Hedging a Jewellery Order with Limited Margin
A Coimbatore jeweller has contracted to supply 25 kg of 22-karat jewellery in three months at a price fixed today, and will buy 24-karat gold then. The exchange's gold futures contract is 1 kg of 995 purity, quoted at Rs 73,500 per 10 g. The firm has Rs 35 lakh of free cash for margins. Exchange initial margin is 10% of contract value, plus an additional 2% margin imposed for the festival season. The CFO proposes buying 25 lots. The compliance officer points out that 22-karat jewellery contains 91.6% gold, so the actual fine-gold requirement is about 22.9 kg, and that the firm's board-approved hedging policy caps derivative exposure at 60% of forecast purchases. Gold mini contracts of 100 g and gold options with a 1 kg lot are also available; the at-the-money call carries a premium of Rs 1,200 per 10 g.
1. Compute the contract value, the margin per lot, and the maximum number of futures lots the firm can carry. Reconcile this with the hedging policy and the economic exposure.
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Contract value per lot = 1 kg = 100 x 10 g x Rs 73,500 = Rs 73,50,000. Margin at 10% + 2% = 12% = Rs 8,82,000 per lot.
Fine-gold exposure = 25 kg x 0.916 = 22.9 kg, so a full hedge needs 23 lots (22.9, rounded).
With Rs 35 lakh the firm can post margin for only 3 lots (3 x 8,82,000 = Rs 26,46,000), leaving about Rs 8.5 lakh as a variation-margin buffer. Four lots would consume Rs 35,28,000 and leave nothing for mark-to-market calls, which is how hedgers get forcibly unwound at the worst time.
The board policy limit of 60% of 22.9 kg, i.e. about 13.7 kg or 13 lots, is not the binding constraint; margin is. The firm is therefore economically long 22.9 kg but hedged for only about 3 kg, roughly 13% coverage. That gap must be reported to the CFO as residual risk, not treated as hedged.
2. Assume the firm buys 3 futures lots at Rs 73,500 per 10 g and gold then falls 8%. Quantify the futures loss, the margin call, and the offsetting benefit in the physical market. What lesson does this hold for hedge accounting and liquidity?
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An 8% fall is Rs 5,880 per 10 g, i.e. Rs 5,88,000 per kg. On 3 lots the mark-to-market loss is 3 x 5,88,000 = Rs 17,64,000. The margin account drops from about Rs 26.5 lakh to about Rs 8.9 lakh, which is below the 12% requirement of Rs 8.82 lakh only marginally, so a small further fall triggers a call for cash the firm may not have.
Economically the firm is better off: the 22.9 kg it must buy is cheaper by 22.9 x 5,88,000 = about Rs 1.35 crore. The futures loss is a real cash outflow today, while the gain is unrealised and only appears when the gold is purchased and the jewellery delivered.
This mismatch is the classic hedger's liquidity trap. The hedge must be sized so that variation margin can be met in all plausible scenarios, and the firm should either hold a cash buffer, use a shorter-dated hedge rolled forward, or replace part of the futures position with long calls.
3. Compare buying 23 at-the-money calls at Rs 1,200 per 10 g with the futures programme for this exposure. Address cost, basis, and which risks remain unhedged in either case.
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Option premium = Rs 1,200 per 10 g = Rs 1,20,000 per kg; for 23 lots (23 kg) the cost is 23 x 1,20,000 = Rs 27,60,000. That fits inside the Rs 35 lakh, and a long option needs no variation margin, so there is no forced-unwind risk. Futures at 3 lots cost Rs 26.5 lakh in margin but hedge only 3 kg.
So the option route covers the full 22.9 kg exposure with a known, capped cost, at a premium of about 1.6% of notional. The futures route gives cheaper but far smaller coverage and carries unlimited mark-to-market funding risk.
Residual risks are common to both. The futures contract is 995 purity while the hedge is on 91.6% content, so the hedge is on fine-gold value; making charges, GST, import duty changes and the local basis are not hedgeable. The option strike choice also matters: a higher strike is cheaper but leaves a deductible. The firm could combine both: a core futures position funded by cash plus calls for the balance.