Introduction to Precious Metals Risk Management/Hedging and Ratios

How to Manage Precious Metals Price Risk

There are numerous examples of how future and options can be used to manage economic risks inherent in commercial operations and in investment portfolios. This module discusses risk management using COMEX and NYMEX Precious Metals futures.

Market prices respond to changing circumstances. We all know that prices will be different in the future to how they are today, but we do not know how different they will be. At a more basic level, while some people make predictions, no one knows with certainty whether prices will be higher or lower in the future.

One of the most well-known risk management uses of futures contracts is to hedge against uncertain outcomes in the future.

Example

Consider an auto parts manufacturer who has won an order to deliver catalytic converters. Platinum is a significant constituent in the production of these items and the production run will require 32 kg, approximately 995 ounces. of platinum. The firm will take delivery of platinum in two months at the prevailing spot price.

The current spot price is around $867 per ounce and NYMEX April futures are priced at $870 per ounce. To hedge the future payment, the manufacturer needs to buy futures. His requirement is for 995 ounces. Each NYMEX futures contract is for 50 ounces. Buying 20 contracts would provide exposure to 1,000 ounces of metal.

Two months later, the spot price has risen by $90 to $957 per ounce. The firm will take delivery of the metal it needs from a local supplier and does not wish to take delivery through the futures contract. It closes out the futures position in the market at a price of $954 per ounce. The gain made on the futures transaction is $84,000.

This gain offsets the rise in the price of platinum in the physical market, which has resulted in the manufacturer paying $89,550, or over 10%, more for their supply compared to the spot market price at the time they knew they had the exposure. The futures trade therefore provides an effective hedge against the rise in price of the physical supply.

Adding Precious Metals to your Portfolio

Precious metals are widely used in investment portfolios. Futures contracts can be the means of making an investment in precious metals but can also be used as a hedging tool for portfolios consisting of other precious metal assets.

Example

Consider a fund that has an investment in gold. Most of this is held through a holding of gold bars, but around 1% of the fund is held in cash to cover short term cash flow requirements. At the end of May, the spot price of gold is $1,212.1 per ounce. The fund has 20,000 ounces in gold bars and $250,000 in cash, and therefore has an end of month valuation of $24,492,000.

At the end of June, the spot price has risen to $1320.7 per ounce, an increase of 8.96%. Because of the cash balance, the value of the fund has risen to $26,665,000, which is an increase of 8.87%, which is an underperformance versus the benchmark spot price.

This underperformance could be managed with futures. COMEX Gold futures has a 100-ounce contract size. A two lot position therefore represent 200 ounces, or 1% of the physical holding. At the end of May, the August futures settlement price was $1217.5 per ounce, and at the end of June was $1320.6 per ounce. The two lot position has therefore netted a gain of $20,620 over the month. When added to the gain in value of the physical holding, the performance of the fund including the futures position is 8.96%, in line with the benchmark.

Managing Economic Exposure

Futures contracts can be used to overlay physical positions to adjust the economic exposure. 

Example

An investor has a holding of 1200 ounces of gold. The current spot price is $1236.5 per ounce, and therefore the value of the holding is $1.48 million. The investor expects that over the next few weeks silver will outperform gold; however she does not wish to close her long term physical position.

The investor modifies her market exposure by selling COMEX Gold futures and buying COMEX Silver futures. The COMEX Gold June futures contract is currently priced at $1231.5 per ounce. The contract size is 100 ounces; therefore the investor needs to sell 12 contracts in order to neutralize her exposure to gold. At the prevailing futures price this transaction has a notional value of $1.477 million. The COMEX Silver May futures contract has a price of $14.756 per ounce, and a contract size of 5,000 ounces. In order to most closely replicate the notional value of the gold futures trade, 20 Silver futures contracts should be purchased.

Over the next few weeks, the prices for both gold and silver increase, but silver has outperformed gold, with the silver spot price rising 16.7% compared the gold spot price rise of 4.7%.

The investor’s physical holding of gold has increased in value by $69,000. However, as planned, this is neutralized by the return on her short position in gold futures. The COMEX Gold June futures price is now $1291.8 per ounce, and this leg of the trade has lost $72,360 in value. The silver futures transaction increased in value to $17.474 per ounce, therefore her silver futures transaction has made a gain of $271,800.

Overall the combined position has made a net gain of $268,440. The investor can close out her futures positions with her physical gold holding being unaffected.

Summary

COMEX and NYMEX Precious Metals futures contracts can be used to manage risk exposures to precious metals.

Additional Resource

Precious Metals Spot Spreads: Complete Guidebook