7244AFE Risk Management Consulting Report for QGold Corporation

This report offers a financial risk management analysis for QGold Corporation, an Australian gold mining company. The report recommends using CME gold futures contracts to hedge commodity price risk, suggesting a short position in 288 contracts to cover a 50,000 troy ounce exposure and detailing an initial margin requirement of $979,200. It identifies additional risks such as foreign exchange fluctuations, technological disruptions, and evolving environmental regulations. The report also discusses the dangers of derivative misuse, including speculative trading and systemic risk, while advising QGold to implement strong internal controls. The report uses data to determine optimal hedge ratios and contract numbers. Furthermore, the report addresses the importance of hedging strategies and the potential risks associated with derivatives, while also explaining the systemic risks that can destabilize the financial system.

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Risk management consulting report
QGold Corporation
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Risk management consulting report
Contents
1) Executive Summary.......................................................................................................................1
2) Introduction...................................................................................................................................2
3) Financial Risk Management for QGold Corporation.....................................................................3
3.1. Hedging Strategyfor QGold........................................................................................................3
3.1.1. Use of gold futures to hedge QGold’s commodity price risk:..............................................3
3.1.2. Optimal hedge ratio of the gold futures contracts:...............................................................3
3.1.3. QGold’s risk exposure in terms of troy ounce of gold:........................................................4
3.1.4. Required number of gold futures contracts that should be traded by QGold to hedge its
commodity price risk:....................................................................................................................4
3.1.5. Total initial margin requirement for the gold futures contracts:...........................................4
3.1.6. Other major risks faced by QGold apart from the commodity price risk of gold:................4
3.2. Dangers of misusing of derivatives products to firms:................................................................6
3.3. Derivatives pose a danger to the whole financial systems- Systemic Risk:................................8
3.4. Whether QGold should use derivatives products to hedge its risk exposures:..........................10
4) Conclusion...................................................................................................................................11
5) References ..................................................................................................................................12
6) Appendices..................................................................................................................................15
6.1. Appendix 1: Excel screen-shots of the optimal hedge calculations in figure 1, based on the
monthly data for spot and futures prices in the past two years......................................................15

Risk management consulting report

Risk management consulting report
1) Executive Summary
This report is on the financial risk management of QGold Corporation. QGold is an
Australian gold mining company that faces risk from the uncertainties in the prices of gold.
The report recommends the use of CME gold futures contracts to hedge this commodity price
risk. QGold should take short position in 288 gold futures contracts to hedge its risk exposure
of 50,000 troy ounce of gold. The company should post initial margin of 9,79,200 USD as per
the contract specification of CME gold futures. The report also analyses other major risks
faced by QGold and it found that the company faces risks from fluctuations in foreign
exchange, technological disruptions and changing environmental and sustainability
regulations. The report discusses various misuses of the derivatives by the firms as they drift
away from the given mandate of managing risks into the speculative trading. The firms also
use derivatives for the price manipulations. The report also discusses the systematic risk of
the derivatives to the stability of financial markets. It is found that the increased volatility in
the underlying markets, use of excessive leverage and concentration of the credit risk are the
main factors due to which the derivatives pose a danger to the whole financial system.
Though there are inherent risky characteristics in the derivative trading but they also offer
benefits to the firm by helping them hedge their risks effectively. So, it is advised that QGold
should use gold futures contract to hedge its risk exposure but the company should be careful
about the misuses of the derivatives as that can have fatal effects. The company should make
its corporate internal controls stronger to stop potential frauds and misuses of these
derivatives.
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Risk management consulting report
2) Introduction
This consulting report is regarding the financial risk management of the QGold Corporation.
QGold is based in Australia and the company is into gold mining. It produces gold from
goldfields at Charters Towers located in north eastern Australia. The company has plans to
expand its business operations over the next few years. QGold aims to grow its cash flows by
expanding its gold mining operations. It is seeking to define approximately 15 million troy
ounces of gold. The company has made a lot of capital investment to develop the goldfield
and it has started extracting gold and gold production from these mines. QGold faces price
commodity risk as its profit and loss is subjected to the changes in the price of gold. The
company is very sensitive to the gold’s price as for each 10 cent change in the price per troy
ounce of gold the company’s income changes by US$5000. QGold is concerned about this
risk exposure as the price of gold is quite volatile so the company is considering some
derivatives risk management strategies to hedge this risk.
This report devises a hedging strategy for QGold by suggesting what kind of futures contract
should be used by the company and what position it should take in these futures contracts to
hedge its commodity price risk. The report further analyses the movement in the changes in
spot gold prices and changes in gold futures prices to find optimal hedge ratio. The
company’s risk exposure is measured in terms of troy ounces of gold to decide the number of
contracts QGold should trade to hedge this risk. The company will also need to post initial
margin for these futures contracts and this report calculates that requirement. The report also
evaluates few other major risks faced by QGold apart from the gold’s price change risk.
The report addresses various concerns regarding the dangers of misusing of the derivatives
products like futures to the firms. It discusses the characteristics of the derivatives that make
it risky and along with it the report also explains various reasons for such misuses. The
document also explains the systemic risk arising from the derivatives that can destabilise the
whole financial system.
The final portion of this report recommends whether QGold should use derivatives like gold
futures contracts to protect itself from the uncertainties in the prices of gold.
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3) Financial Risk Management for QGold Corporation
3.1. Hedging Strategyfor QGold
3.1.1. Use of gold futures to hedge QGold’s commodity price risk:
QGold is concerned with the uncertainty in the gold prices. So, it can use COMEX Gold
futures (GC) for hedging its exposure. The company is concerned with the price uncertainty
in late September so it can use October 2019 futures contract. It is advised to use futures
contract with delivery close to but later than the hedging period expiry. This will avoid the
increased volatility in the price of underlying in the delivery month but if the difference
between the contract delivery month and hedge expiration is higher, it will increase the basis
risk (Hull, 2018).
QGold is a mining company producing gold so it is naturally long in cash and it faces risk
from the decrease in the prices of Gold. So, the company should take short position in
COMEX Gold futures, October 2019 contracts. If the prices of gold declines in the coming
time then QGold will gain from these futures contract as the company will still be able to sell
gold at predetermined higher prices.
3.1.2. Optimal hedge ratio of the gold futures contracts:
The optimal hedge/ minimum variance hedge ratio is required for finding the optimal number
of futures contracts for hedging purpose. QGold can use optimal hedge ratio to reduce its risk
exposure to price uncertainty to the maximum possible extent at the most favourable costs
with-out under or over hedging. The optimal hedge ratio is given by the ratio of standard
deviation of the changes in spot prices to futures prices multiplied by the correlation between
the changes in futures and spot prices (Jovanovic, 2014).
Standard deviation of changes in spot prices = 2.3211%
Standard deviation of changes in futures prices = 2.2459%
Correlation coefficient between changes in spot prices and changes in futures prices =
55.66%
Optimal Hedge ratio= (std dv of changes in spot prices/std dv of changes in futures
prices)*Correlation between changes in two prices = 0.5752
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Figure 1: Appendix 1 shows the excel calculations for the optimal hedge ratio.
3.1.3. QGold’s risk exposure in terms of troy ounce of gold:
It is given that QGold benefits US$5,000 for each 10 cent increase in the price per troy ounce
of gold sometime in late September 2019. So, the total risk exposure = 5000/0.1 = 50,000
troy ounce of gold.
3.1.4. Required number of gold futures contracts that should be traded by QGold to hedge its
commodity price risk:
According to the CME Group (n.d.) gold futures contract specification:
One contract Unit = 100 troy ounces.
Total exposure of QGold = 50,000 troy ounces of gold.
Number of required futures contracts = Optimal number of contracts = Optimal hedge ratio *
(Total gold exposure of QGold in troy ounces / Troy ounce of gold per future contract) =
0.5752 * (50,000/ 100) = 288 contracts.
3.1.5. Total initial margin requirement for the gold futures contracts:
According to the CME Group (n.d.):
Initial margin requirement per gold futures contract = 3,400 USD.
Total initial margin requirement = Initial margin requirement per futures contract * Number
of required futures contract.
Total initial margin requirement = 3,400 USD * 288 = 9,79,200 USD.
3.1.6. Other major risks faced by QGold apart from the commodity price risk of gold:
QGold is a gold mining company based in Australia but its sales of gold metals are
denominated in US dollars. According to Poitras (2013), the company faces risk from the
fluctuation in the foreign exchange. If the USD weakens in comparison to AUD, then the
company will record losses as it will get fewer proceeds in the domestic currency. QGold can
use forward contracts to hedge this risk as the company can get into a contract to buy AUD in
future at a pre-determined USD amount. So, if the AUD strengthens the company will not be
affected as it will still get the domestic proceeds according to previous decided rate. This will
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remove the uncertainty from the foreign rate fluctuations but additional credit risk will be
added as the counterparty to the contract can default on its obligations.
Another risk faced by gold mining companies like QGold is from technological disruptions.
Digital effectiveness is required for the firms to keep their competitive advantage. So, the
company needs to invest appropriately across the whole value chain to establish a digital
mine to emerge as a top player in the market (Mitchell, 2018).
QGold faces real risk from the inherent uncertainties in the mining business. The company
has a growth objective to increase its gold production but it is difficult to be sure of the actual
outputs from the mining field as the initial production estimates generally needs to be revised
when new information evolves. The company can use insurance contracts to hedge against
such uncertainties but the costs can be too high because of the large numbers of variables
involved.
The company also faces risk from the changing regulations and awareness regarding the
environmental and sustainability practises. Australian government has been focusing on the
sustainable resource management in mining industry (Australian Trade Commission, 2013).
So, the evolving environmental and safety regulations has created a need for the innovation in
technologies and services to adopt sustainable mining practices.
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3.2. Dangers of misusing of derivatives products to firms:
Derivatives products like futures help firms hedge their risks from interest rate, foreign
exchange and commodity price risk. Due to the complex nature of the derivatives pricing and
accounting there can be various misuses of the derivatives by the firms. If the internal
controls are weak, the risk managers can sometime move away from the given mandate of the
risk management and indulge in the speculative trading to earn more profits. The issue with
the derivatives is that they involves a lot of leverage, if these contracts do not have proper
underlying to hedge then even the small market movements can cause huge losses to the
firm. This use of derivatives as a kind of speculative tool and using high levels of leverage
can even led to insolvency if the firm does not properly control the resulting market
exposures and liabilities. For example companies may use derivatives to game commodity
exposures like a mining companies use gold futures contracts to hedge their commodity price
risk from the fall of prices of the commodity they produce, but they may drift from this
hedging mandate into speculating on gold prices. These kinds of risky activities that are
unrelated to the core business of mining can be fatal. The reason for this problem is that the
firms use derivatives products to generate additional income and internal control systems do
not intentionally challenge this kind of profit-making. Enron is an example of a firm that
drifted from its original business into financial derivatives. It eventually engaged in numerous
fraudulent activities and recorded revenues from the derivative trading as profits from the
firm’s core business. This shows the pull of management to the speculative use of derivatives
to supplement earnings (Hodgkins, 2014).
Firms may use derivatives contract for price manipulation as even the small change in the
prices can generate huge profits. For example, commodity producing firms can use futures
contracts to manipulate commodity pricing. Such contract manipulation distorts the capital
allocation efficiency of the markets by creating surpluses or shortages of underlying assets to
move benchmark prices.
Gold mining firm can use derivatives for market manipulation by accumulating a huge short
position in future contract and then sell large quantities of gold to lower benchmark prices.
The firm will lose in real market by selling undesired quantities of the underlying asset at
unfavorable prices but it can make extraordinary profits in the futures contract due to the
large position from resulting move in the benchmark prices (Zhang, 2018).
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Some other examples of the failure of the firms due to the misuse of the derivatives:
Metallgesellchaft lost US$ 1,340 million in 1994 via oil forwards; Orange County
(California) lost US$ 1,810 million due to reverse repo operations and Ashanti Goldfields lost
US$ 570 million in 1999 in exotic gold products. These derivatives losses are due to the
malpractices and faulty risk appraisal procedures (Capelle-Blancard, 2010).
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3.3. Derivatives pose a danger to the whole financial systems- Systemic Risk:
In theory, derivatives should promote efficiency in the market and optimally allocate risks but
in practice they raise lot of problems.
Derivatives involve the use of excessive leverage and several financial meltdowns have been
caused due to this reason for example, the LTCM bailout. LTCM’s interest rate derivatives
had a notional principal of approximately US$ 1,000 billion before its near-bankruptcy but
the fund’s equity was just US$ 4 billion and its total assets were of US$ 125 billion. This
leveraged heavy derivatives activities of Long-Term Capital Management posed significant
threat to the financial markets which led the Federal Reserve to quickly arrange a rescue
effort (Wijerathna, 2017).
Another issue with derivatives is their impact on the volatility of the underlying spot markets.
Derivatives positions with high leverage encourage excessive speculation that can destabilise
the markets.
According to Capelle-Blancard (2010), the complexity and the concentration of risks is one
more source of concern about the derivatives. The concentration of few players in derivatives
markets can set off chain reactions of default and it is likely to feed systemic risk. In 2006,
the United States’ five largest institutions alone were committed to more than 98 per cent of
the derivatives notional amounts. This is in a way contrast to the main advantage of
derivatives to allow better dissemination of risks.
According to Buffet (2002), the derivatives can exacerbate the unrelated financial troubles of
the firm due to the pile-on effect that occurs as many derivatives contracts generally need a
firm going through credit downgrading to provide immediate collateral to its counterparties.
This requirement imposes a sudden massive demand for cash collateral, which can create a
liquidity crisis for the organisation leading to further downgrades. Such spiralled movement
can lead a corporation to a bankruptcy. Further the issue is that the highly concentrated credit
risk makes the troubles of one corporation quickly infect the others, which can trigger
significant systemic problems.
The complexity also presents in the valuation of derivatives contracts as their final value
depends on counter-parties creditworthiness and the involved parties record profit and loss in
their current income statements without any money changing hands. These reported earnings
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are based on mark to model as many times these contracts are customised and they do not
have any real market. So, these earnings are usually overstated due to the false assumptions.
Such manipulations become public later on when the firm actually reports realised profit/loss
and it affects the shareholders and equity markets.
In 2012, JPMorgan a large bank based in the U.S. had incurred $2 billion loss in trading on a
complex derivatives portfolio. The initial purpose of this portfolio was to reduce firm’s risk
but it got out of control. What happened was that few employees in the bank’s chief
investment office, doubled down after a loss with yet bigger bets. Instead of managing the
bank’s risk level they tried to become profit makers by using complex derivative trades which
had almost nothing to do with hedging (Hurtado, 2016).
The growth of financial derivatives during last few decades has been extra ordinary. The total
notional value of the outstanding over the counter derivatives were around $600 trillion in
2018 that is many times global GDP (BIS, 2018). This huge value of the derivatives contracts
along with its dangerous characteristics make derivatives too risky if not used properly
because of the magnitude of extreme risks, high uncertainty/volatility and possibility of
systemic risks. This makes derivatives a serious threat to the stability in the financial markets.
Government regulation of the derivatives market has been weak and the regulation was the
responsibility of the involved parties. So, only these parties were aware of who owed how
much to whom and the degree of posted collateral to cover potential losses. The drawback of
such approach became apparent during 2008 crisis, as a single insurance company AIG owed
several billions on subprime-mortgage bets to various large banks world-wide and the
company did not have enough cash to pay up. So, to keep AIG afloat in order to avert a
broader collapse, taxpayers had to provide $182 billion (Bloomberg, 2019). There have been
few changes to the regulations and introduction of the central counterparties and clearing
houses for the OTC contracts but still derivatives are too dangerous if not use cautiously due
to the inherent risky nature of these contracts.
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