Gold Derivatives: Gold Derivatives: - World Gold Council

producer faces price risk because of the time which elapses between making the
production decision and selling the commodity. When the producer decides to
invest in new capacity he incurs known costs, but the revenues are uncertain
because the price he will eventually receive for his output is unknown. In deciding
how much to produce (‘the investment decision’), the producer has to depend
on his own forecast of the future spot price of the commodity and bear the
risk of his forecast being wrong.
Suppose now that a forward market is opened. The producer has two decisions
to take: an investment decision (how much, and indeed whether, to produce),
and a hedging decision (what proportion of the output to be sold forward rather
than spot). Provided certain conditions are met (the producer is too small to
affect prices, the producer is seeking to maximise the utility of terminal wealth,
and the only significant source of uncertainty is the future spot price), then in
the presence of a forward market the investment and hedging decisions are
separable. The investment decision should be taken purely on the basis of the
forward price at the time the investment decision is taken. The producer should
act as if all the output will be sold on the forward market. The forward price of
the commodity should determine the production level whether or not the producer
decides to sell his output forward, and whether or not he believes the
forward price is reasonable.
That is not to say that the producer should sell all his output forward. If for
example the forward price is far below the producer’s expectation of the future
spot price, and if he believes in his own forecast, he should not sell all his output
forward. Rather he should sell some or all of his output on the spot market.
To put the point another way: in the absence of a forward market, the producer
necessarily acts on the basis of his own forecast of future spot prices and takes
investment decisions which take account of the uncertainty of the price at which
he will actually sell. With a forward market, investment decisions can be taken on
the basis of the current forward price, and uncertainty about the future price is no
longer a factor in investment decisions.
A number of important consequences flow from this separability result. In a world
where producers do not know much about the forecasts and production plans of
other producers, the forward price captures valuable information which makes
the investment process more efficient. The forward market makes it difficult for
the infamous ‘hog cycle’, beloved of economics text books, to materialise. In the
hog cycle, underproduction one year leads to a shortage with consequent high
prices. This attracts new producers into the market, leading to a glut the following
year. The result is a very volatile price. In the presence of a forward market in
hogs, this type of behaviour would not occur. With a forward market, the feedback
loop is instantaneous and production plans which in aggregate will lead to
Gold Derivatives: The market impact 89