FINM3405 Tutorial 2
Philip Gray 2009
Derivatives & Risk Management
On 1 September, the spot price of gold is USD 926 per ounce. The risk to the business is
that the price at which we will sell the gold late November will be lower than this. This
will have a negative impact on firm profit. To summarise, we are exposed to falling gold
To eliminate the risk of a decrease in gold price, we want to lock in a sales price we will
get for gold in November. We can lock in the selling price for gold by going
Another way to think about this is as follows. We can establish the correct hedge position
(long or short?) by doing today in the futures market what we will be doing in the
physical market in November. In November, we will be physically selling
ounces of gold, so we enter a short futures position today. No matter which way you look
at it, entering a short gold futures position is the correct hedge.
You have a short position covering 100,000 ounces of gold at a contracted futures price of
$935 per ounce. In other words, we are able to physically deliver 100,000 ounces of gold
and will receive USD93.5m (100,000
USD 935). The contract specifications are likely
to be very strict with respect to the quality of the gold delivered, the time and place for
delivery. At expiry in late November:
We physically deliver 100,000 ounces of gold to person on the other side of the
In exchange for this delivery, we receive 100,000 × $935 = USD 93.5m.
To close-out the short position, we enter an equal and opposite futures position; namely,
futures contract for 100,000 ounces of gold with November delivery. The
futures price at which we close-out will be exactly (or very close to) the spot price of gold
at the end of November ($930) – otherwise an arbitrage opportunity exists (see Tutorial 1
Since we went short at $935 per ounce and closed-out by going long at $930 per ounce,
we have a futures trading profit of $5 per ounce. On 100,000 ounces, this is a total profit
of $500,000. That closes-out the futures position, but we still have a truckload of gold.
We then physically sell our 100,000 ounces of gold at the end-of-November spot price of
$ 930 per barrel and realise $93m. Add the $500,000 futures profit and the net monies
received are $93.5m.
Note that this is exactly the same as we achieved when the gold was
physically delivered under the futures contract.