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derivatives purely for hedging, the presence of risk premia could confound the effects of
derivatives use when it generates negative expected cash flows. 204
Adam and Fernando [2003] analyze a sample of 92 North American gold mining firms in
the period 1989-1999, and find that the firms earn positive derivatives cash flows that are
highly significant both economically and statistically. 205 The bulk of the cash flow benefit
from the use of derivatives appears to stem from persistent positive risk premia in the gold
market, i.e. forward prices that persistently exceed future spot prices (contango). While
continually selling forward is a risky strategy for pure speculators, gold mining firms have
a comparative advantage in capturing the benefits of a positive risk premium. Namely, they
are inherently long in gold (gold reserves). Hence, they can deliver the physical leg when
the spot price at maturity turns out to be higher than the forward price, and do not need to
face cash calls due to the negative mark-to-market of the position.
Nonetheless, to the extent that this risk premia in the gold market are attributable to
systematic risk in gold prices, theory would dictate that a firm’s systematic risk should be
adjusted upwards to offset any positive cash flows that it earns from these risk premia.
Surprisingly, Adam and Fernando [2003] find no evidence of such an adjustment. Hence,
results show that hedging has been tremendously profitable for most gold mining industries
during the sample period. In view of the large body of literature that shows the presence of
risk premia in a wide range of currency and commodity markets, there is no reason to
believe that this corporate behavior is unique to the gold market only.
204 Consider, for example, an oil producer who wants to lock in its revenues in the short run by selling
forward in the paper market. As the oil forward curve is – in most of the cases – backwardated (prices of
closer maturities exceed those of back-end maturities), by hedging the oil producer locks in its revenues at
lower levels than the spot price, which latter is mostly a better estimate of expected future spot prices.
205 The sample firms realize an average total cash flow gain of $2.73 million per quarter, while their average
quarterly net income is only 0.87 million.
199