a finance problem about option?

Question

you have just been hired as a financial adviser by a gold mining company. In order to guarantee its revenue for the current year,the company has sold call option on gold worth 150% of its annual production. These call options have average strike price of 5% above the current market price and mature in
the next year. There is a rumor that a central major bank will soon announce a halt in sales of gold, what do you advise your client and why?

Answer 1

nice homework problem -- congratulate your Professor.

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Spot gold, and options, trade world-wide [Sydney, Tokyo, Shanghai, Bombay, Middle East, London, New York] so the moment this rumor swept the trading pits, you may be sure that the call option price jumped.

Thus, whatever was going to happen to the option price has already happened and your client can not beat the market.

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Under its current operating plans, your client sold options on 150% of its estimated annual production.

They will be able to fulfill the 100% part of the contract with their production over the next year, so that can be thought of as an ordinary hedge. [sold options against the future production.]

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The remaining 50% of production on which options were sold amounts to a speculation in the gold market by your client. [I'll call these "excess call options" below.]

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With the spot price of gold rising, I'd recommend that your client re-examine its production plans for the coming year to determine the cost of increasing output and the volume of gold that such a production increase might achieve.

{This may take the form of running more daily shifts, or opening additional drifts, or re-opening operations that had been closed in lower price years, or running a previously uneconomic secondary treatment operation on the tailings from existing or past production, etc.}

Hard operating decisions need to be made, and quite soon, about the extent to which expanding production is a viable way of being able to fill the excess call options.

The alternative to trying to fill the excess call options is to buy them back immediately and record the loss this implies. [This should be easily calculated.]

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If you are an advisor to the Board or the CEO, there is an issue they need to address concerning the prudence of the company speculating in the gold markets. In general, producers focus on production and may hedge against future operations, users work on the efficiency of their operation may hedge against future price increases, while speculation is left to professionals in that business.

The possible loss your client is looking at here is exactly why most producers do not hedge in excess of their planned annual output. {"Who authorized this speculation and was it within the scope of their authority?" -- Someone may need to be fired.}

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If the rumored central bank action become reality [as it did in 2007], you can expect that the price of gold will rise a fair percentage [25 to 40% does not seem unreasonable], as the fundamental condition of the market is and has been that end user demand [electronics and jewelry plus hoarding in India and China] is below the industry's aggregrate planned production level.

Higher prices will, of course, lead many existing producers to consider exactly the same steps to increase output that your client is considering. However, in the short run [months, as opposed to years] output is fairly inelastic -- added workers have to be trained or lured back from other jobs, more capital equipment has to be ordered, built, shipped, and installed plus workers trained, etc.

As a whole, the industry will react to higher prices by discovering and opening added mines in many parts of the world. This will put a "lid" on the price level in the long run -- absent some conflict induced shock, $100 gold likely will not be seen [or if it is, not for long].

GL with your homework

Answer 2

Your client is the mining company. There are some real problems here. The gold mining business relies on major finds or shuts down. It has in some towns dismantled the whole structure above ground to move to a new area with better returns.

Answer 3

Do not be in a hurry.Wait for and not listen to roumors that the sales ill stop.THE REASON COULD BE TO REDUCE THE 5% MAY BE REDUCED
WAIT AND SEE

Answer 4

nothing........banks are not sellers of gold....................and do not control it;s sale.try government.............
buy back the 50% over production options................
you can sell at the mkt and make more..........depending on what price you sold the options at...........
see what the rise in the price of gold has been for the past 5 and 10 years........
check oil and sub prime........uncertainty will move gold up..............