American Barrick Resources

Corporation
How Sensitive Would Barrick
Stock Be to Changes in Gold
Price in the Absence of Risk
Management?
Pre-tax earnings 223m
(Exhibit 2)
Reduction in earnings if (99m)
gold sold at spot
1,280m oz.X(422-345)
Exhibits 2 and 12
Proforma pre-tax earnings 124m

Taxes (26m)
21% tax rate, exhibit 2
After-tax earnings 98m
Elasticity of Earnings and Profits
for 1% Change in Gold Price
1% change in gold price $3.45
Number of ounces 1,280m
Additional pre-tax profits $4.4m
Additional after-tax profits $3.5
Additional profits as % of earnings 3.5%
Cash flow = Earnings + Noncash charges
= 98m + 69m = 167m
Additional profits as % of cash flow 2.1%
What is Barricks Risk
Management Program?
 Guidelines
Fully protected against price declines for 3
years output.
20-25% for next decade.
Why Manage Gold Price
Exposures?
 Arguments
Pure bet on operational efficiencies for
investors.
Do they want that or do they want gold?
Have funds available to invest when
external financing is costly.
Eliminating deadweight costs of distress.
Tax arguments: If net income is negative,
lose use of tax shields.
 Ownership and Risk
Management
If managers have large stake in firm, they
dont want the risk.
Eliminating hedgeable risks makes it
possible to have concentrated ownership.
Barrick management owns 29.6% of
Barrick for a value of $900m.
Lets look at the other firms: Exhibit 3.
What Instruments Did They Use
to Manage Risks?
 Gold Financing of Acquisitions
Cullaton gold trust:
3% of mine output when gold price was below
$399 per ounce.
Rising to 10% when gold price was at $1,000
per ounce.
How to value this?
 Tricky: Nonlinear
Fraction paid:
Min[(0.03 + 0.07*Max((P - 400)/600),0),
0.1]
Example: 600, 0.03 +0.07*0.33 = 0.053.
Payoff:
Min[(0.03 + 0.07*Max((P - 400)/600),0),
0.1]*P
Example: 0.03*600 + 0.053*600 = 32.
Payoff

120

100

80

60

40

20

200 400 600 800 1000 1200

Gold price
 Gold Loans
Gold loan is equivalent to risk-free loan
plus forward sale of gold.
 Forward Price and Contango
To get gold at future date:
Solution one: Invest at risk-free rate + Long
forward.
Solution two: Buy gold today.
Twist: Since you dont need gold until
future date, you can lend it and earn gold
lease rate.
 Example: Exhibit 9
Interest rate is 16.83%; lease rate 2%.
Cost of forward strategy for one year:
F/1.1683
Cost of spot strategy. Since you gain 2% by
leasing, you need 1/1.02 units of gold to get
one at maturity: S/1.02
F = S*1.1683/1.02 = S*1.1545or forward
exceeds spot by 15.45%
 Collars
Barrick was willing to use options, but only
in the form of costless collars.
Buy put and sell call so that premium of put
equals premium of call.
Example: One year, gold at $333, LIBOR at
4%, gold lease rate at 1.8%, and volatility of
gold at 7%.
 Examples
Put at $300 strike, premium is $0.30.
Call at $350 strike, premium is $5.44.
To create a costless collar, sell 0.055 call for
each put.
If call is at $370 strike instead, premium is
$1.29. You have to sell 0.23 calls.
 Spot Deferred Contracts
What are they?
 Spot at t = 0 is $300, LIBOR is
6% and lease rate is 2%
Forward at t=0 $312
Production 200 oz. 200 oz.

t=0 t=1 t=2 t=3

 Case 1: Hedge With Forwards,
Spot Is at $500 at t = 1
Value of production sold at forward:
200 x 312 = $62,400.
Value of production sold at spot:
200 x 500 = $100,000.
Value of forward contract just before t=1:
-$37,600
 Case 2: SDC contracts
At t = 0, Barrick enters in contract to sell
either at t = 1 or at t = 2.
If at t = 1, it chooses not to deliver on
contracts, it sells on spot market at $500.
The price set so that both parties are
indifferent between rolling over the contract
for another year or closing out the SDC
contract and initiating a new one-year
forward contract
 Setting the Price
Keep LIBOR and gold lease rate constant.
Forward at t=1 is then:
500 x (1+ 0.06 - 0.02) = 520
Barrick made a loss of $188 that has to be
carried forward at 6%.
So, new price is 520 - $188 x (1.06) =
$320.72
Did Barrick Follow Its Policy?
 No.
Stopped writing options in 1990 and used
only spot deferred.
By 1992, historical low for gold and gold
volatilities.
In 1992, it could insure against gold prices
falling below $330 at $4.8 an ounce. With a
collar, it had to give up 88% of upside
above $350. Refused to do so.
 In 1992, could have sold forward at $340
for cash costs of $205.
Was not willing to do so.
So, Barricks risk management involved
substantial speculation.
 Who Uses Derivatives?
Many surveys. Lets look at the 1998
Wharton/CIBC survey.
Sent out to 1,928 firms. 399 responded.
50% use derivatives.
42% have increased usage since previous
year; 46% kept constant.
Users: 83% of large firms; 45% of medium
size companies; 12% of small firms.
 Most commonly managed risks
for users
FX, 96%.
Interest rate, 76%.
Commodity, 56%.
Equity, 34%.
 Concerns
Accounting treatment (high concern for 37%).
Market risk (31%).
Monitoring/evaluating hedging results (29%).
Credit risk (25%).
Liquidity (21%).
SEC disclosure (21%).
Reaction by analysts, investors (18%).
 Which FX hedging
Balance sheet commitments (frequently for 54%;
average exposure hedged, 49%).
Off balance sheet commitments (24%; 23%).
Anticipated transactions less than 1 yr (46%;
42%).
Anticipated transactions more than 1 yr (12%;
16%).
Hedge competitive exposure (11%; 7%).
Hedge translation (14%; 12%).
 Maturity effect for FX hedging
Percentage 90%
80%
of responding 70%
firms 60%
50% 0%
40% 1-25%
30% 26-50%
20% 51-75%
10% 75-100%
0%
1-90 91- 181 1 - 3 3+
days 180 days - years years
days 1 year

Maturity of exposure
 Does market view matter?
49% sometimes alter timing of hedges and
51% sometimes alter size according to
market view.
6% frequently take positions, 26% do so
sometimes, to exploit market view.
 Interest rate derivatives
Almost all firms using interest rate
derivatives report swapping from floating to
fixed.
 Options
68% of firms use options; 44% use FX
options.
42% use European, 38% use American,
19% use average rate, 9% use basket, 13%
use barrier.
47% of FX derivatives users use basket
options, 39% use average rate, and 69% use
barrier!
 Reporting and valuation
4% report to directors monthly, 23%
quarterly, and 17% annually.
19% value daily; 9% weekly; 27% monthly.
40% want risk management to decrease
volatility; 22% want increased profit.
60% of those who do not use do so because
lack of exposure.
 Tufanos analysis
Looks at gold industry.
Advantage: Detailed data on exposures and
hedges.
Disadvantage: One industry.
Key result: Managerial options and
ownership are important.
 Why the Spectacular Success of
Derivatives?
They enable you to alter risk.
Derivatives can allow you to take risks that
are advantageous.
Derivatives make it possible for you to shed
risks that are costly.
It is only recently that finance figured out
how to do all this well.