Financing And Hedging Techniques For The Gold Jewellery Industry

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Standard Bank Group Precious Metals
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• Financing And Hedging Techniques For The Gold
  Jewellery Industry
• Dubai, 21st February 2005
• Jeffrey Rhodes

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Agenda

• What Is Hedging?
• Why Hedge?
• How To Hedge?
• Futures
• Forwards
• Options
• OTC Products
• Gold Loans
• Some Lessons
• A Glimpse Into The Future

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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 selling
• or futures contracts. A hedge can help lock in
  existing profits. Examples include a
• position in a futures market to offset the
  position held in a cash market, holding a
• security and selling that security short and a
  call option against a shorted stock. A
• perfect hedge eliminates the possibility for a
  future gain or loss. An imperfect hedge
• insures against a portion of the loss

The focus of todays presentation is the hedging
of physical gold holdings to protect merchants
against adverse movements in the underlying gold
price
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Why Hedge?

• In todays 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
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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.

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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

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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

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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

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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 clients currency
  account with the bank is credited with the money
  paid in and simultaneously the clients 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 clients 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

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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 merchants bank, however a
  flexible financial institution will understand
  that their clients liquidity is held in the form
  of gold rather than cash and should be willing to
  accept gold bullion or jewellery as call margin

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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

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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 Dubais 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
  Dubais 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?

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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
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• Limited. SBG is the largest banking group in
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• as at the end of 2003, with assets exceeding 81
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• Standard International Holdings S.A. (SIH)
• SIH is the Luxembourg based holding company for
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• SIHs principal subsidiaries are Standard Bank
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  Standard
• New York Securities Inc., and new banking
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  (Banco Standard
• de Investimentos SA) and Russia (Zao Standard
  Bank).
• Standard Bank London Limited (SBL)
• Established in 1992, SBL is the focal point for
  the international merchant banking activities of
  SBG,
• specialising in Natural Resources and Emerging
  Markets. SBL is authorised and regulated by the
• Financial Services Authority.

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Where is Standard Bank for Precious Metals?
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Exchange Traded and OTC Markets

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Precious Metals - Contacts

• Telephone Reuters Code
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Disclaimer

• Authorised and Regulated by the Financial
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• Whilst every care has been taken in preparing
  this document, no representation, warranty, or
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• (express or implied) is given and no
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• Bank Group, or any of its employees as to the
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• nor that the information remains unchanged. This
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  Group to the
• recipient to buy or sell. In deciding whether to
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  in respect of or
• in connection with the commodities discussed in
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• solely for distribution to institutional
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