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Hedging for the Uninitiated or Skeptical

iconOct 9, 2016 10:55
Source:SMM
Futures markets and hedging have received a lot of attention recently.

By Daniel Uslander

ScrapMonster Contributor

Futures markets and hedging have received a lot of attention recently. With the dramatic swings in the ferrous scrap markets that we’ve seen over the past few years, no surprise that futures exchanges both here and abroad have developed and launched new markets designed to help recyclers protect themselves against unexpected adverse price changes in scrap steel markets. On the non-ferrous side, futures contracts have been around for many years and although the uptake may have been slow at first, “Basis COMEX” is the way copper--be it scrap or finished material--gets priced nowadays. Similar story for aluminum. So now is it steel’s turn?

It just may be prime time for steel futures. Scrap markets are global markets and the US is the world’s largest scrap producer, so why shouldn’t the US evolve into a hub for scrap futures trading? Successful futures markets need two crucial constituencies: the commercial hedgers that require a legitimate tool for price protection and the speculators who are willing to assume the price risk that hedgers wish to “trade away” to someone else.

Taking a Closer Look

Hedging is not gambling. Hedging isn’t even trading. In the context of futures on scrap steel, hedging is a financial transaction designed to preserve--in some approximate way--margins achieved in the (hedged) physical transaction. For example, let’s say a scrapyard commits to deliver 2000 tons of scrap to a mill in 90 days. Assume further that they don’t have the material in the yard. The sales price to the mill has already been negotiated. The scrap yard is therefore completely exposed to the possibility that the market can get away from them as they seek to build the inventory needed to fill the order. In this case hedging would consist of the buying of futures contracts, i.e. taking a long position and holding that long position until the material coming into the yard from various sources is priced. As the scrap yard buys material from its sources at agreed upon prices, the contracts reflecting the volume of each completed purchased would be liquidated. This process continues until all 2000 tons are bought. A few additional considerations:

First, the object of the hedge is to preserve to the fullest extent possible conditions in the market at the moment the deal with the mill was consummated.   The scrap yard quote to the mill was based on their own assessment of what they need to pay in order to attract 2000 tons into the yard. The hedge is an acknowledgement that they could be wrong. Market conditions could force prices higher. On the other hand, market conditions could result in an increased flow of scrap and lower prices. In either case, hedging is not thought of as adding to or taking from the bottom line of any given transaction. Hedging only allows the “snapshot” of prices at that moment when a deal is agreed upon to be preserved going forward.

Next, every prospective hedger needs to consider the contract design. That is, a contract’s value is based on the level of an index. Does that index correlate with price levels encountered in the market when the hedger buys or sells scrap? Does the grade of scrap used to calculate the index correlate with the grade of scrap featured in the physical transaction? There are three available scrap futures contracts: one tracks US Midwest Shredded, one tracks US Midwest Busheling and one tracks Turkish 80/20 Heavy Melt. Although it is possible all three contracts could work, our observation in futures markets is that when exchanges compete with similar contracts there will be winners and losers. The winner will be the contract that can attract the most liquidity, that is, a futures market with available buyers and sellers in reasonable (commercially relevant) volumes such that the spread between the highest price buyer and the lowest price seller is relatively narrow.

Finally, the prospective hedger needs to appreciate how exchanges and futures contracts “work”. Each trade done on a commodity futures exchange is matched by a clearinghouse that guarantees the creditworthiness of each trade. The clearinghouse is the counterparty to every transaction. The mechanisms and financial guarantees in place to ensure that trades are completed and settled as intended are quite substantial. Customers do not look to other customers to make good on trades, rather the exchange, its clearing members and their clearinghouse interposition their capital and bank lines to ensure that trades settle as per the intentions of the participants. It is the role of the clearinghouse as the “buyer to every seller and the seller to every buyer” that allows customers to construct futures strategies that at times can help them reach a higher level of creditworthiness with their own lenders. Lenders like it when their scrap yard customers hedge their inventories thereby protecting the value of their collateral. 

OK, so now that we understand why we are hedging and we’ve established some reasonable expectations, we can consider what the futures prices look like, what they mean and how to construct and place orders. That comes next. Over time, we’ll bring the entire industrial metals complex into the discussion and add other hedging instruments--namely options--into the mix. Should be fun.

BE ADVISED THAT TRADING FUTURES AND OPTIONS INVOLVES SUBSTANTIAL RISK OF LOSS AND IS NOT SUITABLE FOR ALL INVESTORS OR PRODUCERS.


Scrap Steel

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