Construct a swap!

Hey all, Can someone give me an example of how: “Gold mining companies use swaps to hedge future deliveries of gold” simple question I know. Just want to make sure I have this whole idea of a swap right.

gold mining company is a PRODUCER of a commodity. they mine gold so they can sell the gold in the market. therefore, when they mine the gold, they have “exposure” to the price fluctuations of the gold prices. Producers are have a “net long” exposure of whatever asset they produce and subsequently OWN. To hedge the price fluctuations (because they dont want to risk the chance that they will have to sell at a lower market price a.k.a price will drop) they want to hedge the position by entering into a short position (via put options). thus u have a swap.

pacmandefense Wrote: ------------------------------------------------------- > gold mining company is a PRODUCER of a commodity. > they mine gold so they can sell the gold in the > market. therefore, when they mine the gold, they > have “exposure” to the price fluctuations of the > gold prices. Producers are have a “net long” > exposure of whatever asset they produce and > subsequently OWN. > Yep > To hedge the price fluctuations (because they dont > want to risk the chance that they will have to > sell at a lower market price a.k.a price will > drop) they want to hedge the position by entering > into a short position (via put options). thus u > have a swap. Nope - this is about swaps (which is a derivative) not put options. Suppose that a gold miner is going to take 1000 oz of gold/month out of the ground. Suppose that gold is currently selling at $700/oz so he is taking $700K of gold from the ground every month. The gold miner enters into a swap contract in which he will exchange (Change in gold price in %) * 700,000 for some interest rate (this would be figured out from the carrying cost of gold). If gold prices drop, the producer loses on the sale of his gold but gains on the swap. If prices increase, vice versa. Either way, he has locked in the price of gold at $700/oz (which isn’t exactly true because of the other leg - what he has done is to lock in gold prices at the current gold forward prices).

so just to get this straight in JoeyDVivre’s example: The gold miner is paying a fixed rate with another party for the other party to pay the miner when the price of gold drops and receive money when the price of gold rises. Is this correct? Thanks!

Yep…