More On Hedging Gold Stocks
By Brad Zigler | December 02, 2008 | 11:54 AM | 0 Comments
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Yesterday's column ("Gold Hedging: Up Close And Personal") prompted several readers to request hedge ratios for their gold stocks.
Without further ado, here are the numbers for the most-requested issues:
Gold Stock Hedge Ratios
"All fine and good," I hear you say. "But what's all this mean? How do I use this?
Here's the down-and-dirty on hedging gold's volatility.
The hedge ratio defines the size of a position in the PowerShares DB Double Gold Short ETN (NYSE: DZZ) relative to the stock. The ratio is determined by comparing the stock's recent volatility with that of the exchange-traded note.
Take Yamana Gold (NYSE: AUY), for example. AUY's annualized volatility, or price variance, was clocked at 94.8% in 2008, while that of DZZ was 67.5%. To match the price volatility of AUY, 1.41 times as many dollars must be invested in a DZZ hedge (derived as 94.8% รท 67.5%).
Let's say you're now considering a $20,000 investment in AUY, but are concerned about current gold market volatility (for a look at the costs of recovery from a bout of volatility, see "Recovering Market Losses"). To buy the hedged version of AUY, you'd split up your $20,000 risk stake between the stock and the DZZ notes. A fully hedged stock position - that is, one in which gold volatility is neutralized - would devote 41%, or $8,200, of risk capital to AUY and 58%, or $11,800, to DZZ.
A little algebra helps us arrive at those values. The size of the AUY stake, let's call it x, is found by:
x + 1.41x = 100%
2..41x = 100%
x = 41%
The hedged position, i.e., 100% of your capital, is made up of the AUY stock, and a DZZ position that is, dollarwise, 1.41 times larger.
The hedge ratio can also be used to determine the hedged size of an existing position in AUY. If you're now considering price protection on a position entered previously, you might consider selling down the stake to 41% of present value and investing the proceeds in DZZ.
Yamana Gold (NYSE: AUY) Hedged And Unhedged Since March 2008
With perfect hindsight, a gold-hedged position in AUY would have lost 19.1% from March, while an unhedged position would have plummeted 73.1%. Applying the law of breakevens illustrated in the "Recovering Market Losses" article, the unhedged position requires AUY to make a 272% turnaround to reach breakeven. The hedged position, in contrast, needs only a 24% move to bounce back.
Keep in mind that DZZ only mitigates gold's price volatility. There are residual risks remaining in the hedged AUY position: equity market risk and management risk. Those are, in fact, the risks you WANT in a stock investment, right?
Now, a couple of cautions about hedging. First, hedging isn't rote. You hedge an existing position when you figure the cost is justified by market conditions and when they're lower - counting timing risks, taxes and transaction fees - than just selling out to rebuy later.
Second, the hedge results shown in the chart above are based upon "in-sample" data. That is, we're looking back at a period where the volatilities of the two instruments are known - not just forecast. From this point forward, our hedge ratio reflects our best guess at what future volatility may be, but it in no way guarantees us the results obtained from the in-sample case.
With that in mind, a hedge needs to be monitored and perhaps adjusted during its life to compensate for increased or decreased market volatility.
Third, a DZZ hedge requires capital. Cash money. You need to purchase the DZZ notes from your risk capital stake. That's money that isn't going to be put to work elsewhere in your portfolio while it's cushioning your gold stock. You'll have to decide if that's a worthy trade-off.
There are other ways to hedge a gold stock investment. We'll compare and contrast your hedging options in an upcoming feature.
In the meantime, you can post your comments or questions here or through contact@hardassetsinvestor.com .
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