Hedging FX Exposure in Gold Trades

Lori Aldinger, Director, FX Research and Product Development

The COMEX Gold futures market is the global benchmark reference for the gold market. While the COMEX contract specifies delivery in New York, gold is produced and exported globally. International trade in gold is conducted in US dollars, making the COMEX contract a valuable hedging tool, but the conversion of trade revenues into local currency means there is an additional foreign exchange (“FX”) risk component that may need to be managed.

FX rates fluctuate separately from the price of metals, and movements in the FX rate can have a substantial positive or negative impact on incomes from international trade.

South Africa produces a substantial amount of gold and supplies the international market. Estimates for 2019 put South African gold production at 118.2 metric tons, with 103 metric tons of this amount exported. In 2019, South Africa was the eighth largest producer and the fifteenth 15th largest exporter of gold.1

Movements in the South African rand (“ZAR”) can have significant implications for the returns that are generated from South African exports of gold. For example, we can look at market prices in the period from January 2019 up to and including October 2020.

Volatility in USD/ZAR FX rate creates price variation in income for USD and ZAR impacted producers in gold markets

Source:  CME Group. Active month COMEX Gold futures settlement price; converted to ZAR using CME ZAR/USD futures settlement price.

During this period of increased global uncertainty, prices for gold in US dollars rose 17 percent in comparison to the values seen at the end of the fourth quarter of 2019. At the end of October 2020, the active Gold futures contract was priced at $1,879.90 per troy ounce. However, over the same period, the rand depreciated in value relative to the dollar, moving from ZAR 14.11 per dollar to ZAR 16.33 per dollar. This currency depreciation effect had a beneficial effect for South African gold exporters, as the COMEX Gold futures price expressed in ZAR increased from ZAR 21,359 to ZAR 30,692 per troy ounces, which was approximately a 44% increase.

Such significant volatility in the FX markets highlights the uncertainty that exporters face. It is worth noting that any depreciation in the ZAR/USD exchange rate that benefits an exporter – i.e., an appreciating dollar versus the rand since the exporter is selling in – will conversely have a negative effect on the importers (a depreciating rand versus the dollar since the importer is buying in dollars).

CME offers futures and option contracts on the South African rand exchange rate, which can be used to manage this FX exposure. These contracts are physically delivered for the amount of ZAR 500,000. Using prices at the end of October 2020, this equates to a contact notional value of $30,625, which can be compared to the dollar value of a Gold futures contract of $187,990.

Below is an example of how the CME South African Rand futures contract can be used to hedge the FX component of a South African gold export transaction.

Scenario

In late August, a South African gold producer has an export order to a gold importer for 12,000 troy ounces of gold, to be delivered at the end of November. The agreed terms are for payment in US dollars at a rate equal to the COMEX Gold November futures price on the delivery day, minus $30 per troy ounce.

Transaction information

Gold export quantity

12,000 troy ounces

Agreed sale price

COMEX Gold November futures price minus $30 per troy ounce

Current COMEX Gold November futures Price

$1,875.40 per troy ounce

COMEX Gold Futures contract size

100 troy ounces

Current CME South African Rand December Futures Price

$0.063850 per South African rand

CME South African Rand Futures contract size

ZAR 500,000

The price of the COMEX Gold futures November contract is $1,875.40 per troy ounce. Selling 120 lots of Gold futures at this price will hedge the exposure to gold price fluctuations. With a price of $1,875.40 per troy ounce established through the use of the Gold futures hedge, the producer can be confident in achieving a dollar revenue of $1,845.40 per troy ounce on the sale of the gold, which includes the agreed discount of $30 per troy ounce with the importer. The FX component of the transaction can be hedged using the CME South African Rand futures contract (product code RA). To determine the hedge transaction required, the producer needs to determine whether to buy or sell futures, and the quantity to be transacted.

The CME South African Rand futures contract is a physically settled contract and buying one contract is equivalent to buying South African rand in exchange for US dollars. Selling the ZAR futures is equivalent to selling South African rand in exchange for US dollars.

The South African gold producer will wish to convert the US dollar proceeds into South African rand upon the delivery of the gold, and therefore will be buying South African rand. The associated FX risk exposure can be hedged by buying CME South African Rand futures contracts. These futures should be purchased to implement the hedge and sold to close out the position once the FX hedge is no longer required. This will create a “pay off” on the FX portion of the ZAR futures hedge equal to the difference between the price the producer paid for ZAR futures and the price at which they closed the ZAR futures trade out. Trading in the South African Rand futures terminates on the first Monday prior to the third Wednesday of the delivery month. If that is not a business day, then the last trading day is the business day prior to that day.2 This would make December the appropriate futures contract month to hedge this transaction.

The number of FX futures needed to hedge the transaction can be calculated by considering the currency exposure. With the Gold futures hedge, the producer will expect to receive $22,144,800 from the sale.

The ZAR futures price, quoted in US dollars per South African rand, is $29,371.97, which is the equivalent of ZAR 15.66 per US dollar. At this exchange rate, the sale proceeds will be ZAR 346,825,372. The contract size of the CME South African Rand futures contract is ZAR 500,000. Therefore, to hedge the FX exposure, the producer needs to buy 694 ZAR futures.

We can examine what might happen to this hedged position in different outcomes. To focus on the FX component, let’s assume that the gold price is unchanged over the one-month period.

Outcome 1:  Using futures to hedge a declining South African rand exchange rate

A decrease in the value of the South African rand can also be viewed as an increase in the value of the US dollar, measured in South African rand. In this example, we assume a decrease in value from $0.06385 to $0.06085 per South African rand, a decline of 4.7%. This can also be seen as a change in value from ZAR 15.66 per US dollar to ZAR 16.43 per US dollar.

With the gold price stable at 1,875.40 dollars per troy ounce, the US dollars proceeds from the sale are $22,144,800, and the return from the gold futures hedge is $0. In local currency terms, the proceeds are ZAR 363,924,404, which is higher than anticipated had the exchange rate not changed. This higher outcome is offset by a loss on the ZAR futures position. Overall, the cashflow has been maintained in line with expectations, which is the purpose of the hedging strategy.

 

Physical Gold

Physical ZAR Cashflows

South African Rand Futures

Late August

 

Expected ZAR 346,825,372

Buy 694 lots of December Rand futures @ 0.06385

Late November

Sell 12,000 troy ounces @ 1,845.40 dollars/troy ounce

Actual ZAR 363,924,404

Sell 694 lots of December Rand futures @ 0.06085

Futures Pay Off

 

+ ZAR 17,099,032

-$1,041,000

(- ZAR 17,107,642)

Outcome 2:  Using futures to hedge an increase in the South African rand exchange rate

An increase in the value of the South African rand can also be viewed as a decrease in the value of the US dollar, measured in South African rand. In this example, we assume a marginal increase in value from $0.06385 to $0.06685 per South African rand. This can also be seen as a change in value from ZAR 15.66 per US dollar to ZAR 14.96 per US dollar.

Again, with the gold price stable at 1,875.40 dollars per troy ounce, the US dollar proceeds from the sale are $22,144,800, and the return from the gold futures hedge is $0. However, in local currency terms, the proceeds are ZAR 331,261,032, which is lower than anticipated had the exchange rate not changed. To compensate, the ZAR futures hedge position records a gain of $1,041,000, which equates to a gain of ZAR 15,572,177.

 

Physical Gold

Physical ZAR Cashflows

South African Rand Futures

Late August

 

Expected ZAR 346,825,372

Buy 694 @ 0.06385

Late November

Sell 12,000 troy ounces @ 1,845.40 dollars/troy ounce

Actual ZAR 331,261,032

Sell 694 @ 0.06685

Impact

 

- ZAR 15,564,340

+$1,041,000

(+ ZAR 15,572,177)

Conclusion

Gold markets remain volatile and hedging price risk remains an important consideration. In addition, the volatility in foreign exchange markets can also be an unpredictable factor that firms are looking to hedge. By hedging FX risk, companies can stabilize future cash flows that in turn creates greater confidence in business performance.

The CME suite of metals futures sit alongside a number of key FX futures contracts and these are providing participants with the key hedging tools to manage growing risks in the sector.

Explore South African Rand Futures

Explore Gold futures

Sources

1. Source:  World Gold Council, 2020.

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