gold pricing seasonality at the time of our contract

– Uncertain political influences We estimate 25% volatility

Market Outlook: Our ViewMarket View Summary

Apollo Exposure versus View

• After further investigation, it seems as if Apollo’s -25F (short) exposure is less than ideal given the current up/volatile market environment

• Given the situation, Apollo realizes it is necessary to hedge their initial exposure and effectively reverse their position to long

Critical Price and Risk Premium Calculation• Today is October 30, 2007• For the Gold Contract due April 28, 2008 (GCJ8),

there are 181 remaining days to maturity • Using the Market Implied Standard Deviation of

21.85%, there is a likely range of $623.76 to $1036.41

• Based on market research, we predict still higher volatility of 25%, which gives us a wider likely range of $601.34 to $1075.05

• As our position is short and our view has the price of gold rising, our view does not equal a traditional short hedge that would leave us Net -2F.

• To hedge our view, we first buy +25 contracts to reverse the position. Based on CP- = 601.34, the loss is 24.86%.

• Next we buy an additional 5 contracts (20.11% of position) based on our 5% or $100,000 loss limit

• Our Net Hedge is to buy 30 contracts against our -25F initial exposure.

Correlation 0.2000 Taken from Riskmetrics based on the Gold and the S&P 500*.

Gold Standard Deviation 21.85% Taken from Riskmetrics. This is an annualized monthly volatility of 6.263%.

Market Standard Deviation 22.44% Taken from Riskmetrics. This is an annualized monthly volatility of 6.432%.

Gold Beta 0.1947

Market Premium 4.9548% S&P Average historcal return taken from Bloomberg

Gold Risk Premium Estimate 0.9649% Using the CAPM Method.

Market View Our ViewFutures Price 0Ft 800.3 800.3Rate 5.29% 5.29%Risk Premium 0.96% 0.96%Time 0.4959 0.4959Standard Deviation 21.85% 25.00%# of Standard Deviations 1.65 1.65Loss Limit 5% 5%Exposure? Short Short# of Contracts -25 -25

S-Market 804.03 804.03

Critical Price + 1036.40 1075.05Critical Price - 623.76 601.34

Loss @ Upper Critical Price 30% 34%Loss @ Lower Critical Price -22% -25%

Hedge Entire Position 25 25Additional Hedge to Critical Price - Limit (%) -22.67% -20.11%Additional Hedge * Outstanding +25 (Contracts) 5.7 5.0

Total Contracts to Buy against original -25F 31 30

*There has been an observed declining trend in the correlation between Gold and the S&P 500. Average correlation is 0.2.

Risk Premium Calculation

Value at Risk Initial Short Position -25F

Probability of doing worse than +1.65 standard deviation (or 1036.2337) is 4.95%

V@R Center and Confidence Interval

623.8617 804.0314 1036.23370%10%20%

30%40%50%

0.00 200.00 400.00 600.00 800.00 1000.00 1200.00 1400.00

Price Value at Risk (V@R) Underlying GC

Today 10/30/2007 Futures price 800.3 Monthly price volatility (stan. dev.) 6.26

Risk Limit 100,000 # of contract underlying 100# s.d. V@R (e.g. 1.00) 1.65 Exposure (+/-Contracts) -25Exposure (maturity) Date 4/28/2008 $ underlying -$2,000,750For risk premium-adjusted V@R Adjustment (+/-Contracts) 30 OK@ 525 Funding Rate 5.29% Monthly Estimates T>30 days= 181 Risk Premium Estimate 0.96% Riskmetrics (optional) Riskmetrics inferred (optional)

weight last 150 obs. Own estimate monthly vol*sqrt(181/30) Own estimateStandard deviations (s.d. E.g. 1% as 1.0) 6.2600 6.2600 15.3763 15.3763

Short V@R @ price*exp(+#*sd) 888.0837 888.0837 1036.2337 1036.2337$ V@R 43,892 43,892 117,967 117,967

Short upside @ price*exp(-#*sd) 722.3328 722.3328 623.8617 623.8617

$ profit -38,984 -38,984 -88,219 -88,219

0%5%

10%15%20%25%30%35%40%45%

0.00 200.00 400.00 600.00 800.00 1000.00 1200.00 1400.00

Value at Risk Net Position +5F

Probability of doing worse than -1.65 standard deviation (or 623.8617) is 4.95%

Price Value at Risk (V@R) Underlying GC

Today 10/30/2007 Futures price 800.3 Monthly price volatility (stan. dev.) 6.26

Risk Limit -100,000 # of contract underlying 100# s.d. V@R (e.g. 1.00) 1.65 Exposure (+/-Contracts) 5Exposure (maturity) Date 4/28/2008 $ underlying $400,150For risk premium-adjusted V@R Adjustment (+/-Contracts) 0 OK@ 5

Funding Rate 5.29% Monthly Estimates T>30 days= 181 Risk Premium Estimate 0.96% Riskmetrics (optional) Riskmetrics inferred (optional)

weight last 150 obs. Own estimate monthly vol*sqrt(181/30) Own estimateStandard deviations (s.d. E.g. 1% as 1.0) 6.2600 6.2600 15.3763 15.3763

Long V@R @ price*exp(-#*sd) 722.3328 722.3328 623.8617 623.8617$ V@R -38,984 -38,984 -88,219 -88,219

Long upside @ price*exp(+#*sd) 888.0837 888.0837 1036.2337 1036.2337

$ profit 43,892 43,892 117,967 117,967

0%5%

10%15%20%25%30%35%40%45%

0.00 200.00 400.00 600.00 800.00 1000.00 1200.00 1400.00

Our initial exposure is -25F

With a market down view, our loss would be (800.30 – 1075.05)/800.30 = 34.33%

To comply with our loss limit, we would hedge +21F, for a net exposure of -4F

Initial Hedge: -25F+30F

However, our view is that Gold futures will RISE significantly above the current futures price

Therefore, our loss would be (601.34 – 800.30)/800.30 = 24.86%

To comply with out loss limit, we would initially buy +25 contracts to reverse the short position and consequently buy up to our loss limit, or +30F for a net exposure of +5F

Target Loss 5.00%= =

Actual Loss 24.86%20.11%

100% - 20.11% = 79.89%

79.89% X 25F = 20F

-25F + 30F= +5F

Target Loss 5.00%

= =Actual Loss 34.33%

14.56%

100% - 14.56% = 85.44%

85.44% X 25F = 21F

-25F + 21F= -4F

Calculated Profit of aCombined -25F+21F Position-25F +21F -25F+21F

740.3 1,500.0 (1,260.0) 240.0750.3 1,250.0 (1,050.0) 200.0760.3 1,000.0 (840.0) 160.0770.3 750.0 (630.0) 120.0780.3 500.0 (420.0) 80.0790.3 250.0 (210.0) 40.0

800.3 0.0 0.0 0.0810.3 (250.0) 210.0 (40.0)820.3 (500.0) 420.0 (80.0)830.3 (750.0) 630.0 (120.0)840.3 (1,000.0) 840.0 (160.0)850.3 (1,250.0) 1,050.0 (200.0)860.3 (1,500.0) 1,260.0 (240.0)

Calculated Profit of aCombined -25F+30F Position-25F +30F -25F+30F

740.3 1,500.0 (1,800.0) (300.0)750.3 1,250.0 (1,500.0) (250.0)760.3 1,000.0 (1,200.0) (200.0)770.3 750.0 (900.0) (150.0)780.3 500.0 (600.0) (100.0)790.3 250.0 (300.0) (50.0)

800.3 0.0 0.0 0.0810.3 (250.0) 300.0 50.0820.3 (500.0) 600.0 100.0830.3 (750.0) 900.0 150.0840.3 (1,000.0) 1,200.0 200.0850.3 (1,250.0) 1,500.0 250.0860.3 (1,500.0) 1,800.0 300.0

Market DataFutures Price: Maturity 04/28: $800.3

Prices taken from Bloomberg as of 10/30/07

Calls PutsIn-at-out of money

Strike Price

Apr Strike Price

Apr

OTM++ 870 17.7 730 12.2OTM+ 850 22.1 750 17.7OTM 825 29.1 775 26.7ATM 800 39.4 800 39.2ITM 775 51.7 825 53.4ITM+ 750 67.3 850 71ITM++ 730 81.5 870 86.3

Beyond Apollo’s initial hedge, the company is also looking for alternative hedging opportunities through options

The adjacent table summarizes options prices at various strikes as of October 30, 2007

Hedging Alternatives: Options

Hedge Summary: Map of AlternativesFutures Level of Confidence

Price View: Uncertain =Market Certain

Direction vs. Vol Up Vol Stable Vol Downmarket view (option prices cheap) (option prices fair) (option prices rich)

UP Synthetic Long Call Synthetic Short Put

(forward cheap) (suggested)

? Or Stable Long Straddle

(forward fair) Long Strangle

DOWN

(forward rich)

Bull Spread

Above is a map of alternative hedging strategies centered around our market view

Most consistent with our view is the synthetic long call, versus other alternatives that alter various market view factors (direction/vol)

Synthetic Long Call: -25F+25C+25C-25P With a market up/volatile view, we strongly recommend the synthetic long call as a primary hedging strategy

The call option allows Apollo Gold to take advantage of an unlimited upside, while having the flexibility of an insured downside

To create a synthetic long call from our initial position, using options:Synthetic Long Put + Synthetic Long Forward = Synthetic Long Call

+ =-F+C = Synthetic Long Put +C+P = Synthetic Long Forward

-25F+25C+25C-25P-25F +25C +25C -25P Combined

680.3 3,000.0 (985.0) (985.0) (2,012.5) (982.5)700.3 2,500.0 (985.0) (985.0) (1,512.5) (982.5)720.3 2,000.0 (985.0) (985.0) (1,012.5) (982.5)740.3 1,500.0 (985.0) (985.0) (512.5) (982.5)760.3 1,000.0 (985.0) (985.0) (12.5) (982.5)780.3 500.0 (985.0) (985.0) 487.5 (982.5)

800.3 0.0 (977.5) (977.5) 980.0 (975.0)820.3 (500.0) (477.5) (477.5) 980.0 (475.0)840.3 (1,000.0) 22.5 22.5 980.0 25.0860.3 (1,500.0) 522.5 522.5 980.0 525.0880.3 (2,000.0) 1,022.5 1,022.5 980.0 1,025.0900.3 (2,500.0) 1,522.5 1,522.5 980.0 1,525.0920.3 (3,000.0) 2,022.5 2,022.5 980.0 2,025.0

-25F+25C+25F-25F +25C +25F Combined

3,000.0 (985.0) (2,992.5) (977.5)2,500.0 (985.0) (2,492.5) (977.5)2,000.0 (985.0) (1,992.5) (977.5)1,500.0 (985.0) (1,492.5) (977.5)1,000.0 (985.0) (992.5) (977.5)500.0 (985.0) (492.5) (977.5)0.0 (977.5) 7.5 (970.0)

(500.0) (477.5) 507.5 (470.0)(1,000.0) 22.5 1,007.5 30.0(1,500.0) 522.5 1,507.5 530.0(2,000.0) 1,022.5 2,007.5 1,030.0(2,500.0) 1,522.5 2,507.5 1,530.0

(3,000.0) 2,022.5 3,007.5 2,030.0

Note that the maximum cost of creating a synthetic long call position ($982.50 per oz or $98,250 per contract) falls within our loss limit of 5% or $100,000

Ideally, by buying 25 calls and 25 forwards, we would achieve the same results with less cost ($977.50 versus $982.50)

Synthetic Short Put: -25F-25P-10P+25C The synthetic short put is an alternative hedging strategy that would be appropriate if we saw a significant decrease in volatility while remaining bullish

A market up/stable view would allow us to trade for income by selling short puts

To create a synthetic long call from our initial position, using options:Synthetic Short Call + Synthetic Texas Hedge = Synthetic Short Put

+ =-F-P = Synthetic Short Call -10P+25C = Synthetic Texas Hedge

-25F-25P-10P+25C Therefore, a -10P hedge is more appropriate given our risk appetite

Unfortunately this also limits the income gained from the position to $394.50 as we are selling less put options

(4,000.0)

(3,000.0)

(2,000.0)

(1,000.0)

0.0

1,000.0

2,000.0

3,000.0

4,000.0

680.3 720.3 760.3 800.3 840.3 880.3 920.3

r

(3,000.0)

(2,000.0)

(1,000.0)

0.0

1,000.0

2,000.0

3,000.0

4,000.0

5,000.0

626.3 684.3 742.3 800.3 858.3 916.3 974.3

-25F -25P -10P +25C Combined620.3 4,500.0 (3,512.5) (1,405.0) (985.0) (1,402.5)650.3 3,750.0 (2,762.5) (1,105.0) (985.0) (1,102.5)680.3 3,000.0 (2,012.5) (805.0) (985.0) (802.5)710.3 2,250.0 (1,262.5) (505.0) (985.0) (502.5)740.3 1,500.0 (512.5) (205.0) (985.0) (202.5)770.3 750.0 237.5 95.0 (985.0) 97.5800.3 0.0 980.0 392.0 (977.5) 394.5830.3 (750.0) 980.0 392.0 (227.5) 394.5860.3 (1,500.0) 980.0 392.0 522.5 394.5890.3 (2,250.0) 980.0 392.0 1,272.5 394.5920.3 (3,000.0) 980.0 392.0 2,022.5 394.5950.3 (3,750.0) 980.0 392.0 2,772.5 394.5980.3 (4,500.0) 980.0 392.0 3,522.5 394.5

-25F -25P -25P +25C Combined620.3 4,500.0 (3,512.5) (3,512.5) (985.0) (3,510.0)650.3 3,750.0 (2,762.5) (2,762.5) (985.0) (2,760.0)

-25F -25P -10P +25C Combined620.3 4,500.0 (3,512.5) (1,405.0) (985.0) (1,402.5)650.3 3,750.0 (2,762.5) (1,105.0) (985.0) (1,102.5)

-10P versus -25P Hedge Downside at CP-

Note that a -25F-25P-25P+25C hedge would position our downside far beyond our risk limits

Alternative Bull Spread: -25F+25Citm-25Pitm

Calculated Profit of aCombined -25F+25C-25P Position

-25F +25C -25P -25F+25C-25P680.3 3,000.0 (1,292.5) (2,282.5) (575.0)700.3 2,500.0 (1,292.5) (1,782.5) (575.0)720.3 2,000.0 (1,292.5) (1,282.5) (575.0)740.3 1,500.0 (1,292.5) (782.5) (575.0)760.3 1,000.0 (1,292.5) (282.5) (575.0)780.3 500.0 (1,160.0) 217.5 (442.5)

800.3 0.0 (660.0) 717.5 57.5820.3 (500.0) (160.0) 1,217.5 557.5840.3 (1,000.0) 340.0 1,335.0 675.0860.3 (1,500.0) 840.0 1,335.0 675.0880.3 (2,000.0) 1,340.0 1,335.0 675.0900.3 (2,500.0) 1,840.0 1,335.0 675.0920.3 (3,000.0) 2,340.0 1,335.0 675.0

L or S (Long/Short) S L SF, C, or P F C PForward/Strike Price 800.3 775.0 825.0Price (C or P), 0.0 (F) - FV 0.00 51.70 53.40Number of Contracts 25 25 25

The Bull SpreadView: Limited Up, Concerns about a big Down

Maximum Income = $67,500

Maximum Loss = $57,500

Vs. Loss Limit = $100,000

This position gives insurance on our view of volatility but it conflicts our view on direction. Additionally in the likely scenario that price increases at any rate above 800.3 will generate income for our view.

Alternative Long Straddle: -25F+25C+25C

Calculated Profit of aCombined -25F+25C+25C Position

-25F +25C +25C -25F+25C+25C680.3 3,000.0 (985.0) (985.0) 1,030.0700.3 2,500.0 (985.0) (985.0) 530.0720.3 2,000.0 (985.0) (985.0) 30.0740.3 1,500.0 (985.0) (985.0) (470.0)760.3 1,000.0 (985.0) (985.0) (970.0)780.3 500.0 (985.0) (985.0) (1,470.0)

800.3 0.0 (977.5) (977.5) (1,955.0)820.3 (500.0) (477.5) (477.5) (1,455.0)840.3 (1,000.0) 22.5 22.5 (955.0)860.3 (1,500.0) 522.5 522.5 (455.0)880.3 (2,000.0) 1,022.5 1,022.5 45.0900.3 (2,500.0) 1,522.5 1,522.5 545.0920.3 (3,000.0) 2,022.5 2,022.5 1,045.0

L or S (Long/Short) S L LF, C, or P F C CForward/Strike Price 0.0 800.0 800.0Price (C or P), 0.0 (F) - FV 0.00 39.40 39.40Number of Contracts 25 25 25

The Long Straddle

View: High Volatility, Neutral on Direction

Maximum Income = Unlimited

Maximum Loss = $195,500

Vs. Loss Limit = $100,000

In the case of no volatility, however, and if the position stays at the money or slightly OTM or ITM, we could nearly double or loss limit (undesirable).

Based on our certainty in volatility this should not be a concern.

Alternative Long Strangle: -25F+25C+25C

The Long Strangle View: Volatility in either direction; less certain than the Long Straddle.

Maximum Income = Unlimited

Maximum Loss = $110,250

Vs. Loss Limit= $100,000

This is a better option than the Straddle based on our view of volatility but closer to our loss limit. Furthermore we can adjust our in-the-moneyness of the options to meet our loss limit. As the call increases more OTM, we are safer within our loss limit.

The contained risk of stability and its associated loss is outweighed by the possibility of great gains with average to above-average volatility.

Combined -25F+25C+25C Position

(5,000.0)(4,000.0)(3,000.0)(2,000.0)(1,000.0)

0.01,000.02,000.03,000.04,000.05,000.0

620.3 680.3 740.3 800.3 860.3 920.3 980.3

Price at Contract Maturity-25F +25C

+25C -25F+25C+25C

Calculated Profit of aCombined -25F+25C+25C Position

-25F +25C +25C -25F+25C+25C620.3 4,500.0 (1,292.5) (442.5) 2,765.0650.3 3,750.0 (1,292.5) (442.5) 2,015.0680.3 3,000.0 (1,292.5) (442.5) 1,265.0710.3 2,250.0 (1,292.5) (442.5) 515.0740.3 1,500.0 (1,292.5) (442.5) (235.0)770.3 750.0 (1,292.5) (442.5) (985.0)

800.3 0.0 (660.0) (442.5) (1,102.5)830.3 (750.0) 90.0 (442.5) (1,102.5)860.3 (1,500.0) 840.0 (442.5) (1,102.5)890.3 (2,250.0) 1,590.0 65.0 (595.0)920.3 (3,000.0) 2,340.0 815.0 155.0950.3 (3,750.0) 3,090.0 1,565.0 905.0980.3 (4,500.0) 3,840.0 2,315.0 1,655.0

L or S (Long/Short) S L LF, C, or P F C CForward/Strike Price 800.3 775.0 870.0Price (C or P), 0.0 (F) - FV 0.00 51.70 17.70Number of Contracts 25 25 25

Recommendation

• Consistent with our market view of Up/Volatile, we recommend Apollo Gold choose the Synthetic Long Call

• In analyzing the above five positions, the Long Call gives the appropriate combination of upside (unlimited) versus downside (within our loss limit)

• The Long Strangles and Straddles also have this unlimited upside but are outside our loss limit range

• Bull Spreads, while well within our loss limit range, limit our upside for a position on an underlying that is very likely to increase

Position Name Maximum Gain Maximum Loss Loss AllowanceSynthetic Long Call Unlimited $98,250 $100,000Long Straddle Unlimited $195,000 $100,000Long Strangle Unlimited $110,250 $100,000Bull spread $67,500 $57,500 $100,000Synthetic Short Put $39,450 large downside $100,000