Hedging Against Rising Gold Prices using Gold Futures

Businesses that need to buy significant quantities of gold can hedge against rising gold price by taking up a position in the gold futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of gold that they will require sometime in the future.

To implement the long hedge, enough gold futures are to be purchased to cover the quantity of gold required by the business operator.

Gold Futures Long Hedge Example

A goldsmith will need to procure 10,000 troy ounces of gold in 3 months' time. The prevailing spot price for gold is USD 851.00/oz while the price of gold futures for delivery in 3 months' time is USD 850.00/oz. To hedge against a rise in gold price, the goldsmith decided to lock in a future purchase price of USD 850.00/oz by taking a long position in an appropriate number of NYMEX Gold futures contracts. With each NYMEX Gold futures contract covering 100 troy ounces of gold, the goldsmith will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the goldsmith will be able to purchase the 10,000 troy ounces of gold at USD 850.00/oz for a total amount of USD 8,500,000. Let's see how this is achieved by looking at scenarios in which the price of gold makes a significant move either upwards or downwards by delivery date.

Scenario #1: Gold Spot Price Rose by 10% to USD 936.10/oz on Delivery Date

With the increase in gold price to USD 936.10/oz, the goldsmith will now have to pay USD 9,361,000 for the 10,000 troy ounces of gold. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the gold futures price will have converged with the gold spot price and will be equal to USD 936.10/oz. As the long futures position was entered at a lower price of USD 850.00/oz, it will have gained USD 936.10 - USD 850.00 = USD 86.10 per troy ounce. With 100 contracts covering a total of 10,000 troy ounces of gold, the total gain from the long futures position is USD 861,000.

In the end, the higher purchase price is offset by the gain in the gold futures market, resulting in a net payment amount of USD 9,361,000 - USD 861,000 = USD 8,500,000. This amount is equivalent to the amount payable when buying the 10,000 troy ounces of gold at USD 850.00/oz.

Scenario #2: Gold Spot Price Fell by 10% to USD 765.90/oz on Delivery Date

With the spot price having fallen to USD 765.90/oz, the goldsmith will only need to pay USD 7,659,000 for the gold. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the gold futures price will have converged with the gold spot price and will be equal to USD 765.90/oz. As the long futures position was entered at USD 850.00/oz, it will have lost USD 850.00 - USD 765.90 = USD 84.10 per troy ounce. With 100 contracts covering a total of 10,000 troy ounces, the total loss from the long futures position is USD 841,000

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the gold futures market and the net amount payable will be USD 7,659,000 + USD 841,000 = USD 8,500,000. Once again, this amount is equivalent to buying 10,000 troy ounces of gold at USD 850.00/oz.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the gold buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising gold prices while still be able to benefit from a fall in gold price is to buy gold call options.

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