Financing And Hedging Techniques For The Gold Jewellery IndustryDubai, 21st February 2005

Jeffrey Rhodes

Standard Bank Group Precious Metals

Agenda

What Is Hedging?

Why Hedge?

How To Hedge? Futures Forwards Options OTC Products

Gold Loans

Some Lessons

A Glimpse Into The Future

What is Hedging?

Some simple, and not so simple, definitions are:

‘Any technique designed to reduce or eliminate financial risk; for example, taking two positions that will offset each other if prices change’

‘A hedging transaction is a purchase or sale of a financial product, having as its purpose the elimination of loss arising from price fluctuations. With regards to currency transactions it would protect one against fluctuations in the foreign exchange rate’

‘A strategy designed to reduce investment risk using call options, put options, short sellingor futures contracts. A hedge can help lock in existing profits. Examples include aposition in a futures market to offset the position held in a cash market, holding asecurity and selling that security short and a call option against a shorted stock. Aperfect hedge eliminates the possibility for a future gain or loss. An imperfect hedgeinsures against a portion of the loss’

The focus of today’s presentation is the hedging of physical gold holdings to protect merchants against adverse movements in the underlying gold price

Why Hedge?

In today’s world of gold a crucial fact to note is that the amount of newly mined gold each year is virtually matched by gold jewellery consumption.

In 2003 new mine production was 2,593 tonnes, according to GFMS, compared to annual jewellery fabrication demand of 2,531 tonnes. In other words the gold jewellery industry underpins the global gold market

The wholesalers and retailers that make up this market are, or should be, more concerned with generating profit from the difference between ‘the making charge’ they pay to jewellery manufacturers and revenue generated from jewellery sales rather than the underlying price of gold bullion

It is crucial for physical merchants to minimise their exposure to the inherent speculative elements of the international gold market so that they can ensure their business remains healthy in all market conditions and is not hurt by excessive volatility in the international gold price caused by factors completely outside of their control

In my view a physical gold merchant that does not hedge the value of inventory held

is a in fact a speculator

How to Hedge?

There are a number of traditional hedging techniques that are used by international gold bullion and jewellery traders and merchants to safeguard, or insure, the underlying value of their physical gold assets using a variety of financial markets and instruments. These include:

Futures

Forwards

Options

OTC products such as the metal trading facility or unfixed accounts, specifically designed for the physical gold market.

Futures

There are a number of International Futures Exchanges which offer gold futures contracts the major one being the COMEX Division of the New York Mercantile Exchange, while in India there are two relatively new but flourishing regional exchanges, MCX and NCDEX.

The use of futures as a hedging tool is popular, however as with anything there are arguments for and against

PROS CONS

Price transparency Liquidity can be poor

Well regulated Transaction costs

Low credit risk Inflexible maturities

Low original margin Lack of confidentiality

Small size tickets Price volatility

Forwards

Forwards are used by both producers and consumers, products include

Swaps, Fixed or Outright Forwards, Floating Forwards, Spot Deferred Contracts,

Forward Rate Agreements

Gold fabricators, principally the gold jewellery industry, can match their purchases of physical gold with their production schedules

Gold jewellery demand is seasonal, peaking at certain times of the year, such as prior to Diwali, Wedding Seasons, Christmas, Chinese New Year, Eid Holidays, the circumcision season in Turkey. Instead of waiting until the metal is needed and risking having to pay higher gold prices, the jeweller can buy for forward dates that match their fabrication plans if the spot price falls to what is considered to be an attractively cheap level

While having obvious benefits in ‘normal markets’, this hedging practice can prove costly if demand does not match expectations due for example to an unexpected downturn in regional economies, an increase in geo-political tensions, or simply a change in fashion

Options

Options are often misunderstood as speculative instruments that help to cause unnecessary and unwanted price volatility, however the truth is that an option is a form of price insurance and is a crucial tool in managing price risk and exposure

Options can be traded on an ‘Over The Counter’ basis with a bullion bank, or on a futures market such as the COMEX

Exchange traded options are typically American style

OTC options are usually European style, can be Asian

Buying a Call gives the option purchaser the right, but not the obligation, to buy a specified quantity of metal at a previously agreed upon price (strike price) at a previously agreed upon date (expiry date). By paying a premium, the buyer controls the upside risk, while retaining advantages of a downward price move

Selling a Put - In exchange for collecting premium, the put seller has a contingent obligation to buy a specified quantity of metal at a previously agreed upon price (strike) at a previously agreed upon date (expiry). A consumer with a buying target below the market could sell puts struck at that target price and will collect premium regardless of whether that level is reached

Over The Counter Products

The Metal Trading Facility is the classic, tailor made OTC product that was developed specifically to meet the needs of the physical gold markets of the Middle East and South East Asia

The product is also known as a Deferred Settlement Facility or Margin Trading Account, and can be regarded as an undated forward which eliminates the need to roll positions forward each day. In Dubai it is called an ‘Unfixed Account’

It is effectively an exchange of assets with the gold merchant buying gold from a bullion bank, paying the currency equivalent of the gold plus an an agreed margin to protect against adverse market moves, but not actually fixing the final price to be be paid. The client’s currency account with the bank is credited with the money paid in and simultaneously the client’s gold account is debited with the ounce equivalent

This short paper position perfectly hedges the physical metal held until such time as the merchant sells at which point the hedge is lifted, I.e. the client’s currency account is debited and gold credited

While the MTF position is open with the bank the client receives interest on his credit currency balance and is charged interest on the debit gold balance

Gold Loans

Probably the most straight forward and commonsense method of financing that simultaneously hedges gold price exposure for a physical gold merchant

Simply by borrowing gold rather than cash to finance the growth of his business the gold merchant creates a paper liability that equally matches the physical assets held either in the form of jewellery, bullion or scrap. The monetary value of both sides of the balance sheet will rise and fall in equal proportion

In order to maintain the hedge the physical merchant should replenish stocks as sales are made or certainly within a very short period of time in order to avoid creating an exposure to the gold price

Gold loan rates should be cheaper than currency borrowings – over a ten year period the three months gold LIBOR rate has averaged just under 1% per annum

A potential problem is margin calls on the paper liability from merchant’s bank, however a flexible financial institution will understand that their client’s liquidity is held in the form of gold rather than cash and should be willing to accept gold bullion or jewellery as call margin

Some lessons ……

Hedging of physical gold holdings means protecting against adverse movements in the underlying gold price

There are a wide range of simple hedging products available to physical gold merchants

Make more use of options, view them as an insurance not a speculative product

Adopt the ‘Unfixed Account’ approach, gives flexibility

Remember that a physical gold merchant that does not hedge the value of inventory held is a in fact a speculator

A Glimpse Into The Future ……

Imagine a financing product for the gold jewellery industry that:

Eliminates exposure to the international gold price Requires no original cash margin Is not subject to variation or call margin Reduces financing costs Reduces making charges Frees up capital Allows complete flexibility of supply Is highly relevant to Dubai’s Gold Souk but has global potential

A pipedream or could it be a reality?The answer is a reality, the solution has arrived.

Standard Bank has partnered with key players in Dubai’s vibrant gold market to develop an innovative gold jewellery financing tool, based on new technology, that has these attributes and we plan to roll out the product to the market over the next few months.

Thank you - Questions Please?

About Standard Bank

Standard Bank Group (SBG)

SBG was established in Port Elizabeth, South Africa in 1862 as The Standard Bank of British South

Africa Limited and is listed on the Johannesburg Stock Exchange under the name Standard Bank Group

Limited. SBG is the largest banking group in Africa as measured by market capitalisation, over $8 billion

as at the end of 2003, with assets exceeding $81 billion, and it has representation in 39 countries across

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SIH is the Luxembourg based holding company for the international investment banking activities of SBG.

SIH’s principal subsidiaries are Standard Bank London Limited, Standard Bank Asia Limited, Standard

New York Securities Inc., and new banking subsidiaries established in 2003 in Brazil (Banco Standard

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Financial Services Authority.

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