Question

You are a Gold Exploration Company (“Company”) with a licence to explore over one specific site only. If you find gold you then have the right to mine or extract the gold from this site. The preliminary geology analysis from some dirt samples has just come back and suggests you have located a very rich gold seam, with up to 0.5 million ounces of gold. The price of gold is at a historical high. As the manager of the Company you are very excited by this news and you immediately decide to hedge the Company’s exposure to gold price risk by selling long-dated (up to 5 years expiry dates) gold futures contracts traded on a major US Futures Exchange Market. Required. However, just before you implement this action or strategy to sell gold futures contracts you speak to your Friend, who has done Finance 362. You ask your Friend to explain one advantage of entering into this strategy and two disadvantages or risks of this strategy. Briefly explain one advantage of entering into this strategy.

Briefly explain two disadvantages or risks of entering into this strategy

Answer 1

One advantage of entering into this strategy-

A.Entering into Forward Market for hedging with the risk associated with fluctuations in the price of the gold will be helping to reduce the risk of any quick and sudden move which will be adverse in the nature and it will be reflecting locking the rate of the future and it will be leading to no fluctuation in receivables and payables due to proper hedging through forward contract

Two disadvantage of entering into this strategy as follows-

A. There will always be a cost involved and if the profits are not more than the cost involved then it can be leading to a loss. So, there will be having cost and it will be leading to complete loss if there is no sudden movement

B. There is a high degree of counterparty risk associated in gold contracts and it can be having negative impact in the overall profitability of the investor.