APPLIED FINANCE CENTRE

Faculty of Business
and Economics

Assignment Cover Sheet

Unit Code: ECFS868 Unit Name: Financial Risk Management

Lecturer’s Name Max Morley Study Centre: Sydney CBD

Assignment Title: Risk for Gold Producers

Student’s Name: Estefany Beristain Sosa

Student Number: 44232187

Due Date: 29/10/2017 Date Submitted:

Word Count: 2,657

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Question 1

Gold returns in AUD/USD

USD returns
Volatility per month (using all available data) 4.44% 3.28%
Volatility per annum (using all available data) 15.39% 11.35%
Mean per month (using all available data) 0.36% -0.01%
Mean per annum (using all available data) 4.46% -0.18%
Correlation per month (using all available data) 39.78%

Question 2

Question 3
Question 4

Path Calculations:

a) Generate random numbers for each month and normal variables.

Gold Price

AUD/USD

b) Generate prices for each month.

Gold Price

AUD/USD

c) Calculate the gold price in AUD.

For both histograms, it can be seen that gold prices and AUD/USD followed a normal distribution
because both were constructed assuming normality, however the gold prices had a slightly right skewed
distribution while the AUD/USD has a symmetric distribution. The gold prices have a higher variability
than the AUD/USD prices.
Question 5

EBT path 1:
a) Generate volume with random variable

b) Generate fixed costs

c) Generate variable costs

d) Generate EBT
The EBT Annual distribution is slightly right skewed, the shape of the distribution is similar to the gold
prices distribution. With 50% of chance the EBT will be on average 133 million, have a maximum EBT
of 619 million and a minimum EBT of 187 million. With 95% of confidence level the shortfall in earnings
for a year relative to the expected earnings are on average 190 million. Given the samples, the EBT
distributions has fat tails and there is a slight uptrend in the data.

Question 6

Hedge construction:

𝐸𝐵𝐼𝑇 𝐻𝑒𝑑𝑔𝑒
= 𝑉𝑜𝑙𝑢𝑚𝑒 𝑡𝑜𝑛 − 1 ∗ 𝑜𝑢𝑛𝑐𝑒𝑠 ∗ 𝑅𝑎𝑛𝑑𝑜𝑚 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑜𝑓 𝐺𝑜𝑙𝑑𝑒𝑛 𝑃𝑟𝑖𝑐𝑒 𝑖𝑛 𝐴𝑈𝐷 + 1 𝑡𝑜𝑛 ∗ 𝑜𝑢𝑛𝑐𝑒𝑠
∗ 𝐺𝑜𝑙𝑑 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 31DEFGHIJK 𝐴𝑈𝐷 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠 − 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
The EBT Annual distribution with hedge is right skewed. With 50% of chance the EBT will be on average
131 million, have a maximum EBT of 392 million and a minimum EBT of 70 million. With 95% of
confidence level the shortfall in earnings for a year relative to the expected earnings are on average
106 million. Given the samples, the EBT distributions has fat tails and there is a slight uptrend in the
data.

Comparing the EBT and the EBT with hedge, it can be seen that the mean and median are almost the
same with only a variation of 3% and 2% respectively. However, it is clear that the reduction of variability
th
(45% less) reduces the fat tail that EBT distribution was having, therefore the 5 percentile reduction of
144% and the Earnings at Risk of 45%. In resume, the hedge reduces the variability of the EBT and
therefore the expected shortfall in earnings and the company should hedge both currency and the gold
price to reduce the risk of having losses.

Question 7
With 95% of confidence the cash shortfall relative to the threshold of zero will be zero with hedge, and
the probability of a breach liquidity during the year is 4%, that means that considering the initial cash
flow of 30 million 4 of 100 times we can be out of funds to pay suppliers and staff considering that we
have a hedge on both currency and gold price. Without hedge the company has a higher probability of
having a breach liquidity of 11%, that means 64% more than with hedge.

Question 8

The previous results assumed a normal distribution, and the parameters of the normal distribution were
estimated according to an historical estimation considering the historical prices from 1990 to 2017, that
means it has been assumed than the future prices of the gold and currency are going to be similar to
the prices between 1990 to 2017. However, if the future prices differ from the historical prices the risk
measures and previously risk analysis will not be valid.

Another alternative for parameter estimation beside historical estimate are using economic models or
hypothetical scenarios.

a) Historical Crisis Scenario

This scenario considers the worst most recent historical period. Parameter estimation will be done by
using the historical prices of the GFC from 2008 to 2010 to estimate the variance and the correlation to
model the expected returns for both gold and currency. Taking crisis scenarios for risk analysis can
give us an accurate measure on how well the company can endure crisis periods. To be consistent with
a random walk, that the best forecast of the future exchange rate is the current exchange rate I would
set the mean to zero, although the table shows the mean during the crisis period.

The crisis scenario increases the EAR by 33%, it has heavier tails than the distribution with the original
parameters. Additionally, the breach probability increases to 5% but the CaR remain in the same level.
The mean is increased slightly by 3%. It is highlighted that even than the volatility of this scenario is
39% higher than the original the hedge does a good work at protecting the earnings from being lost as
the EAR increases 33% and the breach probability 36%.

b) Stress Scenario

I will stress the volatility of the previous scenario arbitrary by 50% more for the gold price and the
currency returns to build a Black Swan scenario, where the worst can happen but has not been seen
previously. Stress testing scenarios are commonly used mostly by banks to test the sufficiency of the
reserves in case of a loss.

The stress scenario increases the EAR by 78%, it has heavier tails than the distribution of the historical
prices scenario. Additionally, the breach probability increases 181% and the cash shortfall results in
23.29 million. The mean is increased 10%. It is highlighted that in this scenario the shortfall in earnings
of 188 million is higher than the expected average earnings of 179 million.

c) Implied Volatility Scenario

The implied volatility of the options is directly observable from option markets and are a good
approximation of the volatility of the gold prices considering other market issues, such as de gold
lending rate that has a high correlation with the gold price.

The implied volatility is less than the basis scenario therefore the EAR is reduced by 7%. Additionally,
the breach probability decreases by 17%. The mean also decreases by 1%. The volatility is reduced by
th
10% and the 5 percentile is increased by 15% which means the distribution of the returns in this
scenario has a positive skewness.

Question 9

• Market risk:
a) World price of gold: World prices determine the volume of gold that is mined, if the prices
are low, the volume produced will be low. Gold industry expects a decline in the prices
through 2021-22.
b) Demand from gold ore mining: Demand from gold ore miners is expected to increase in
2016-17.
c) US dollars per Australian dollar: It has a key role in the revenue of producers. The
Australian dollar is projected to strengthened through 2021-22.
d) World price of nickel: Is expected to increase in the next years. The nickel feedstock is one
of the war material purchases included in the cost structure.

• Economic risk: The industry is forecast to decline at an annualised 0.5% over the decade
through 2021-22, largely due to low volume growth, volatile pricing and weak margins.

• Substitute products: There are substituted metals that can be used instead of gold, for example,
in jewellery and manufacturing processes it can be substitute by silver.

• Operational Risk: Melting gold requires well - established processes, the degree of purity has
to satisfy the requirements of the global market. Additionally, gold mining requires high skilled
workers that incurred in labour risks due to the chemical process of melting gold.

• Competition risk: There is a greater foreign competition. Some industry segments have
disappeared. Although competition risk is reduced because there are high barriers to entry
because of the high initial investment that has to be done to acquired permits, equipment, plant
and machinery.
 • Geographical risk: Two of the major gold markets are China and UK, due to its geographical
location Australia has an advantage in terms of transport costs for Asiatic markets, however it
has higher costs and higher operational risk for UK deliveries.

• Political risk: Australia is an attractive trading partner because of its political and financial
stability, however the Asiatic markets political stability which is its principal market might not be
as stable given that there are development countries.

• Regulation and Policy: As mention Ibisworld, although no specific regulations apply to the
industry, the mining operations are subject to environmental approvals and surveillance of
environmental organizations to prevent an alteration in the ecosystem where the plant is
operating.

Question 10

According to an enterprise risk management framework an organization should have coordinated

activities to direct and control de organization with regard to risk. The company must identify, analyse,
evaluate, treat and monitor risks.

Analyse.

My recommendations for the firm to incorporate an appropriate risk analysis can be summarized in the
following steps:

1) The company should identify the context:

a. External Environment: The gold mining industry faces a continuously reduced in
revenues due to low gold prices and a strengthen of the Australian dollar.
b. Internal Environment: Organizational structures, the firm objectives, strategies and
policies.

2) The company should identify its strategy, objectives and capital structure.

3) The firm should identify the risk associated with that strategy. A probability of occurrence has
to be assigned and the possible impact according to each risk. Depending on the type of risk it
can be analysed using a qualitative or a quantitative method.

Qualitative Method: I would recommend the firm to make a Risk Assessment Matrix using a
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relative scale to measure the likelihood and impact of the risky event.

The matrix will be helpful to identify visually the most threatening risks for the firm.

Quantitative Method: The risk to be asses must be based on the firm objectives, for example,
to maximize earnings. The likelihood and severity of the risks are determined using numerical
models such as Controlled Interval and Memory (Chapman & Cooper, 1983; Cooper,
MacDonald, & Chapman, 1985), Monte Carlo Simulation (Kwak & Ingall, 2007; Whiteside,
2008), Factor Rating (Hollmann, 2012; Trost & Oberlender, 2003). In this case I would

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https://www.project-management-skills.com/qualitative-risk-analysis.html
 recommend the use of Monte Carlo analysis as the numerical model to use as it is a handy
method, easy to use and to interpret.

Evaluation.

Quantitative Risks: Using the Risk Assessment Matrix the firm should rank the risks to define each of
them by their order of importance.

A summary can be done when all the risks are identified.

For example,

Type of Risk Sources of Risk Profile

Risk
Market Risk Commodity Major
and Fx Prices
Political Risk Australian Minor
regulations
Geographical Deliveries to Minor
Risk China and UK

Qualitative Risks: The firm should identify the appropriate risk measures given their targets. In this case,
my recommendation is that the firm defines target values according to an investment portfolio
management approach, that means that one of the firm objectives can be earnings maximization with
the minimum risk. With this in mind, I recommend the following risk measures.

• Focus of risk: Earnings and Liquidity

• Risk Horizon: One year
• Risk Measure:
o Earnings: Earnings at Risk
o Liquidity: Cash Flow at Risk
• Risk Model: Monte Carlo Simulation (historical parameter estimation from 1990 to 2017)
• Confidence Model: 95%

Treatment.

Qualitative Risks: I would recommend that the firm have contingency plans to mitigate the severity of
the risk in case of an adverse scenario where the company operations can be interrupted. Nowadays,
many companies have plans to be followed by the employees in the daily firm operations that include
preventive plans and contingency plans as measure to reduce the likelihood of the risk and in case the
risk materialized the plan are intended to reduce the severity of the risk through contingency plans.

Quantitative Risks: Given the sources of risks, I would recommend to the firm that for each type of risk
mitigation and surveillance measures are defined and implemented in the firm’s processes. Risk
revaluation must be tested periodically and the periodicity must be defined previously.

Type of Risk Sources of Risk Measure Risk Risk

Horizon Profile
Market Risk Commodity and Earnings at Annually Major
FX Prices Risk
Cash Flow
at Risk
Political Risk Australian Changes in Annually Minor
regulations policies that
affect the
current
company
policies
 Geographical Deliveries to Costs and Monthly Minor
Risk China and UK Percentage
of Deliveries
completed

For each measure, risk limits must be defined according to the shareholders risk appetite and the future
decisions regarding the strategy of the company must be taken according to the risk policies and limits.
In the particular case of the gold company, I would recommend a conservative risk policy, therefore
taking the hedge position given that in the next years the gold prices are expected to decline and the
Australian dollar appreciated. With the hedge position the volatility of the expected earnings is reduced
by 45%, so that gives a major certainty in the company income. Additionally, having a 30$ million cash
on hand proves to be enough to have a cash flow at risk of zero at a threshold of zero with a low
probability of breach of 4% so I would recommend keeping this cash available and test its sufficiency
and according to the operating cycle of the company.

Another aspect to be consider is the one regarding the cash flows of the company, according to the
inflows and outflows the company might have a natural hedge that might remove the need of hedging
its position using derivatives. Given that in the mining industry synergies with other mining companies
are usually done to mine in case other metals are found in the same field it might be possible for the
gold company to consider a natural hedge in synergy with this companies that might be affected by the
same concerns.
References

1. IBIS Industry Reports, Gold ore mining.

2. De Mello, L., Sheedy, E. and Storck, S. (2015), A Practical Guide for Non-Financial Companies
When Modeling Longer-Term Currency and Commodity Exposures. Journal of Applied
Corporate Finance, 27: 89–100.
3. Commodity derivatives, markets and applications, Neil Schofield, Wiley Finance.
4. Commodities and commodity derivatives, Helyette Geman, published Wiley Finance.
5. Project Management Skills, https://www.project-management-skills.com/qualitative-risk-
analysis.html