Over the Hedge -

Metal Manufacturers Go for the Gold (or Silver)

First, as a precious metals consumer, you should consider hedging when your final cost of goods is strongly related to gold or silver prices. This is the situation of many Northeastern jewelry manufacturers. Manufacturers filling their order books now may buy gold forward in some form, fixing the cost of gold used in their goods, thereby stabilizing their profit margin, even if the price of gold runs up between the time that orders are booked and goods are manufactured.

How should you hedge?

Futures contracts offer efficient pricing (i.e. a narrow spread between the bid price and the offer price) but the standardized size of contracts might force users into unintended over-hedging or under-hedging, sometimes referred to as a “tail”. Forward contracts permit customization, but that tailored look may come at a price: the bank may put you in the position of being a price taker, subject to a dealing desk that might provide different quotes for different customers, depending on your importance to their bottom line. The spot bullion market provides a mixture of efficiency and flexibility, but you still must establish a comfort level with your counterparty.

The ease of opening an account, dealing on a continuous electronic quotation and covering hedges with a few mouse clicks - even as prices are changing - makes the online spot bullion market an excellent choice for the new or smaller hedger. Compared to the proliferation of foreign exchange services now available online, there are still relatively few desks (besides bank desks) that offer a gold and silver spot bullion service. Here are some of the things you need to look for where bullion dealing services are available:

• Is your counterparty a regulated entity, or are they exploiting the fact that bullion trading exists in a regulatory “gray area”?
• Can you deal in precise ounce quantities, or are you steered to dealing in “lots”?
• As your position is rolled forward, are the rates used for debits and credits fair and competitive?
• Is the dealing software easy to use and stable? Is the bid/offer spread competitive?
• Does a team of actual dealers back up the software on a 24 x 5.5 basis?

How online dealing platforms work.

A manufacturer of gold jewelry takes an order for 85 one-ounce gold medallions, to be delivered in 60 days. The invoice price is $1500 per medallion. The production is scheduled for sometime next month. The company likes to separate the hedging function from the supply function. They will pay spot for immediate delivery when their production schedule is set, but they need to fix the cost basis of the metal today. Based on a current gold price of $600 per ounce, a full 40% of the cost of goods is physical bullion. Even a 5% move up in the price of gold will result in significant compression of their margins.

This risk is mediated by hedging. The company goes on an online dealing platform and purchases 85 ounces of spot bullion. The position is secured with a margin deposit or a “good faith” deposit that is kept with the dealer to cover any adverse price changes of the price of gold that will run approximately 2% of the notional value or actual value of the gold. That means that with prices at $600 per ounce, the margin deposit will be (600 x 85 X 2%), or $2550. Each purchase must be secured with a margin deposit, so for example, if gold is $600 per ounce, we will establish in your account a position of 1 ounce of gold for 600 x .02, or $12. Your account will now experience appreciation or depreciation as if you owned 1 ounce of gold. This happens even though your account only has $12 in it, not the $600 per ounce that the metal sells. That ability to control relatively large volumes of the item with very little actual money is called leverage.

One month later, international tension and a new wave of oil price volatility drive the price of gold up to $650 per ounce. The company is now ready to manufacture the medallions so they order metal through their customary supplier and as they do so, they liquidate the hedge. The hedge account realizes a $50 per ounce profit, which is (85 x 50), or $4250. The account will also incur a small interest debit as the long gold position is rolled forward. The hedge results in the company preserving the profit margin on this transaction.

Had gold prices headed lower after the hedge was implemented, the company would have still earned the same margin on the medallions: the lower price of acquiring gold in the spot market would have been offset by a realized loss in the hedge account. The rationale for hedging is not undermined by how the hedge account “performs”: the idea is to try and preserve the economics of the transaction from the moment the deal is done until the time when payment and delivery occur.

This transaction was made simple and efficient through the use of a regulated spot dealer, offering an online dealing platform designed to be used as a financial tool, not as a procurement market for metal. By keeping procurement and hedging separate, smaller users of the markets may be able to realize efficiencies that will drop to the bottom line. It’s your good fortune that as the financial markets become more competitive and specialized, you are now in a position to work with service providers who can help you optimize your hedging plan.

Daniel Uslander is co-head of the Corporate and Private Client Group at IKON Global Markets, a full service foreign exchange dealer and Futures Commission Merchant located on Wall Street in New York City. He can be reached at 212-482-8272, or by email at dan@ikongm.com.