Iron Ore prices were volatile during 2016, having almost doubled in price from approximately $40/mt CFR China in January to $80/mt CFR China in December. To mitigate such price risk exposure, we can utilize futures contracts to hedge.
Hedging strategies can be used by many different market participants including but not limited to miners, steel mills, traders and banks.
Hedging Physical Iron Ore Futures
Iron Ore 62% Fe, CFR China (TSI) futures are cash-settled contracts and there is no physical delivery. The Commodity Code is TIO.
There are multiple hedging strategies that can be employed by market participants but in the following example we look at a miner who sells some of their physical iron ore at a floating price using an index such as Platts or The Steel Index (TSI) 62% Iron Ore as requested by their customer, a steel mill.
Did You Know: Iron Ore futures have seen phenomenal growth since 2010 when the annual benchmark was abandoned in favor of quarterly prices. In 2016, over 1.4 billion metric tons of futures were exchange traded.Iron Ore 62% Fe, CFR China (TSI) futures are cash-settled contracts and there is no physical delivery. The Commodity Code is TIO.
EXAMPLE
In September 2015, the spot Iron Ore market is $55/mt CFR China and a miner sells 100,000mt physical Iron Ore at TSI average for December 2015. This is the miner’s floating price risk.
The miner also has a breakeven/replacement sales cost of $45/mt CFR China. The breakeven/replacement price is defined as the value the entity would have to pay to replace the same asset at the present time based on its current worth.
In the derivatives market the miner also sells 200 lots of December 2015 futures contracts, which is equivalent to 100,000mt at $50/mt CFR China.
In December the Iron Ore market rises to $80/mt CFR and settles at this average price.
Physical
Sold December 2015 TSI average.
December 2015 TSI average was $80/mt.
Breakeven/replacement cost is $45/mt CFR
Physical P&L = $80-$45 = $35 loss
Financial
Sold December 2015 futures at $50/mt
December settles at $80/mt
Financial P&L = $50-$80 = $30 profit
Total P&L = Physical P&L + Financial P&L = $35-$30 = $5 profit
By using futures contracts the miner has made $5/mt profit (less trading costs) irrespective of the market direction.
Hedging Physical Iron Ore Options
Iron Ore 62% Fe, CFR China (TSI) Average Price options are European-style contracts, which means they can only be exercised on their expiration date. The Commodity Code is ICT.
EXAMPLE
In September 2015 the spot Iron Ore market is $55/mt CFR and you SELL 100,000mt physical iron ore at a floating price for December 2015 delivery.
You have a breakeven/replacement sales cost of $45/mt CFR China.
You also buy a put option contract for 100,000mt/ 200 lots December 2015 with a strike price of $50/mt. for a premium of $5/mt.
In December the market was $80/mt CFR and settles at this average.
You did not exercise the right to sell at $50/mt because the physical market was $80/mt CFR.
Physical:
Sold Dec 2015 TSI average
TSI Dec 2015average $80/mt CFR
Replacement cost $45/mt CFR
Physical P&L $80-$45 = $35 PROFIT
Financial:
Bought 100,000mt December 2015 put option with strike $50/mt for $5/mt premium
Dec 2015 settled @ $80/mt CFR
Financial P&L = $5 LOSS for premium
Total P&L = Physical P&L + Financial P&L = $35-$30 = $5 profit
By using an options contract, the miner paid 5/mt as an insurance premium for the put option but did not require it as the underlying physical market performed in their favor and made a total of $30/mt (less trading costs).
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