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FAQs on scrap futures hedging

Keywords: Tags  CME Group Inc., Harriet Hunnable, U.S. Midwest scrap futures contract, Young-Jin Chang, AMM U.S. Midwest Ferrous Scrap Index, CME Globex, CME ClearPort

A quick guide and tool for those watching and wondering about the evolution of futures contracts and indices, tools that aim to bring stability to the ferrous scrap market.

What is a futures contract?
Futures contracts are financial risk management tools. A futures contract is a contractual agreement to buy or sell a commodity or financial instrument at a pre-determined price in the future, enabling companies to hedge risks associated with general economic and market factors. A futures contract details the quality and quantity of the underlying asset. Some futures contracts call for physical delivery of the asset, while others are settled in cash. Exchange-traded futures contracts are available for many commodities and financial instruments, such as nonferrous metals, oil, currencies, indices, equities, bonds and, more recently, steel and scrap.

What are ferrous scrap futures contracts?
Like steel futures contracts, scrap contracts are a financially settled derivative, which means there won’t be actual physical delivery of the product. Scrap futures provide dealers, consumers and generators of scrap a tool to offset price risk in a given price scenario, like protecting inventory in a downward move or to lock in prices forward for longer periods. CME Group Inc. managing director of metal products Harriet Hunnable said the scrap contract is an “effective tool to enable price risk management throughout the entire supply chain, from raw materials to finished steel products. In addition to being an efficient risk-management tool for regional industry participants, we firmly believe our U.S. Midwest scrap futures contract has the potential to become a global benchmark for price discovery and managing volatile input prices.”

How do they work?
When employing a financially settled contract, “everything you do on the physical side stays the same,” said Young-Jin Chang, CME Group’s director of metals research and product development. “All you’re doing is on the financial side and accounting side; you’re trying to hedge some of that volatility and fix your profits so you can somewhat more stabilize your business if that makes sense for your business.”

How are ferrous scrap futures contracts settled?
The contract, available for trading on CME Globex for submission for clearing through CME ClearPort, is financially settled against AMM’s U.S. Midwest Ferrous Scrap Index. The first CME Group product based on AMM’s price assessment services is designed to offer risk management for the steel industry based on market data from AMM.

Who is CME Group?
As the world’s leading and most diverse derivatives marketplace, CME Group is where market players attempt to manage risk. CME Group exchanges offer a range of global benchmark products across all major asset classes, including futures and options based on interest rates, equity indices, foreign exchange, energy, agricultural commodities, metals, weather and real estate. CME Group operates its CME Globex electronic trading platform and trading facilities in New York and Chicago.

What is hedging, and is it helpful?
Hedging is about decreasing or transferring risk. It can help any business that needs to reduce its exposure to adverse and unpredictable price movements. It is a risk management strategy used to limit or offset the probability of loss from fluctuations in the prices of commodities, currencies or securities. Hedging employs various techniques, but basically involves taking equal and opposite positions in two different markets, such as cash and futures markets. Many steel mills already hedge currencies and energy sources, and others hedge some or all of their raw material purchases. The possibility of hedging is open to all in the industry: brokers, dealers, mills, traders, end-users and others.

Why scrap futures now?
When CME Group added the first ferrous scrap futures contract available to the North American steel industry to its product suite on the Nymex exchange, it was a reaction to volatility in the ferrous scrap market. The U.S. Midwest scrap futures contract has the potential to do for steel raw material prices what West Texas Intermediate futures contracts have been for oil--a global benchmark and liquid product that can help the industry manage volatility. The global economy shifted the dynamics of business, creating a need for such a contract to help mitigate exposure to wild fluctuations prevalent in the scrap and steel industries. “Volatility is here to stay and globalization is inevitable,” Chang said.

What is AMM U.S. Midwest Ferrous Scrap Index?
The index, launched in June 2012, is quoted in U.S. dollars per gross ton, delivered to the mill. The AMM index methodology is a tonnage-weighted calculation of transactions that have been normalized to a base specification using value-in-use curves as defined by the market. This methodology uses the input of high-quality data. The index is based on actual transactions reported to AMM by any market participant conducting trades on a delivered-Midwest-mill basis and isn’t restricted to a panel or select group. The U.S. Midwest Ferrous Scrap Index also utilizes aggregate transaction data, where available, to maximize the proportion of the market represented in the final index.

The scrap futures market is off to a slow start. Is this a bad omen for its fate?
More than 3,000 tons were traded in October, the first full month for the futures contract, which was seen as a positive sign for the new hedging tool. “This is actually very good considering this is a very new market. We see this as a very positive sign for growth,” Chang said at the time. Participants are hedging small tonnages of 20 to 100 tons of busheling to try the contract out. December saw the lowest interest since the contract’s launch. As of the end of February, open interest stood at 4,800 tons, calculated through August, and 6,340 tons have cleared so far in 2013. Other futures markets, including those for finished steel products, also started off slowly, so the cautious reception thus far doesn’t mean it will remain a less-popular market choice.

What about the idea that futures are an unknown to the scrap industry?
Scrap metal was one of the last few major commodities without a futures contract. The big question is whether the players in the market will use the contract. Scrap players up and down the supply chain say the new hedging tool has piqued their interest, even as others remain wary of the fledgling product. Chang said inquiries into the new product have been flowing in steadily since June 20, when the CME first announced its licensing agreement with AMM. “We’re getting quite a few inquiries coming from scrap participants: scrapyards, processors and (steel) producers. They’re inquiring about learning more about the contract and understanding it. Of course, there will be a learning curve,” she said.

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