personal finance

The mechanics of hedging gold

What is hedging?

Insuring oneself against price risk and volatility by taking a position contrary to the one on the physical market.

How does it happen in gold?

If you are a jeweller having an order to sell a quantity of jewellery to a customer by say end of June. You have to buy gold bars from a bank or bullion dealer, make jewellery and sell it by June end. Assume by June end gold price falls from the current levels. You make an inventory loss if you buy gold today. So, the moment you give an order to purchase gold from the spot market, you sell an equal quantity on a commodity derivatives exchange. Assume gold costs Rs 30,000 per 10 gm today. You buy a kilo of gold for Rs 30 lakh and simultaneously sell a futures contract for around the same sum. Now assume by June end gold falls to Rs 29,000. Had you not hedged yourself, you would face an inventory loss of Rs 1,000 per 10 gm , and the price of jewellery too would reduce.

Had you hedged, by selling gold futures , the loss of Rs 1,000 on spot would have been made up by a corresponding gain on the futures market. When you actually sell jewellery worth a kilo, you would buy back what you sold on the futures market and be net neutral. In practice hedging has a cost and only those companies with scale and experienced treasury hedge themselves.

Where do companies hedge gold ?

Either on the over- the -counter market, dominated by banks, or on commodity exchanges, like MCX. More recently BSE and NSE have launched gold derivatives. With time these would gain traction, stakeholders believe.

Who is the counterparty to the hedger ?

The counterparty is the speculator — hedge fund or retail — who takes an informed decision contrary to that of the hedger.


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