2. What are Derivatives Derivative is a financial instrument (or, more simply, an agreement between two parties) that has a value, based on the expected future price movements of the asset to which it is linked—called the underlying asset — as a share or a currency or a commodity Most common derivatives are swaps, futures, and options Derivatives are usually broadly categorized by: the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives or credit derivatives); the relationship between the underlying asset and the derivative (e.g., forward, option, swap); the market in which they trade (e.g., exchange-traded or over-the-counter); their pay-off profile. 2
3. Why Commodity Derivatives… Dynamic Price Discovery Transparency – Information Dissemination Hedging Tool Even smaller players reap same advantage as big ones Takes care of counter party default Easy to sell / buy in liquid market Leverage 3
6. The mining and transport of this raw material is capital intensive, which leads to supply constraints not readily filled by other materials.
7. These factors thus expose the steel mills not only to supply constraints, but also to transport uncertainties, which can lead to volatile price fluctuations.
8. Demand is expected to rise with the continual growth of emerging markets.
9. China produces nearly one-half of the world’s finished steel, making it the premier destination for seaborne iron ore shipments.5
10. What Impacts Iron Ore Prices? Steel-making Demand for Iron Ore Quality and Grade Specifications Available Supply Seaborne Freight 6
13. Output increased mainly in four major producing countries- Brazil, Australia, China & India.
14. China’s Iron Ore import was 628 million tons – 70% of seaborne trade.8
15. World Iron Ore Scenario….contd It is anticipated that around 685-million tons of new production capacity may come on stream between 2010 and 2012. It is predicted that the world iron-ore market would be characterized by tight conditions over the short term, but that supply would gradually catch up with demand and that prices would decline from current levels, although they would stay higher than in the period before 2008. 9
17. Top 5 Iron Ore Producing Countries 1. China 2. Brazil 3. Australia 4. India 5. South Africa Top 5 Iron Ore Consuming Countries 1. China 2. Japan 3. India 4. Russia 5. USA Top 5 Iron Ore Exporting Countries 1. Australia 2. Brazil 3. India 4. South Africa 5. Canada Top 5 Iron Ore Importing Countries 1. China 2. Japan 3. South Korea 4. Germany 5. Taiwan Iron Ore : World Scenario 11
30. …. Iron Ore is moving in the direction of setting prices as Copper, Nickel or other base metals are on a completely transparent Exchange under the full control against any type of manipulations …. Source: Iron Ore Market 2009-2011 (UNCTAD) 18
32. Example - Hedging It is January 2011 and the price for iron ore CFR China 62% Fe fines currently stands at $ 174.60/dmt. Buyer (Steel mill) A steel mill in China expects to import iron ore 62% Fe fines of a Cape size shipload of 75,000 metric tons (mt) in March 2011 and wishes to fix this cost as they have just clinched a major deal to supply flat steel products in 2011. To hedge this position, this steel mill will bid at $169.00/dmt for March 2011 Iron Ore Swap on CFR China 62% Fe Fines. Seller (Iron ore trader) At the same time, an iron ore trader with an inventory of iron ore wishes to hedge against a possible decline in stock value from drop in iron ore rates. The trader would like to lock-in the iron ore price of $169.00/dmt. 20
33. Example - Hedging Buyer: Steel mill Seller: Iron ore trader Product: Iron Ore CFR China 62% Fe Fines Quantity: 75,000mt (750 lots) Contract Price: $169.00/dmt Settlement Date: 31st March 2011 Settlement Basis: Average of the spot price assessments of the contract month Due to natural calamity in Japan, the price of iron ore CFR China 62% Fe fines falls from $174.60/dmt to $169.36/dmt in March 2011. As a result, the steel mill doesn’t suffer an increase in input cost. 21
34. Hedge Result Buyer Steel Miller Physical Ease in cost = $2,62,000 [(174.6-169.36)*500*100] Futures Payoffs = $ 18,000 [(169.36-169.00)*500*100] Net P/L = $ 2,80,000 [262000+18000] Seller – Iron Ore Trader Physical Rise in Value = $2,25,000 [(109-106)*500*100] Futures Payoffs = -$2,62,000 [(105.5-109)*500*100] Net P/L = -$ 37,500 [225000-262000] 22
35.
36. Any gain or loss in the spot market offset (partially if not fully)with the loss or gain respectively in the derivatives market.
37. For a stable and manageable balance sheet of a company, hedging in indispensible. 23
40. Steel buyers can access the iron Ore swaps market to hedge (with basis risk) a portion of their price risk
41. … this is similar to airlines hedging jet fuel exposure using crude oil contracts
42. … or steel contracts which meets the needs of buyers in different parts of the world
43. There are several steel contracts available at Exchanges (LME, DGCX etc). Volumes are increasing.25
44. Iron ore and steel 3-4 years from now Iron Ore Miners Steel Mills Steel Users Spot Iron Ore Spot Steel Locked in Price (Margin) Locked in Price (Margin) Locked in Margin Iron Ore Swaps and others Buyers and sellers of Iron Ore use Iron Ore swaps and FFAs (Freight swaps) to lock in forward prices, effectively hedging against adverse movements in the price of Iron Ore and ocean freight. This achieves predictable pricing and allows P+L planning in a spot trading environment. Iron ore & Steel Swaps and Futures Buyers and sellers of Steel products use Iron Ore swaps and different steel swaps and steel futures contracts to lock in the forward price of Steel, which will fluctuate according to the cost of delivered Iron Ore (Ore/Freight combination) supply/demand pressure of steel and the marginal operating environment of steel mills. 26
45. INDIAN World’s 1st Exchange to launch an Iron Ore Future Contract… 27
46. About ICEX Recognition granted by Govt. of India on 9th October 2009 Operations Commenced on 27th November 2009 Currently Trading in 11 Commodities Over 450 memberships with more than 1000 TWS spread across India 28
48. Key Stakeholders Reliance Exchange Next Ltd - A wholly owned subsidiary of Reliance Capital, represents Reliance entry into Exchange vertical. R Next aims to be present across asset classes in the Exchange space MMTC Ltd - Leading exporter of Minerals, largest buyer of Fertilizers, biggest importer of Bullion & Non- Ferrous Metals in India and active player in agro-products Indiabulls- Top ranked business houses in India with business interests in Real Estate, Infrastructure, Financial Services, Retail, Multiplex and Power KRIBHCO -World’s premier fertilizer producing Cooperative Society IDFC- Specialized financial intermediary for infrastructure development IPL - Biggest canalizing agency for import of Urea and other fertilizers on behalf of GOI 30