(a) (20 marks) Scenario 1: Assume CTG has entered into long-term contracts with customers but has not yet hedged these commitments. Requirement: Identify, assess/measure and evaluate the financial risks for CTG associated with the long-term contracts with customers. (Quantify the risks as far as possible. Interpret and discuss your answers.)

Chum Tsum Gold Ltd. (CTG) is a gold mining company in the U.S. In order to expand its market share, CTG is considering offering long-term contracts for gold to customers (including many independent gold jewelers). It believes that such contracts will be attractive to customers because customers can lock in a fixed gold price ($1,900) and stabilize their future profit margins over long periods. CTG has estimated that it can enter into contracts to supply customers with 6 million ounces of gold over a period of 5 years (i.e. 100,000 ounces per month). These commitments are quite large for CTG as they will exceed the firm's mining capacity. To lock in its own profit margin, CTG plans to hedge against the possibility of gold price increases. Ideally it should have entered long-term forward contracts on gold, matching the maturity of the contracts and of the commitments. However, in the absence of a viable market for long-term contracts, CTG will use short-term futures contracts and implement a rolling hedge, where the long-term exposure is hedged through a series of short-term contracts, with maturities around 3 months, that will be rolled over into the next contract as they expire. The spot gold price is $1,800. CTG believes that it will initially enter into the futures contracts (for hedging) at a price of $1,810. It has estimated that the annual expected return and the annual standard deviation of gold are 10% and 17%, respectively. Financial highlights of CTG (from the latest financial statements): Total cash: $900 million Total current assets: $3.7 billion Total assets: $12.8 billion ** Ignore curve risk (backwardation or contango) and basis risk. Chum Tsum Gold Ltd. (CTG) is a gold mining company in the U.S. In order to expand its market share, CTG is considering offering long-term contracts for gold to customers (including many independent gold jewelers). It believes that such contracts will be attractive to customers because customers can lock in a fixed gold price ($1,900) and stabilize their future profit margins over long periods. CTG has estimated that it can enter into contracts to supply customers with 6 million ounces of gold over a period of 5 years (i.e. 100,000 ounces per month). These commitments are quite large for CTG as they will exceed the firm's mining capacity. To lock in its own profit margin, CTG plans to hedge against the possibility of gold price increases. Ideally it should have entered long-term forward contracts on gold, matching the maturity of the contracts and of the commitments. However, in the absence of a viable market for long-term contracts, CTG will use short-term futures contracts and implement a rolling hedge, where the long-term exposure is hedged through a series of short-term contracts, with maturities around 3 months, that will be rolled over into the next contract as they expire. The spot gold price is $1,800. CTG believes that it will initially enter into the futures contracts (for hedging) at a price of $1,810. It has estimated that the annual expected return and the annual standard deviation of gold are 10% and 17%, respectively. Financial highlights of CTG (from the latest financial statements): Total cash: $900 million Total current assets: $3.7 billion Total assets: $12.8 billion ** Ignore curve risk (backwardation or contango) and basis risk