FX Markets Drive Increased Hedging Opportunities in Copper Trades

During the COVID-19 pandemic, and the period of increased global uncertainty it has created, prices for copper have been volatile. From the lows in March 2020, prices in USD had risen 65% by the end of the year. However, over the same period, there has been an appreciation in the value of the CNH in relation to the US dollar, moving from around CNH 7.1222 per USD to CNH 6.5074 per USD as measured by the spot rate for USD/CNH. This latter effect has somewhat softened the price increase for Chinese copper importers, as the COMEX price expressed in CNH has increased from CNH 33,280 to CNH 50,410 per metric ton, which is approximately a 51% increase, as compared to the 65% increase in USD terms.

Such volatility in the FX markets highlights the uncertainty that importers face. It is worth noting that any move in the FX rate that benefits an importer – i.e., an appreciating CNH versus USD since the importer is buying in USD – will conversely have a negative effect on the exporter.

CME offers futures contracts on the RMB FX rate, the USD/Offshore RMB (CNH) futures contracts, which can be used to manage this FX exposure. These contracts are cash settled with reference to the USD/CNH spot rate published by the Treasury Market Association in Hong Kong. Each futures contract is for US $100,000, which is comparable to the USD value of a COMEX Copper futures contract of approximately US $102,000 at the time of writing.

Below is an example of how the CME USD/Offshore RMB (CNH) futures contract can be used to hedge the FX component of a copper delivery into China.

In October, a copper trader has organised a shipment of copper scrap into China with loading in two months and delivery three months forward. Using copper futures markets, the trader can hedge the load out cost in US dollars. It is assumed that the delivery price is fixed in RMB. The return from the trade is exposed to the FX rate between the US dollar and the Chinese renminbi. As with the copper price, the FX risk can be hedged with futures.

The exposure to the copper price can be hedged with COMEX Copper futures. With each futures contract representing 25,000 pounds of copper, buying 220 futures for the December contract month will effectively hedge this position with respect to the price of copper.

The trader can undertake a similar exercise to hedge the delivery value in China. With these hedges in place, the effective acquisition cost is US$ 3.1250 per pound, and the agreed effective delivery price is CNY 48,000 per metric ton. This is a potentially profitable trade. However, the trader has a three-month period of uncertainty relating to FX risk. Although the settlement amount is in CNY (onshore), the trader could effectively hedge the FX Risk offshore using CNH instruments as the two currencies are closely linked and the conversion rate is very close to one.

The FX component of the transaction can be hedged using the CME USD/Offshore RMB (CNH) futures contract (Globex product code CNH). To determine the hedge transaction required, the trader needs to determine whether to buy or sell futures, and the quantity to be transacted.

Even though the CME USD/Offshore RMB (CNH) futures contract is a cash settled contract, it provides hedging for FX risk linked to USD/CNH exposure just like a physically delivered contract; buying one contract is equivalent to buying USD in exchange for CNH. Selling the futures is equivalent to selling USD in exchange for CNH.

In the current example, it is assumed that the price of the shipment is fixed in CNH, and that the trader has a base currency of the US dollar and will wish to convert the Chinese renminbi received on delivery of copper into US dollars. The associated FX risk exposure can be hedged by buying CME USD/Offshore RMB (CNH) futures contracts. These futures should be bought to implement the hedge and sold to close out the position once the FX hedge is no longer required. This will create a futures payoff on the hedge being the difference between the price paid to open and the price at which the hedge is closed out at. Trading in the USD/Offshore RMB (CNH) Futures terminates on the second Hong Kong business day prior to the third Wednesday of the contract month¹. This would make January the appropriate futures contract month to hedge this transaction since the CME USD/Offshore RMB (CNH) futures contract is listed and active in consecutive calendar months.

The number of FX futures needed to hedge the transaction can be calculated by considering the currency exposure. With the copper delivery, the trader will expect to receive CNH 120,000,000.

The futures price, quoted in Chinese renminbi per US dollar, is CNH 6.7200 which is the equivalent of US$ 0.148810 per Chinese renminbi. At this exchange rate, the expected income will be US$ 17,857,143. The contract size of the CME Chinese Renminbi futures contract is US$ 100,000; therefore, to hedge the FX exposure, the producer needs to buy 179 futures.

With long positions in both COMEX Copper futures and CME USD/Offshore RMB (CNH) futures, the trader will also take advantage from a reduced margin on the combined position due to the margin offset made available between the contracts by CME Clearing.

We can examine what might happen to this hedged position in different outcomes.

An appreciation of the RMB versus the USD can also be viewed as a decrease in the value of USD, measured in RMB. In this example, we assume an appreciation of the RMB such that the price of the January futures contract goes from CNH 6.7200 to CNH 6.4700, which represents an appreciation of 3.9%. This can also be seen as a change in value from US$ 0.148810 to US$ 0.154560 per RMB.

With the copper delivery price fixed at CNH 48,000 per metric ton, the sale proceeds of CNH 120,000,000 have a US dollar value of US$ 18,547,141, which is greater than expected had the exchange rate not changed. This improved outcome is offset by a loss made on the FX futures position. Overall, the cashflow has been maintained in line with expectations, which is the purpose of the hedging strategy.

A depreciation of the RMB versus the USD can also be viewed as an increase in the value of USD, measured in RMB. In this example, we assume a depreciation of the RMB such that the price of the January futures contract goes from 6.7200 to CNH 6.9700, which represents a 3.6% depreciation. This can also be seen as a change in value from US$ 0.148810 to US$ 0.143472 per RMB.

With the copper delivery price fixed at CNH 48,000 per metric ton, the income of CNH 120,000,000 in this scenario has a US dollar value of US$ 17,216,643. This is lower than expected, and the decline is enough to wipe out any potential profit from the trade, even before transportation costs are factored in. To compensate though, the FX futures hedge position records a gain of CNH 4,475,000, which maintains the overall return from the transaction.

In the example given above, the trader’s base currency was assumed to be USD and the price of the shipment was assumed to be fixed in RMB. Similar hedging strategies would apply for the case where the price of the shipment was determined in USD and the trader’s base currency is RMB. In the latter case, the trader would need to hedge the purchase of USD to settle the payment obligation and this could be hedged once again by buying CME USD/Offshore RMB (CNH) futures contracts as in the example shown.

The FX hedging strategy shown for trade in physical copper is also applicable in cases where a trader has the FX exposure in RMB arising from positions in financial derivatives denominated in different currencies.

Copper markets remain volatile and hedging price risk remains an important consideration. In addition, the volatility in foreign exchange markets can also be an unpredictable factor that firms are looking to hedge. By hedging foreign exchange risk, companies can stabilize future cash flows which in turn creates greater confidence in business performance.

The CME Group suite of metal futures sit alongside a number of key foreign exchange futures contracts, which together provide participants with effective hedging tools to manage growing risks in the sector.

In addition, traders with positions in CME USD/Offshore RMB (CNH) futures and Copper futures can receive significant margin savings of 50%.

Salient features of the futures contracts discussed in this article:

¹ See https://www.cmegroup.com/trading/fx/emerging-market/usd-cnh_contract_specifications.html.