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May 2013, Singapore

Iron Ore Trading Risk &

Risk Management

Ø  This presenta,on has been prepared by FIS. It is distributed to customers and to the general public for informa,on purposes only, it cannot be relied upon as a trading recommenda,on and does not cons,tute a solicita,on to trade.

Ø  FIS shall have no liability to the user or to third par,es, for the quality, accuracy, ,meliness, con,nued availability or completeness of the data nor for any special, direct, indirect, incidental or consequen,al loss or damage which may be experienced because of the use of the informa,on in this presenta,on or otherwise arising in connec,on with this presenta,on, provided that this exclusion of liability shall not exclude or limit any liability under any law or regula,on applicable to FIS that may not be excluded or restricted. The informa,on contained herein is proprietary informa,on of FIS and may not be reproduced or otherwise disseminated in whole or in part without FIS’s prior wriAen consent. FIS is regulated by the FSA. © 2013 Freight Investor Services.

Disclaimer

Agenda

•  Why do I need risk management tools? –  Vola,lity = price risk –  Risks of different commodi,es –  Different counterpar,es’ interests and concerns –  Forward curve provides price visibility

•  What is an OTC Swap? –  Differences between OTC swaps and futures –  Contract specifica,ons

•  How does a swap work? –  How to get start –  The role of the broker

•  IOS market development –  Market volume –  Market par,cipants –  How does iron ore pricing evolu,on affect the IOS market

•  Risk Management Using IOS: An Illustra,on

•  Summary

www.freightinvestorservices.com

Why do I need risk management tools?

Price VolaElity: Iron Ore

Risks of different commodiEes

6

IOS = FOB iron ore + Freight

Spot Price VolaElity 2012

Iron Ore (Delivered China)

23%

Capesize Vessel Earnings 100%

Fuel Oil (RoUerdam) 21%

Steel (N Europe HRC) 8%

Ferts (Yuzhnyy Urea) 47%

Turkish Scrap 11%

Different counterparEes’ interests and concerns

FFA -‐ IOS

Trading houses

Charterer

Steel Mills

Financials

Ship-‐ Owners

Mining groups

Ø IOS = FOB iron ore + Freight

Ø FFA = Freight ( Australia – China, Brazil – China)

Ø Steel Mills or charterers want to lock their costs at a low level

Ø Mining groups or ship owners would like to lock their profit at a high level

Ø Trading houses want to minimize counterparty default risk when the market goes down

Ø FFAs and IOS provide a flexible op,on

Ø Minimize, monitor, and control the probability and impact of unforeseen events

7

On 30th May 2013 Contract IOS Price TSI Spot $111.60 TSI MTD $124.69 June-‐13 $110.75 July-‐13 $108.00 Aug-‐13 $108.00 Sep-‐13 $108.00 Q4-‐13 $108.75 Cal14 $107.25 Cal15 $102.00 Cal16 $97.50

Forward curve provides price visibility – Where will the market go?

TSI spot average

2008 $68.55

2009 $86.28

2010 $146.71

2011 $167.59

2012 $128.30

On 2nd May 2013 Contract IOS Price TSI Spot $129.40 TSI MTD $129.40 June-‐13 $120.75 July-‐13 $115.50 Aug-‐13 $112.50 Sep-‐13 $110.50 Q4-‐13 $109.75 Cal14 $106.25 Cal15 $102.00 Cal16 $97.50

What is an OTC Swap?




•  An OTC Swap is a financial instrument that can be used to manage price risk

•  An OTC Swap is traded in conjunc,on with, and not in place of a physical trade

•  By trading OTC Swaps in parallel to trading a physical product, a buyer can ‘lock-‐in’ the future price they pay and a seller can ‘lock-‐in’ the future price they sell at in the physical market. This is called HEDGING

•  By HEDGING market par,cipants can achieve forward price certainty in vola,le physical markets

•  Trading OTC Swaps without a parallel physical posi,on is SPECULATION

•  Every market needs speculators to absorb the risk that hedgers offload




•  OTC Swaps are cash seAled, we’re talking here about forwards not futures

•  OTC Swaps do not allow for physical delivery into or out of a warehouse

•  OTC Swaps are cash seAled (‘cash for difference’) against a price index

•  ‘Cash for difference’ means you are paid out the difference between the index and your posi,on at contract expiry if you’re ‘in the money’ or you pay the difference between the index and your posi,on if you’re ‘out of the money’

•  You don’t have to wait for contract expiry, you can trade out of your posi,on at any point prior to contract expiry


SGX Iron Ore Swap Contract

Product Iron Ore Swap

Contract Iron Ore CFR China (62% Fe Fines) Swap

Contract Size 500 metric tons

Ticker Symbol FE

Minimum Price Fluctuation

US$0.01 per dry metric ton Value per tick = US$0.01 x (contract size)

Contract Months Up to 48 consecutive months starting with current month, 12 consecutive months will be added upon expiry in December.

Trade Registration (Singapore Time)

Monday 8:00 am to Saturday 4:00 am 8:00 am to 8.00 pm System not available from 4:00:01 am to 7:59:59 am daily

Last Trading Day Last publication day of The Steel Index (TSI) iron ore prices in the contract month

Final Settlement Price Cash settlement using the arithmetic average of all The Steel Index (TSI) iron ore prices in the expiring month, rounded to 2 decimal places (www.thesteelindex.com)

How does a swap work?



Gejng started:

Ø  Client signs a brokerage agreement permimng FIS to execu,ng on behalf of the client

Ø  Client opens a clearing account with a general clearing member (GCM) of the clearing house, in this case LCH.Clearnet

Ø  A ‘give-‐up agreement’ is signed by the client, FIS and the GCM to permit FIS to ‘give-‐up’ trades to the GCM

Ø  Prior to trading, the clients puts in place a credit facility with the GCM to fund margining

Ø  Once the account has been set up the client can then start trading



The role of the broker:

Ø  FIS establishes trading interest and obtains a firm “bid” and “offer” from the market

Ø  FIS nego,ates and facilitates the transac,on between the client and one or more counterpar,es

Ø  Full trade confirma,on agreed verbally with both counterpar,es


Buyer (Bid) Seller (Offer)


Ø  FIS issues trade recap -‐ including the contract period, contract rate, total contract value, buyer/seller, seAlement index, clearing house and contract volume


Seller Broker

FIS Buyer

Clearing House

Clearing Member Clearing Member

IOS market development

0

50

100

150

200

250

300

350

400

450

500

2009 2010 2011 2012 2013* 2014*

Million tons

IOS IOS opEons

Market volume

Iron Ore Swaps Records in 2011 --- 2013 In lots (500MT per lot) In tonnes Volume cleared in a year in 2011 95,305 47.65 MT

Volume cleared in a year in 2012 217,803 108.90 MT

Volume cleared 2013 YTD on 24th May 168,117 84.08 MT

Volume cleared in a month in Sep 2012 35,414 17.70 MT

Volume cleared in a month in Mar 2013 38,566 19.28 MT

Volume cleared in a day on 10 Sep 2012 3,952 1.98 MT

Volume cleared in a day on 29 May 2013 4,092 2.04 MT

0

200

400

600

800

1000

1200

1400

Pool of AsiaClear Counterparties Over 1200 As of end

April-13

Market participants

More than half are

clearing Iron Ore swaps

About 70% of customers are based in Asia

Ø  Compared with only 5% Chinese clients trading IOS in Jan 2012, there are 35% trading today Ø  10% of the China iron ore import license holders are trading iron ore swaps Ø  Potential growth out of China and FIS is here to help with all the tools and information

Source: SGX AsiaClear

Iron Ore Pricing Structure

Risk Management Using IOS: An Illustration

Using Swaps to Lock-‐in Purchase Price

Hedging example: Steel mills hedging against potential rise in raw material cost, or Traders locking in profit by using a floating price buying and fixed price selling hedging model

Scenario A – July 13 monthly average is at US$120 /MT §  Price of physical iron ore based on index-linked formula = US$120 /MT (payable to the miner) §  July 13 swaps position is cash settled at US$120/MT §  Gain from the swaps position = US$(120 – 108) = US$12.00 §  Actual purchase price for the physical iron ore = US$120/MT less US$12.00 hedging gains = US$108.00 /MT

Scenario B – July 13 monthly average is at US$90 /MT §  Price of physical iron ore based on index-linked formula = US$90 /MT (payable to the miner) §  July 13 swaps position is cash settled at US$90 /MT §  Loss from the swaps position = US$(90 –108) = -US$18 §  Actual purchase price for the physical iron ore = US$90 /MT plus US$18 hedging loss = US$108.00 /MT

Conclusion: By buying swaps to hedge, the steel mill has effectively locked-in a fix price for its iron ore at US$108.00 /MT regardless of what is the monthly average price in July13. While hedging using swaps has capped his maximum purchase price, he has also give up potential savings if prices where to be lower.

30th May13 Iron Ore Spot Price = US$ 111.60 /MT July 2013 Iron Ore Swaps Price = US$108.00 /MT §  A steel mill in China has a contract to buy 100,000 MT of iron ore from a miner for its production in Aug 2013. The price is based on monthly average of Spot TSI 62% CFR China index in the month of July 13. §  He is worried that his purchase price for the iron ore based on monthly average of July 13 spot prices could become higher and decides to fix the purchase price now by buying 100,000 MT or 200 lots of July 13 swaps.

On 31st July13, the following could happen:

Traders: Using Swaps to Lock-‐in Profit

Swaps – bought July 13 swaps (TSI contracts) to lock buying cost at US$108.00 /MT Physical – Signed procurement contract with the miner (Platts index linked floating price) and in the meantime – Sold the cargo at fixed price of US$111 /MT Scenario A – TSI July 13 monthly average is at $120 Platts July 13 monthly average is at $120.50 (suppose your physical settlement with the miner using Platts index and buying swaps in TSI contracts)

§ Profit = ( iron ore selling income – actual purchasing cost – Platts/TSI differential – expenses ) x physical size = [$111 – $108 – $0.50 – $1.00] x 100,000 MT = $1.50 / MT x 100,000 MT = $150,000

Scenario B – TSI July 13 monthly average is at $90 Platts July 13 monthly average is at $90.50 (suppose your physical settlement with the miner using Platts index and buying swaps in TSI contracts) § Profit = ( iron ore selling income - actual purchasing cost – Platts/TSI differential – expenses ) x physical size = [$111 – $108 – $0.50 – $1.00] x 100,000 MT = $1.50 / MT x 100,000 MT = $150,000

On 30th May 13, the trader has executed trades as follows:

On 31st July13, the following could happen:

Summary

In summary, Ø  As the iron ore pricing scheme develops, market becomes more volaEle and

hard to predict, therefore risk issues affect all market players upstream to downstream

Ø  Using OTC Swaps as a risk management tool can miEgate price risk and smooth physical negoEaEons and operaEons

Ø  Swaps are cleared, meaning you’re shielded from credit risk

Ø  More steel mills and steel consumers will be involved as OTC Swaps prove to be a useful risk management tool

Thank you for listening! James Huang 黄勇进 | Iron Ore Broker Freight Investor Services Pte Ltd 6 BaAery Rd, #24-‐04, Singapore 049909 T +65 6535 5189 | M +65 9726 2679 | M +86 158 0192 4699 (China) Email: jamesh@freigh,nvestor.com | Yahoo: james_huang_007 MSN: [email protected] | Skype: hyongjin

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