Apollo Gold Case Study

1
Apollo Gold Case Study

• Fred Leggett
• Madelyn Puente
• 14 December 2007

2
Business Problem
Apollo Gold and streetTRACKS

• Apollo Gold (AMEX AMT) is a gold mining company
  that has entered into an agreement with
  streetTRACKS Gold Trust (NYSEArca GLD), the
  largest gold ETF, to supply 2,000,000 worth of
  gold (equivalent to 25 future contracts) for
  April delivery
• As of October 30, 2007, GCJ8 Futures (April 2008
  delivery) is 800.30 per ounce, with 100 ounces
  per contract
• With new mining ventures and increasingly
  efficient operations that are continually
  reducing throughput time, Apollo Gold is reaping
  the benefits of record Gold prices.
• Apollo applauds its team for landing such a
  lucrative contract however, it seems that the
  company may have acted brashly given the current
  market conditions and streetTRACKS strong,
  bullish views (consequently discussed).

Position Summary -25F

• Total Exposure Value 2,000,000
• Apollo Gold is short as it has already entered
  into the agreement with streetTRACKS
• The company has an established risk loss limit
  only a 5 chance of losing more than 100,000 or
  5
• 5 loss probability associated with /- 1.65
  standard deviations

3
Market Outlook

• Economic environment, including lower interest
  rates and a weakened US dollar, puts upward
  pressure on Gold prices as investors seek Gold as
  a safe haven
• US Dollar and oil prices are key drivers of the
  price of Gold
• Gold is used as an inflationary hedge, and
  inflationary pressures continue to rise with the
  price of oil
• Both the value of the dollar and the price of oil
  are largely political, making the commoditys
  price even more volatile
• Over the past 6 months we see

CLH8 Price 87.99 Call Implied Vol.
26.75 30 D Hist. Vol. 26.13
US has weakened by 8 against the Euro
Gold has risen by 19
Oil has risen in price by 35
Source I-Net CSSS Credit Suisse Analyst
Report- 30 October 2007
4
Market Outlook Volatility
Gold Prices sensitive to USD/EUR Movement

• A one-cent change USD/EUR
• exchange rate drives the gold
• price by US 8/oz

As well as Oil
US and oil volatility are becoming increasingly
important drivers of gold. Gold has also
displayed seasonality between December and March.
As Apollos contract is for April, it could be
affected by seasonal trend or the decline in the
seasonal trend, again affecting volatility
Source I-Net CSSS Credit Suisse Analyst
Report- 30 October 2007
5
Market Outlook Direction

• The forecasted upward trend in Gold prices is
  largely driven by supply and demand
• Global gold production declines as new reserves
  fail to replace the number of dying mines
• Significant inflation rates (see previous slides)
  accelerate this decline
• Once the current deficit exceeds 500 tons there
  will be a significant and lasting increase in the
  price of gold
• An additional 6,679 tons are needed to supply the
  demand through 2015

Conclusion Market forces of Supply and Demand
are invariably pushing the gold price UP
Net Deficit
Source GFMS World Gold Council Credit Suisse
Standard Securities Estimates, 10-30-2007
6
Market Outlook Our View
Market View Summary

• Direction We see the price of gold going up,
  based on
• Supply and Demand market forces
• Rising oil prices
• Golds role as a safe haven against rising
  inflation
• Volatility We estimate higher volatility than
  the markets implied 21.85 volatility based on
• Strong correlations with uncertainty in both oil
  prices and the dollar exchange rate
• Gold pricing seasonality at the time of our
  contract
• Uncertain political influences
• We estimate 25 volatility

Apollo Exposure versus View

• After further investigation, it seems as if
  Apollos -25F (short) exposure is less than ideal
  given the current up/volatile market environment
• Given the situation, Apollo realizes it is
  necessary to hedge their initial exposure and
  effectively reverse their position to long

7
Critical Price and Risk Premium Calculation

• Today is October 30, 2007
• For the Gold Contract due April 28, 2008 (GCJ8),
  there are 181 remaining days to maturity
• Using the Market Implied Standard Deviation of
  21.85, there is a likely range of 623.76 to
  1036.41
• Based on market research, we predict still higher
  volatility of 25, which gives us a wider likely
  range of 601.34 to 1075.05
• As our position is short and our view has the
  price of gold rising, our view does not equal a
  traditional short hedge that would leave us Net
  -2F.
• To hedge our view, we first buy 25 contracts to
  reverse the position. Based on CP- 601.34, the
  loss is 24.86.
• Next we buy an additional 5 contracts (20.11 of
  position) based on our 5 or 100,000 loss limit
• Our Net Hedge is to buy 30 contracts against our
  -25F initial exposure.

Risk Premium Calculation
There has been an observed declining trend in
the correlation between Gold and the SP 500.
Average correlation is 0.2.
8
Value at Risk ? Initial Short Position -25F
Probability of doing worse than 1.65 standard
deviation (or 1036.2337) is 4.95
9
Value at Risk ? Net Position 5F
Probability of doing worse than -1.65 standard
deviation (or 623.8617) is 4.95
10
Initial Hedge -25F30F

• Our initial exposure is -25F
• With a market down view, our loss would be
  (800.30 1075.05)/800.30 34.33
• To comply with our loss limit, we would hedge
  21F, for a net exposure of -4F

• However, our view is that Gold futures will RISE
  significantly above the current futures price
• Therefore, our loss would be (601.34
  800.30)/800.30 24.86
• To comply with out loss limit, we would
  initially buy 25 contracts to reverse the short
  position and consequently buy up to our loss
  limit, or 30F for a net exposure of 5F

11
Market Data
Futures Price Maturity 04/28 800.3
Hedging Alternatives Options
Prices taken from Bloomberg as of 10/30/07

• Beyond Apollos initial hedge, the company is
  also looking for alternative hedging
  opportunities through options
• The adjacent table summarizes options prices at
  various strikes as of October 30, 2007

12
Hedge Summary Map of Alternatives

• Above is a map of alternative hedging strategies
  centered around our market view
• Most consistent with our view is the synthetic
  long call, versus other alternatives that alter
  various market view factors (direction/vol)

13
Synthetic Long Call -25F25C25C-25P

• With a market up/volatile view, we strongly
  recommend the synthetic long call as a primary
  hedging strategy
• The call option allows Apollo Gold to take
  advantage of an unlimited upside, while having
  the flexibility of an insured downside

To create a synthetic long call from our initial
position, using options Synthetic Long Put
Synthetic Long Forward Synthetic Long Call
-FC Synthetic Long Put
CP Synthetic Long Forward
-25F25C25C-25P
-25F25C25F

• Note that the maximum cost of creating a
  synthetic long call position (982.50 per oz or
  98,250 per contract) falls within our loss
  limit of 5 or 100,000
• Ideally, by buying 25 calls and 25 forwards, we
  would achieve the same results with less cost
  (977.50 versus 982.50)

VS
14
Synthetic Short Put -25F-25P-10P25C

• The synthetic short put is an alternative
  hedging strategy that would be appropriate if we
  saw a significant decrease in volatility while
  remaining bullish
• A market up/stable view would allow us to trade
  for income by selling short puts

To create a synthetic long call from our initial
position, using options Synthetic Short Call
Synthetic Texas Hedge Synthetic Short Put
-F-P Synthetic Short Call
-10P25C Synthetic Texas Hedge
-10P versus -25P Hedge Downside at CP-
-25F-25P-10P25C

• Therefore, a -10P hedge is more appropriate
  given our risk appetite
• Unfortunately this also limits the income
  gained from the position to 394.50 as we are
  selling less put options

• Note that a -25F-25P-25P25C hedge would
  position our downside far beyond our risk limits

15
Alternative Bull Spread -25F25Citm-25Pitm
The Bull Spread View Limited Up, Concerns about
a big Down Maximum Income 67,500 Maximum Loss
57,500 Vs. Loss Limit 100,000 This
position gives insurance on our view of
volatility but it conflicts our view on
direction. Additionally in the likely scenario
that price increases at any rate above 800.3 will
generate income for our view.
16
Alternative Long Straddle -25F25C25C
The Long Straddle View High Volatility, Neutral
on Direction Maximum Income Unlimited Maximum
Loss 195,500 Vs. Loss Limit 100,000 In the
case of no volatility, however, and if the
position stays at the money or slightly OTM or
ITM, we could nearly double or loss limit
(undesirable). Based on our certainty in
volatility this should not be a concern.
17
Alternative Long Strangle -25F25C25C
The Long Strangle View Volatility in either
direction less certain than the Long
Straddle. Maximum Income Unlimited Maximum Loss
110,250 Vs. Loss Limit 100,000 This is a
better option than the Straddle based on our view
of volatility but closer to our loss limit.
Furthermore we can adjust our in-the-moneyness of
the options to meet our loss limit. As the call
increases more OTM, we are safer within our loss
limit. The contained risk of stability and its
associated loss is outweighed by the possibility
of great gains with average to above-average
volatility.
18
Recommendation

• Consistent with our market view of Up/Volatile,
  we recommend Apollo Gold choose the Synthetic
  Long Call
• In analyzing the above five positions, the Long
  Call gives the appropriate combination of upside
  (unlimited) versus downside (within our loss
  limit)
• The Long Strangles and Straddles also have this
  unlimited upside but are outside our loss limit
  range
• Bull Spreads, while well within our loss limit
  range, limit our upside for a position on an
  underlying that is very likely to increase