Hedging Silver Inflows: Choosing the Right Instrument

The Most Appropriate Instrument for Hedging Silver Inflows

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A large silver mining corporation in Australia is expecting to have three large inflows of raw silver resulting from a discovery of three silver seams that were previously undetectable. The firm expects the first silver inflow to be ready for sale in nine months, followed by the second inflow three months later and the final inflow six months later. The mining company is expecting the price of silver to begin a downward trend for the next 18 months and wants to hedge the expected inflows without exposing themselves to credit risks. The most appropriate instrument the company should use is a:

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A. B. C.

A

To hedge the expected inflows of silver without exposing themselves to credit risks, the mining company in Australia can consider using derivative instruments such as futures contracts, forward contracts, or swap contracts. Let's evaluate each option and determine the most appropriate instrument.

A. Series of futures contracts expiring in 9, 12, and 15 months: Futures contracts are standardized agreements to buy or sell an asset (in this case, silver) at a predetermined price (the futures price) on a specified future date. These contracts are traded on exchanges, and they carry the benefit of being highly liquid and transparent. However, futures contracts do expose the company to credit risks, as they require margin deposits and potential daily settlement payments. Therefore, this option does not meet the company's objective of avoiding credit risks.

B. Series of forward contracts expiring in 9, 12, and 15 months: Forward contracts are similar to futures contracts, as they also involve agreements to buy or sell an asset at a predetermined price on a specified future date. However, forward contracts are customized and traded over-the-counter (OTC) rather than on exchanges. While forward contracts do not have the same credit risk associated with margin deposits and daily settlements as futures contracts, they still expose the company to counterparty credit risk. If the counterparty defaults, the company may face losses. Therefore, this option also does not meet the objective of avoiding credit risks.

C. Swap contract with payments in 9, 12, and 15 months: A swap contract is a financial agreement between two parties to exchange cash flows based on specified conditions. In this case, the mining company could enter into a silver swap contract with a financial institution or another counterparty. The company would receive fixed payments from the counterparty based on the expected future price of silver, while the counterparty would receive the actual silver inflows. This would allow the company to hedge against the expected downward trend in silver prices without being exposed to credit risks.

The most appropriate instrument for the mining company to use, given their objective of avoiding credit risks, would be a swap contract with payments in 9, 12, and 15 months. This instrument would provide the desired hedge without requiring margin deposits, daily settlements, or exposing the company to the credit risks associated with futures or forward contracts.

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