American Barrick Resources Corporation

How Sensitive Would Barrick Stock Be to Changes in Gold Price in the Absence of Risk

Management?

Pre-tax earnings(Exhibit 2)

223m

Reduction in earnings ifgold sold at spot 1,280m oz.X(422-345)Exhibits 2 and 12

(99m)

Proforma pre-tax earnings 124m

Taxes21% tax rate, exhibit 2

(26m)

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 Barrick’s 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 don’t 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.

• Let’s 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.

Gold price

Payoff

200 400 600 800 1000 1200

20

40

60

80

100

120

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 don’t 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%

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

Production 200 oz. 200 oz.

Forward at t=0 $312

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, Barrick’s risk management involved substantial speculation.

Who Uses Derivatives?

• Many surveys. Let’s 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

0%10%20%30%40%50%60%70%80%90%

1-90days

91-180days

181days -1 year

1 - 3years

3+years

0%1-25%26-50%51-75%75-100%

Maturity of exposure

Percentageof respondingfirms

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.

Tufano’s 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.