Basics of Hedging-Steel!!

Some pointers:

• Your hedge desk should not make a profit. If your hedge desk does make a profit, then it has been speculating.
• Not to hedge, is to speculate.

The first statement might surprise you. And the second might, at first reading, surprise you even more. But they are both truisms.

Hedging is the process of using derivative instruments - futures, options and swaps - to manage the risks imposed by volatile price movements. Familiarity with the basic building blocks of the process provides the novice with the tools to address even the most complex of derivatives. This is because they are all built from relatively simple concepts. That is not to say that hedging is simple. In concept it is, but in practice hedging can get quite complex. Yet all hedging is developed from quite straight forward building blocks. By thoroughly…..But by thoroughly understanding the building blocks with which all the complex derivatives hedging strategies are developed one can rapidly acquire the know-how to hedge away unwanted price risk

At Steel Derivatives we take the raw novice and progressively develop their hedging skill set. Rather than presenting our client with a hedging strategy, we help you develop your own strategy, tailored to your business model.

And further, Steel Derivatives acts in an advisory capacity to help you develop and install the appropriate controls and reporting mechanisms to ensure your hedge desk is appropriately managed. Because hedging should not make a profit. The purpose of a hedge desk is to provide guaranteed stable incomes on the contracts it is instructed to hedge; incomes that will not vary, produce neither a loss nor a profit, not matter what the volatility in product pricing. If your hedge desk does make a profit, or indeed a loss, then de facto it has been speculating. So, to prevent your hedge desk gambling with your company's profitability, all firms necessarily need a set internal controls.

The way many financial institutions view hedging is that, if derivatives instruments are available to hedge away unwanted price risk, then, not to hedge away those risks, is to speculate that those risks will remain favourable to your business model. If, when hedging instruments are available, one retains exposure to price risk, capital lenders will tend to view you as a speculator, one who gambles on pricing remaining favourable. De facto your firm is a higher credit risk. That will tend to dictate less

Steel Derivatives mission is knowledge communication: communicating our knowledge on derivative instruments - steel futures, options, and swaps - to the steel industry.

What are Steel Futures?

In January 2003 Steel Derivatives was retained on a full time basis to drive and co-ordinate the LME's steel futures program.

The majority of the steel industry uses forward contracts. These are contracts where the price is agreed today for steel to be delivered at some later time ie delivery 'forward' of today. All the terms and conditions of the contract - the material specifications, documentation, payments, delivery terms etc - are all tailored to the particular contract. Money changes hands at the time of delivery.

Futures contracts are established on the same principle. A price is agreed today for something to be delivered in the future. But, whilst a forwards contract can be tailored to the specifics of the deal in question, a futures contract is standardized. Same volume, same specification, same documentation, same payments, same delivery terms. The only things in a futures contracts that are non-standardized are:

• The price
• The delivery period

Otherwise Futures contracts are identical to the forwards contracts that the steel industry uses everyday.

There are two important attributes that standardization brings:

• First, if you standardize contracts, they can be exchange traded. This applies to steel, sugar, oil, foreign exchange, government bonds or shares in a company. Provided the contracts are standardized, they can be exchange traded.
• Second, and closely linked to the principle of exchange trading, is the practice of closing out. Essentially if you sell something in an exchange, then buy the same thing back, you cancel out any obligations incurred when selling. Similarly, if you buy something, then sell the exact same thing back to the market, you cancel out any obligations incurred when buying.

The purpose of Steel Futures is to help manage price risks. They are a tool in your risk management tool box.

Futures Vs Forwards (Steel)

What's the difference between forwards and futures ?

• Forward prices are prices agreed today for delivery in the future. The contract which confirms this transaction, and thereby the forward price, is a forwards contract.
• What much of the steel industry deals in now are forwards. You contract today, and commit to prices today, for steel to be delivered in the future ie a period forward of today.
• So what the steel industry has now are monthly forwards contracts. That it prices (and all technical details) agreed today for delivery within a particular month forward of today. Might be 1 month forward, or 3 months forward, or for international shipments 5 or even 6 months forward.

Futures are exactly the same in that capacity. You contract today, and commit to prices today, for steel to be delivered in the future.

The only material difference is that futures contracts are standardised. Every contract is the same. Same underlying, same delivery points, same size, same payment terms etc.

Whereas steel's existing forwards contracts allow individual firms to tailor the contracts to fit with their exact needs, futures contracts do not allow such flexibilities. Futures contracts are merely standardised forwards contracts.

Forwards vs Futures Prices

The forwards price - the price contracted to in your forward contract - is usually unique to that deal. So on any day you'll get a range of forwards prices for the same steel, as determined by differences in payment terms, or delivery terms, or packing, or additional testing. You'll even have different prices for the exact same volume of the exact same steel for the exact same delivery, same payment terms etc.

Not with futures. Because futures contracts are all standardised, and not subject to the tailoring of steel's traditional forwards contracts, at any moment in time there is only one price for each delivery period.

Lets just think about the price at which the steel industry's regular forwards contracts are concluded. The price in a forwards contract is the equilibrium price between what the steel mill thinks its steel is worth - the asking price - and what the buyer thinks its worth - the bid price. You negotiate to arrive at the contract price.

In a futures market, instead of

• One seller and one buyer concluding one contract at one unique price, there are
• Lots of sellers and lots of buyers concluding lots of contracts.

The futures price is the equilibrium price determined by supply and demand of all those contracts.

Price Credibility

So which price is a better reflection of the market ? Which price is more credible ?

• The unique, tailored forwards contract price negotiated between a single seller and single buyer, maybe with unique product, payment terms, and other tailored attributes. And because there are many such contracts, there has to be some interpretation / value judgement to define a 'forward price', otherwise the forward price can only ever be a range.
  

OR

• The futures market price, which is the equilibrium level of many thousands of buy-sell contracts, all standardised, and for which there can only every be one price at any moment in time ?

That's why prices in futures market are trusted. They are reflections of many thousands of transactions - at any one time the futures price is always the equilibrium price of many buyers and sellers. They are credible prices because informed buyers and sellers - you, the steel industry, and other interested parties - will be trading contracts, with firm commitments to make or take delivery of steel.

Steel futures prices are not guesswork or hunches or bets. They are the direct result of informed buyers and sellers quoting, bidding, and trading contracts, with firm commitments to make or take delivery of steel. At any one time the futures price for a particular month is the equilibrium price of that quote / bid / trade activity. That's why they a credible. That's why they are trusted.

Steel Derivatives - History

The Steel Derivatives concept began life as an off-shoot of 'Stemcor Projects & Contracts' (SPC), a division of the Stemcor Group, the world's largest independent steel trading organization. SPC's mission was to supply competitively-priced steels to the world's oil, gas, and power generation companies for their steel-intensive projects such as pipelines, tank storage farms, power stations, petrochemical plants, and off-shore platforms. These projects demanded fixed price steel supply contracts for periods of 6-24 months. With the involvement of financial institutions and its own in house steel procurement expertise, SPC structured novel deals that provided its clients with fixed priced steel, whilst at the same time provided its steel suppliers with prestigious projects at market competitive returns.

As steel price volatilities increased in the latter 1990s, the value at risk of SPCs traditional structured solutions was threatening the sustainability of its activities. Yet in depth exposure to the oil, gas, and energy business models gave SPCs founder and Managing Director, John Short, a critical insight into oil, gas, and energy derivatives - exchange traded futures, and 'over the counter' (OTC) options and swaps instruments. If steel could develop such instruments - lock-in its cash flows, hedge away the negative impacts of price uncertainty whilst retaining the opportunity to participate in favourable movements in price - then price steel's volatility could be managed.

In 2000 Short left the Stemcor Group to pursue the vision of exchange traded steel futures. An informal consulting company was born with a focus on structured finance and risk management techniques in, and steel procurement for, steel-intensive projects in the oil, gas, and general construction industries. Having refined his structured trade and commodity finance skills at a City investment bank, Short went to Oxford University where he led team of finance MBAs on two distinction-graded theses on Steel Futures. The collective knowledge from the MBA team and Oxford faculty was then forged with that of the original consultancy. In 2002 the consultancy was awarded projects examining various aspects of steel futures, options and swaps in Europe, Middle East, SE Asia and Far East.

The culmination of this work led to Short's paper submitted to the Steel Futures I seminar in London (December 2002) declaring that technical design of steel futures contracts was essentially complete. To a large extent, all that remained was 'buy-in' - the desire of direct and indirect participants of the global steel industry to understand and grasp the opportunity to use steel futures in their day to day business.

In January 2003, after further work in Asia, the consultancy was retained exclusively by the LME for their Steel Futures Project. Along with Laplace Conseil, who provided the LME with an initial study, Steel Derivatives is proud to be associated with the LME, whose expertise in running a futures exchange and hosting metals contracts has provided the platform to bring these steel contracts to market. Steel Derivatives remains closely involved with the LME, driving the process forward and heading various 'steel working parties' charged with refining various contract elements in consultation with industry. Meantime our work on OTC products embraces a much wider community of financial instruments and instrument providers, from basic swaps through to complex option products. Furthermore we continue to offer the advisory services on which the company was founded - structured finance, steel procurement, and risk management in relation to steel intensive projects.