GO Bug Wants to Invest $12,000 in Gold $\bullet$ Gold Bullion $\bullet$

question 10

Essay

G.O. Bug wants to invest $12,000 in gold. In December, the spot price of gold is $400 per ounce. Bug is very confident that gold will appreciate by at least 10% before the end of January and is willing to assume fairly risky positions to maximize the return on this forecast. Bug is considering several alternatives:
$\bullet$ Gold bullion. Bug could buy 30 ounces, or roughly 1 kilogram.
$\bullet$ Gold futures. Bug could buy February futures. These contracts trade at $413 per ounce, with an initial margin of $1,500 per contract of 100 ounces. Therefore, Bug could buy eight contracts (12,000/1,500).
$\bullet$ Gold options. Bug considers two February call options with different strike prices. Each option contract covers 100 ounces. The February 410 call quotes at $8 per ounce; the February 430 call quotes at $4 per ounce. Therefore, Bug could buy fifteen contracts of the first option or thirty contracts of the second option.
$\bullet$ Two gold mines. Mines A and B have the same stock price: $10 per share. A British broker has estimated the gold $\beta$ of both mines using a discounted cash flow model as well as historical regression analysis. Mine A is a rich mine with a gold $\beta$ equal to 2; mine B has much higher production costs with a gold $\beta$ equal to 5. Bug could buy 1,200 shares of one of the gold mines.
Bug quickly rules out investing directly in bullion, which does not offer enough leverage.
a. Assuming that Bug's expectations are realized by the end of February, compute the realized returns on the various alternative strategies considered. Simulate various values of the spot price of gold in February (320, 360, 380, 400, 420, and 480).
b. Which investment strategy would you suggest to Bug?

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