Tufano, P. 1996. Who manages risk? An empirical examination of risk management practices in the gold mining industry.

Journal of Finance 51, 1097-1137 WHAT: The article examines a new database that details corporate risk management activity in the North American gold mining industry. WHY: To examine the theories of risk management as means to maximize shareholder value. FOUND: Little evidence to support the theory HOWEVER: 1) Firms whose managers hold more options manage less gold price risk 2) Firms whose managers hold more stock manage more gold price risk Managers hold greater equity stakes as a fraction of their private wealth would be more included to manage gold price risk MEANING: 1) Managerial risk aversion may affect corporate risk management policy 2) Risk management is negatively associated with the tenure of firms CFO, perhaps reflecting managerial interests, skills, or preferences

Academics know little about corporate risk management practices, even though almost three-fourths of corporations have adopted at least some financial engineering techniques to control their exposures to interest rates, foreign exchange rates, and commodity prices. Because, corporation disclose only minimal details of their risk management programs, and empirical analyses have to reply on surveys and relatively coarse data that are anyways vague. The Wharton/Chase Derivatives Survey (1995) reports that over 70% of firms use derivatives to hedge commitments. Gold mining industry: Share a common and clear exposure in that their output is a globally-traded, volatile commodity. Firm can manage exposure using a rich set of instruments: o Forward and futures contracts o Gold swaps o Gold or bullion loans o Rolling forward commitments called spot deferred contracts o Options Firms in gold mining industry disclose their risk management activities in great detail in quarterly reporting to investors. !!! Mining industry is reasonably transparent. Rationales for risk management are based on asymmetric information and deadweight costs of financial distress, but these are seemingly irrelevant. Theories might predict that no firms manage gold price risk. BUT the contrary: over 85% of firms in gold industry used at least some sort of gold price risk management in 1990 1993 Mining firms have adopted very different very different risk management approaches Example 1: Homestake Mining: sold all of its production at spot prices and made vigorous pronouncements against gold price management Example 2: American Barrick: featured its successful heding program on the cover of its annual report Delta: a common measure of exposure of investment portfolios. Represents change in the value of a portfolio with respect to a small change in the price of an underlying asset. Through the logic of dynamic replication: represents the equivalent long or short position in the underlying asset necessary to construct the replication portfolio

Here: delta represents the ounces of gold that the firm has effectively sold short through its financial risk management activities.
Table I

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The Journal of Finance

Sample Data on One Gold Mining Firm's Risk Management Activities

Panel A: Data from "Global Gold Hedge Survey" for One Gold Firm, as of March 30, 1991a 1991 1992 1993

% of Price % of Price % of Price Ounces (US$/Oz.) Production Ounces (US$/Oz.) Production Ounces (US$/Oz.) Production Forward sales Gold loans Puts (purchased) Total Calls (sold) 96,000 22,353 20,000 138,353 20,000 $443 $476 $425 $446 $455 61.2 44,706 44,706 $476 $476 10.3 44,706 44,706 $476 $476 11.0

Panel B: Delta of Firm's Gold Derivative Portfolio, as of March 30, 1991 Position Forward sales-1991 1991 Gold loans-payable 1992 Gold loans-payable 1993 Gold loans-payable Put options maturing 1991d Call options maturing 199ld Aggregate equivalent portfolio position (ounces) Production estimate through 12/93 (ounces)e Delta-percentage = percentage offproduction accounted for by portfolio delta
a b

Ounces 96,000 22,353 44,706 44,706 20,000 20,000

Deltab - 1.0 - 1.0 - 1.0 - 1.0 -0.957 -0.003

Delta-Ouncesc -96,000 -22,353 -44,706 -44,706 -19,140 -60 -226,965 1,066,524 21%

Delta equal to - 1.0 for short forward and gold firm that has 21% The above example demonstrates a embeddedforward positions. of hedged portfolio. c Delta times number of ounces. 226,965 ounces optionsmature on the final day of the periodand are structuredas Europeand Assumingthat the of gold sold short equals 21% of the firms estimated production through the end of 1993 style optionsthat terms: 21% of thethe expirationdate. Uses risk-freerate and gold lease rate has been sold forward, and that portion of Managerial can be exercisedonly on gold to be produced over the next 3 years model. as of March 30, 1991 as inputs to gold price exposure As of this date, the appropriate the mines production has noBlack-Scholes-Merton risk-freerate was 5.9 percent and the gold lease rate was 0.83 percentper annum. The price of gold was $367.10/oz.and the volatility of gold over the prior90 days was 9.6 percentper annum. eImplied by Panel A. !!! were information available on the firms financial risk management positions for all maturities, the risk management f Equals equivalent portfolioposition divided by productionestimate. While these numbers are portfoliofor all the firms in the database, their absolute values are reportedthroughoutthe study. delta could be scaled by the value data of the mines unhedged operations. negative Risk Management in Gold Mining Greater delta-percentage indicates a larger the value production has been hedgedfor a small change in gold price, which would equal value would reflect the change in amount of 1105 unhedged firm through of the equivalent short-sales. II the change in value of the entire production profile, reflecting all reserves, as well as the change in value of the real Table

Ted GoldHedgeSurvey," FirstBostonEquityResearch Source: Reeve,"Global (June 10, 1991),p. 11.

Distribution of Riskin production, development, acquisition, and exploration. options Management Activity in the North American the Gold Mining is $367), and thus have deltas almost equal to 1.0.6 gold price Industry, 1990-1993

each firm and which financial risk management transactions for the remainder of the and have deltas of nearly quarter, it sold are substantially out-of-the-money, rent year andTable represents the level are risk management activity or the subsequent two calendar years of aggregated to form a portfolio delta entered into by the firms in the sample between 1990 zero. In the aggregate, for a $1 drop in the gold ivalent short position in ounces of gold. This equivalent short position is divided by the firm'sprice, the market value of percentage: the %period, to following 3 yearsvariable that projected production that had been effectively sold short. worth of mated productionoverfirm's gold of the form delta-percentage, aTable II repre- $226,965. the the same time derivative portfolio should rise by s the percentage of productionover the following three calendar years that is coveredby risk These delta-percentagefigures are averaged over the 16 quarters for each nagement activities.6 This calculation is reportedusing the weighting for each firm and m, and the distributionof firm observationsassumes that equaloptions expire at the end of the year shown. The other ghing each firm information needed to calculate the delta include the risk-free rate (calculated using Treasury by their proven and probablereserves.

Risk Management in Gold Mining

The calls

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1993, in average delta-

Distribution of Risk Management Activity in the North American Gold Mining Industry, 1990-1993

rates), firm and quarter, financial risk management transactions prior 90 days), and For each the volatility of gold (calculated using the historical volatility over thefor the remainder of the the gold lease rate subsequent two calendar years are aggregated gold leasearate is the delta or by Jessica Cross and Morgan Stanley). The to form portfolio current year and the(supplied Percentage of: interest short position in ounces of gold. This equivalent short position is divided by the firm's Firm Delta-Percentage Industry equivalentrate paid on borrowingsof gold. (average 1990-1993) the estimated productionover FirmssameReserves time period, to form delta-percentage, a variable that repre14.8 14.6 the percentage of productionover the following three calendar years that is coveredby risk sentsExactly 0 14.6 0.1-10 11.3 management activities. These delta-percentagefigures are averaged over the 16 quarters for each 10-20 14.6 25.2 6.4 firm,20-30 the distributionof14.6 observationsis reportedusing equal weighting for each firm and and firm 22.7 30-40 25.0 weighing each firm by their 2.1 proven and probablereserves. 1.9 40-50
50-60 60-70 70-80 80 _90a
Mean

20-30 14.6 rm may have had a delta-percentage exceeding 100 percent; the maximum quarterly deltaor more of the price risk of their projected 3 year output centage is 146 percent. 30-40 25.0

22.4 Exactly 0 0.0 0.1-10 85.9 10-20 These represent averages over the four year period 1990-1993.

Median Standard deviation Minimum Maximum

Firm Delta-Percentage 25.6 (average 1990-1993)

22.9

4.2 4.2 4.2 2.1

4.1 1.0 0.7 12.0

Percentage of: Firms Industry Reserves 14.8 11.3 25.2

Table II reports the level of risk management activity entered into by the 4.2 50-60 ms in the sample between 1990 and 1993, reported as the firm's average 4.2 60-70 ta-percentage-the percentage of the following three years' worth of pro70-80 sold short. The table gives4.2 the ed production that had been effectively 80 weighing each firm equally as well as 2.1 tribution of risk management activity,_90a proven and probable reserves. Looking at the distribution, it is apparent t firms have adopted diverse practices, with 14.6 percent selling all of their Mean 25.6 put at spot prices and 16.8 percent of firms shedding 40 percent or more of Median 22.9 price risk of their projectedthree-year outputdeviation median firm in Standard forward. The 22.4 sample shed 22.9 percent of its output over the multiple-year period shown Minimum financial transactions to 0.0 the table. There are no firms that used these 85.9 rease gold price exposure; thus, it Maximum the financial risk manageappears that

Firms have adopted diverse practices, with 14.6% selling all of their output at spot prices and 16.8% shedding 40% 6.4 forward 22.7 One firm is hedging almost entirely probably a German firm. 2.1 1.9 40-50
4.1 1.0 0.7 12.0

14.6 14.6 14.6 For any one quarter or year,

WHY RISK MANAGEMENT: 1. Financial Distress for risk management (Smith and Stulz, 1985) Gold mining firms encounter financial distress if the price of gold falls below their costs to produce gold and make fixed financial payments. By reducing the likelihood of costly financial distress, risk management can increase the expected value of the firm. Increase in value comes from reduction of deadweight costs, and an increase in debt capacity, which in turn can benefit the firm through valuable tax shields or reductions in agency costs of excess free cash flow. 2. Investment Policy Without risk management, firms will be forced to pursue suboptimal investment policies. Strong link between cash flow and investment due to capital market imperfections o Information asymmetries Risk management programs break dependence of investment on cash flow maximize firm value. 3. Taxes In the presence of convex tax schedule, firms would reduce expected taxes by using risk management to fix the level of taxable earnings. Greater convexity of the tax schedule should lead to more risk management 4. Managerial risk aversion Managers who human capital and wealth are poorly diversified strongly prefer to reduce the risk to which they are exposed If managers judge that it will be less costly to them for the firm to manage this risk than to manage it on their own account, they will direct their firms to engage in risk management. Greater stock ownership more risk management o Stocks provide linear payoffs as a function of stock prices Greater options less risk management o Options provide convex payoffs 5. Signaling managerial skill Managers reputation Managers prefer to engage in risk management so as to better communicate their skills to the labor market Alternatives to risk management as controls Firms can pursue alternatives that substitute for financial risk management. Instead of hedging or insuring, they could adopt conservative financial policies such as maintaining low leverage or carrying large cash balances to protect themselves against potential hardship.