Monday, June 15, 2009
Iron Ore Derivatives- Part 1 - ICAP
Until more recently, Iron Ore as an asset class has remained one of the last significant global commodities absent of an efficient and flexible hedging mechanism to offset price risk.
Furthermore, the underlying volatility experienced in the asset class over the past 24 months has highlighted the inefficiencies of an historic annual price negotiation process which has traditionally seen the world's three largest producers - Australia's BHP, Rio, and Brazil's Vale - meet once a year with China's major steel manufacturing representatives in order to determine an annual benchmark agreement on iron ore price quotas.
The more recent macro environment however has produced challenges to a rigid bilateral trade system absent of options and comparative advantages visibly achieved in other correlated sectors.
Over the past several years, global Coal markets have experienced a gradual transition from an historical fixed pricing mechanism to that of a vibrant and transparent derivatives system delivering tangible benefits to both buyers and sellers.
Similarly, the advent of Forward Freight Agreements (FFAs) in the shipping sector has delivered adaptable bespoke solutions along with quantifiable risk mitigation tools that span both raw material inputs costs and global transportation charges.
These innovations have enabled market participants to leverage natural mutual benefits which promote efficient risk management.
With more than 80% of the world's seaborne trade imported by China's mainland steel mills, global buyers and sellers of physical Iron Ore remain firmly fixated on price demands emanating from Asia.
However until now, these participants have had just two options in which to enter into transactions. Either by basing year round transactions on the traditional benchmark system, or by entering into a ‘spot' agreement openly exposing both parties to possible price fluctuations occurring between an agreed contract date and that of physical delivery.
As a result, segments of the market have argued for increased flexibility, and solutions that offer ‘choice' to buyers and sellers alike.
To this end, the industry has developed its own alternative based on the similar successful derivatives concepts readily observed in other asset classes traded throughout the world
Recognising the benefits similar financial innovations have brought to other asset classes, 2008 saw the emergence of the world's first fixed - floating Iron Ore swap transaction and the beginnings of a significant change in the options now available to the industry.
An Iron Ore swap consists of a buyer and seller entering into a bilateral agreement that requires ‘Party A' to pay a fixed rate price to ‘Party B', while in turn ‘Party B' agrees to pay a floating rate to ‘Party A'. The floating rate reflects the average price of spot iron ore transactions executed in the market over the life of the contract.
Both counterparts also agree to a notional amount of physical underlying (in metric tonnes), a forward fixed duration period, and a specific floating index reference.
Fixed and floating payments are calculated, netted, and cash settled over the life of the transaction Iron ore swaps are currently quoted by the world's leading financial institutions and industry participants, and a number of exchanges have also announced clearing facilities aimed at alleviating bilateral credit constraints.
As the world's premier inter-dealer broker, ICAP now delivers iron ore derivative trade facilitation, price transparency, and research services to producers, mills, freight operators, and trading houses across the globe.
Iron Ore Index Providers
1. The steel Index
62% Fe Content Fines
Minimum cargo - 25,000mt
Delivery CFR Tianjin
Published Weekly - Friday 12:00 GMT
2. Platts
62% Fe Content Fines
Minimum Cargo - 35,000mt
Delivery CFR Qingdao
Published Daily 12:00 GMT
3. Metal Bulletin
62% Fe Content Fines
Minimum Cargo - 30,000mt
Delivery CFR Qingdao-Rizhao- Lianyungang,
Published Weekly Friday 8:00 GMT
Iron Ore Swap Example
Contributed by ICAP
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