CORPORATE FINANCIAL RISK MANAGEMENT

PROF. JOUAHN NAM

PROJECT REPORT 1

CASE STUDY - NEWMONT MINING CO.

Prepared by:

Chunyang TangReema Ayyoub

Efthymios GkotsisUsman RiazZaki Kasim

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INDEX

1. NEM’s Exposure to Gold Price…….…………………..3

2. Should NEM Hedge?.......................................................4

3. Hedging Strategies and Related Payoffs………………5

4. Long Term Hedging Strategies…….…………………..8

5. APPENDIX……………………………………………...10

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1. NEM’s EXPOSURE TO GOLD PRICES

Methodology

In order to measure the NEM’s exposure to gold price change, we adopt the similar Multiple Regression Model following Jorion’s paper (1990)1.

RSi=β0+β1RGi+β2RMi+εi

Where RSi is the rate of return on company’s common stock, RGi is the rate of change in gold price （ GLD ） and RMi represents the rate of change in market index(S&P 500).

As for the time series selection, we decide to run both weekly and monthly regression to examine the coefficients. The data for weekly regression ranges from 12/31/2008 to 2/4/2013 and the monthly observations starts from 12/1/2004 to 2/1/2013. 2

Refer to Appendix 1 for Excel analysis

Weekly Results

After running the regression on 214 weekly observations (significant at 5% level), we got:R2 (Coefficient of determination)=48.8%, interpreting that almost half of the variance can be explained by our model.β1 (GLD return)=1.19, showing that the stock price of NEM is highly correlated with gold price changes.β2 (S&P 500 return)=0.45, which does not bring the same level of exposure as gold.Correlation coefficient for Gold is statistically significant (P<0.05), whereas it isn’t for S&P 500.

Monthly ResultsAs for the regression on 98 monthly observations,R2 (Coefficient of determination)=54.9%,β1 (GLD return)=1.31β2 (S&P 500 return)=0.16Correlation coefficient for Gold is statistically significant (P<0.05), whereas it isn’t for S&P 500.

Conclusion

With outputs from both weekly and monthly regressions, we can say that NEM is highly exposed to gold price changes. For every 1% increase (decrease) in gold

1 Philippe Jorion, 1990, The Exchange-rate exposure of US multinationals.

2 All sources come from yahoo finance.

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prices, it is highly possible to result in 1.2%-1.3% increase (decrease) in the company’s stock price.

2. SHOULD NEM HEDGE?

Other than the obvious reason of gold price fluctuations, there are other risks that need to be considered when taking this decision. First of all, NEM is at great risk of losing control of its ownership on its operations in Batu Hijau, Indonesia due to domestic conflicts. This will decrease its future inflow of gold and will have a sure effect on its net income. Its sales from Batu Hijau were equal to $1,576 million in 2013. If the company hedged against the dropping gold price in 2013 it would have a better chance of better running its operations in Indonesia. Hedging would allow for extra cash flow to pay the extra taxes that the company is adding on the use of the port. Furthermore, it would allow for building a facility for refining the copper further to comply with the new export standards that the government has implemented.

Minimize Expected Tax

The company has a lot of tax carry forwards and tax breaks that it can only implement if it has enough taxable income. The fluctuation of gold prices affects the company’s ability to take advantage of all this because of certain restrictions and time brackets that affect its taxable income. In addition, the U.S. tax system is moving from GAAP to IFRS, which could adversely affect the company’s bottom line. As mentioned in the 1985 paper by Smith and Stulz; “If hedging reduces the variability of pre-tax firm values, then the expected corporate tax liability is reduced and the expected post-tax value of the firm is increased, as long as the cost of the hedge is not too large.”

Underinvestment Problem

The final reason for hedging which is arguably the largest and had the most direct effect on the losses the company incurred in 2013 is the write-downs the company had to make. Their write-downs increased from $52 in 2012 to $4,352 in 2013. This was primarily due to decrease in the company’s long-term gold and copper, rising operation costs and the decreasing gold price assumptions. Furthermore the valuation of the company as a whole was affected and therefore decreased in future cash flows that forced the company to make even more write downs in its operations. Due to fair value accounting standards, the company had to re-evaluate its operations based on current prices in the market and downward predictions that the company and the market expect, thereby devaluing a lot of assets and intangible assets such as goodwill.

When the company does not hedge, it creates an underinvestment problem. By not hedging, the company can lose control of its facilities. Most of the write-downs the company had to make in 2013 and in previous years, when the gold price was not favorable, is due to not hedging against the gold price. If the company hedged, it would not have to make so many write-downs and that would decrease the amount of capital it would have to put in again to the company when prices go up.

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3. HEDGING STRATEGIES AND RELATED PAYOFFS

A. Partial Hedging - Futures Contracts

The first hedging strategy that NEM could have followed was to hedge the gold price in the futures market. This is more of a top-down approach where we hedge on the basis of average production per year.

Precisely, assuming that the level of gold production in 2013 will remain approximately the same as 2012, the company could have hedged its position by shorting future gold contracts with 1-year to expiration. In this way they could have ‘’locked’’ a specific price for their future sales and kept the same level of revenues between 2012 and 2013. By minimizing the revenues fluctuation NEM could have saved a considerable amount of net income, lost by the huge drop in the gold price in 2013.

In order to simplify our analysis regarding the gold futures hedging position, we don’t consider some key specs of these types of contracts, such as the initial futures margin, the maintenance margin, the marginal calls and the daily settlement procedure for simplicity. Moreover we assume that troy ounces equal to ounces and we neglect the sales from copper and other metals since they only account for 8% of the company’s revenues.

Methodology:

In 2012 Newmont Company had a consolidated gold production of 5.466 million ounces, which was sold in the yearly-average price of $1,662/ounce and generated revenues of $ 9.1 billion. Since the management team had estimated that the gold prices would drop in 2013 by 10%-15% (MD&A, 10-K/2013), they could have at least shorted a specific number of 1-year contracts that covers the gold production sold in 2012 and has a settlement price of $1,662/ounce.Following the worst case scenario, where gold price drops by 15% [Actual drop in 2013 was 16.18 % - Average price of gold realized in 2012 was $1,662/ounce-Average price of gold realized in 2013 was $1,393/ounce], we can estimate the profit that NEM could have realized by this hedging strategy:

-Drop in gold price in 2013- 15%. Gold price would have been approximately $1,412/ounce

- By shorting future contracts with settlement price of $1,662/ounce, NEM could have realized a profit of [($1,662/ounce)-($1,412/ounce)] $250/ounce.

-Since a gold future contract covers 100 troy ounces, the company could have realized a profit of $25,000 per contract.

-In order for the company to cover the entire gold production of 2013, they need 5,466,000/100= 54,660 contracts

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-Total profit from the hedging position: 54,660* $25,000= $1.3665 bill Comparing the results of the hedging strategy with the actual numbers of 2013, we realize that the company could have achieved a partial hedging towards the drop of the price of gold.

Conclusion

Precisely, in 2013 NEM experienced a Net loss of $ 2,462 million which was mainly caused by the drop of the gold price and the write-down of two important facilities in Nevada, US and Boddington, Australia. Had NEM hedged, they could have covered the losses from the gold price fluctuation and a part of the expenses regarding the write- down of the two facilities. The after-hedging estimated Net Loss would have been approximately $1.1 bill, instead of $2.4 bill.

B. Full Hedging - Options Contracts

In this strategy, we consider the actual losses incurred in the company in 2013, taking into consideration the fixed and the variable costs. By performing a sensitivity analysis, we determine the strike price of the option, which would generate approximately the same amount of gains as the losses incurred in the company, with $1 drop in the gold price below the specified strike price.

Our reference year is 2012, and from the income statement and average gold prices data for 2012, it is clear that at an average gold price of $1669/oz, the net income was $1.809 billion. Similarly in 2013, at an average gold price of $1411/oz, the company incurred a net loss of $2.462 billion. However, this loss was largely contributed by the write-down of property, plant and mine development which was a total of 4.352 billion. Assuming that the company already knew about this expense at the beginning of 2013, our strategy will aim at hedging this fixed cost as well in our analysis.

Methodology:

We perform a sensitivity analysis in the spreads created by change in gold prices with the change in net income.2012: @ $1669/oz net income = 1.809 billion2013: @ $1411/oz net income = (2.462) billionhence, total spread in gold price 1669-1411 = 258

total spread in net income 1.809 – (2.462) = 4.271 billiontherefore, the change in net income per dollar drop in gold price is:4.271 billion/258 = 16.554 million.This shows that for every dollar drop in gold price, net income would reduce by 16.554 million.

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Strike Price: we decide the price at which the company breaks even in its net profits, or in other words, has a zero net income. This is calculated as follows:

16.554 million * x = 1.809 billion.x = 1.809 billion/16.554 million = $ 109.28This shows that a reduction of the average 2012 gold price by $109.28 would result in the company’s break even net income.From this analysis, we find our strike price to be:

2012 avg. gold price – 109.28 1669 – 109.28 = 1560 (approx.)

With this in mind, we opt for a LONG PUT option of the XAUUSD gold commodity on Feb. 2013 expiring after 1 year, at a strike price of $1560. The main advantage of this option price is its “out of moneyness” at initiation, making our cash outflow in terms of premium much lower than “at the money” options.

Number of contracts:

Every drop in gold price below $1,560 should generate approximately $16.554 million as explained earlier. Every contract generates $100 for every drop in price below the strike price, meaning to generate $16.554 million, we need: .

*Refer to appendix 2 and 3 for contract and payoff graph.

Since we are optimistic (or rather sure since the data is already available) about the gold price to drop to about 1300 by the time of expiration on Feb. 2014 (*refer to appendix 4 for gold price chart), we haven’t considered hedging for the premium paid up front. Our intrinsic value of the option would be:1560-1300-57 = $203/ozPer contract: 203 * 100 = $20,300/contractTotal value of option: 20,300 * 165540 = 3.36 billion.Net Profit: 3.360 billion – 2.462 billion = 898 million

To break even, we can find out the expected gold price to be as:

(1560 – x – 57) * 100 * 165540 = net loss in 2013 = 2.462 billionbreakeven spot price = $1,354.27/oz

Conclusion:

This method follows a bottom up approach for hedging strategy. Instead of considering hedging for the expected average quantity of gold sold for 2013, we are hedging the expected losses that are to be incurred for the fiscal year. This way, we consider everything related to fixed and variable costs completely; by hedging for the total income which technically considers all these factors.

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Trade off:

The payment of premium upfront for the option is an additional cash outflow for the company, which is analogously affected by the money-ness of the option. The more in the money, the more expensive the option would be. We chose a strike price fairly out of the money to reduce the initial cash outflow, but at the same time, took a risk in opting for such an “out of the money” option.

Risk premium,

Risk premium.

4. LONG-TERM HEDGING STRATEGIES

Hedging can increase the firm value in the short and long run. Hedging is a lot simpler in short run compared to long run. The biggest problem that arises in planning to hedge in the long run is the cost of hedging. The cost of the financial derivatives increase significantly as they go beyond 1 year mark. So for our analysis of the Newmont Mining Corporation’s long term hedging strategy we will prefer Operational hedging over financial hedging. As Chowdry and Howe (1999) suggest that firms are likely to use financial instruments to a greater extent to hedge short term exposure and rely on operational hedging more heavily to hegge long term exposure. But in other empirical studies such as Allayannis , Ihrig and Weston (2001) and Kim, Mathur and Nam (2005), the researcher concluded that the operational hedging can only be a compliment to financial hedging and cannot substitute it. So as a long term strategy we have devised a mix of operational hedging and financial hedging, but operational hedging being more crucial due to its effectiveness and cost benefit in the long run.Below are the hedging strategies that we will use .

Operational Hedging Strategies

A. Gold Loans

The best way to align your liabilities and revenues to take the gold or bullion loan. This is a classic operational hedging strategy where the company can minimize the risk of going into financial distress. This strategy would shield NEM from experiencing gold rate exposure that could see their debt in dollars to elevate to uncomfortable levels. So taking loans in gold or gold bullions in the future can be a big risk minimizing strategy.

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B. Diversification

Diversification is another operational hedging strategy where NEM can benefit. NEM can look into expanding into its copper production and reduce the gold production percentage, currently at 80%, to a more moderate number. We think this strategy is a difficult one to implement in the short run and it needs some time to be effective. Still as an operational hedging strategy we will recommend NEM to slowly diversify into more areas as well.

Financial Hedging Strategies

Futures Contracts

As we agree that financial hedging and operational hedging complement each other, we will also use futures contracts. Futures contracts minimize the loss in case of a price drop. The futures contract obligates the buyer to buy at a set price and date. So NEM can mitigate the risk of loss by going into a futures contract and setting the price for the sale. The benefit of using futures contract is that NEM can hedge its sales and avoid the hefty premiums that it would have to pay if it went for options to hedge. As far as other financial derivatives like options are concerned, we don’t plan to use them as a long term hedging strategy. The premiums on options for a 1 year plus period are huge and it is financially unwise to buy the options. We will be using those financial derivatives as an insurance policy in the short term. But for the long term we will be confining a mix of the three strategies stated above.

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APPENDIX

1. NEM’s EXPOSURE: REGRESSION ANALYSIS RESULTS

SUMMARY OUTPUT

Regression StatisticsMultiple R 0.698515559R Square 0.487923986Adjusted R Square 0.483070185Standard Error 0.033310545Observations 214

ANOVA

df SS MS FSignificance

F

Regression 2 0.2230815590.11154

1100.524

1 2.16164E-31Residual 211 0.234124 0.00111Total 213 0.457205559

CoefficientsStandard

Error t Stat P-value

Intercept -0.003464572 0.00230499 -1.503080.13431

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GLD Return 1.194564312 0.09781315512.2127

2 2.7E-26

S&P 500 Return 0.445486765 0.0857155575.19726

8 4.76E-07

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-0.2 -0.15 -0.1 -0.05 0 0.05 0.1 0.15 0.2

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

0.20Weekly GLD Return Line Fit PlotNEM Return

Predicted NEM Return

GLD Return

NE

M R

etu

rn

2. OPTION CONTRACT – VANILLA: XAUUSD

3. PAYOFF CHART – LONG PUT

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4. GOLD PRICE/OZ CHART

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