Question

A New Zealand company produces 20,000 ounces of gold per year. It uses 30% of its production for making gold jewelry sold at a fixed price through stores in Australia and New Zealand, and the rest is sold on the market, where the gold price is determined in US dollars. Australia’s profits are repatriated to New Zealand. The company’s CEO wants to use futures contractc to hedge the entire production. He calls you to seeks your opinion. Recommend a seinsble hedge stragtegy that would be in line with the CEO’s wishes (assume x is the quantity used for making gold jewelry in the New Zealand)

Answer 1

The gold production can be hedged by taking up a short position in a futures contract (i.e. sell the gold ahead). The gold will be delivered at some agreed upon time in the future at the locked in price. The gold jewellery price is already fixed so the short position can be taken up for 20,000 - x ounces of gold which is sold on the market whose price is determined in USD. If the gold price decreases then the futures position will offset the loss as the open position will be closed by buying gold futures. Since the price of the underlying has fallen, the new futures contract price will also be low, so overall, there will be net gain in the futures position by selling high and buying low. This wil offset the loss in the gold market.