Quantifying exposure to market riskthe path to effective price risk management

Disclaimer

This report is issued by Stemcor Risk Management (AG), which is not a regulated entity. The report was prepared and distributed by SRM AG for information purposes only. The report may contain information and opinions which may be used as the basis for trading undertaken by SRM AG and its officers employees and associated companies. The report should not be construed as a solicitation nor as offering advice for the purposes of the purchase or sale of any physical commodity, security, investment, or derivative. The information and opinions contained in the report were considered SRM AG to be valid when issued. The report also contains information to SRM AG provided by third parties. The source of such information will usually be disclosed in the report. Whilst SRM AG has taken all reasonable steps to ensure this information is correct, SRM AG does not offer any warranty as to the accuracy or completeness off such information. Any person placing reliance on the report to undertake trading does so entirely at their own risk and SRM AG does not accept any liability as a result.

Introduction – Market Risk Management

Introduction

Successfully utilizing ferrous derivatives to minimise exposure to price risk, offer new services and expand business requires preparation. Proper measures, reporting systems and risk management strategies need to be developed bear each individual business in mind, before implementation can begin.

Derivatives offer a great deal of potential in enabling market participants to manage their exposure to market risk. However, without the right systems and measures in place, a new participants’ prospects for achieving a positive result are greatly reduced.

Aims & Objectives

A potential hedger should agree and specify clear ad targeted goals and objectives. As an example:

Reactive and proactive

In order to manage exposure to market risk management effectively and to extract maximum benefit from market risk management strategies, a business’s market risk management function must be proactive as well as reactive as an internal resource.

Identify exposure to market risk

Report exposure to market risk

Develop market risk mitigation strategies

Implement & manage market risk mitigation strategies

Strengthen core commercial relationships

Develop and implement new limited-risk commercial/trading strategies

Analyse and understand existing business & resulting exposure to market risk

Identify suitable indices, benchmark existing trade flow and transactional performance against hedgeable indices.

Design, deploy and manage mark-to-market risk reporting systems.

Ensure timely reporting with regular frequency (ideally daily). Analyse and report to management clearly.

Identify suitable market risk management tools and transactional infrastructure.

Regularize and stabilize relationships/trade flow through the use of index-linked contracts/MRM strategies

Establish clear procedure for hedging and monitoring positions, define clear limits & reporting lines.

Educate key personnel on MRM principles and mitigation strategies.

Supervise early strategy development and execution, conduct stress-tests and identify areas for further development.

Identify business’s key supplier/customer relationships & trade routes

Identify gaps in existing service provision/areas for improvement

Design new commercial/trading strategies that leverage core Stemcor competencies and deliver positive change.

Goal Description Explanation

Identifying price risk

Service/Storage

Processor

Substrate

Substrate spot price

Supplier

FP sales price

Finished Product

Supplier

1 2

Example: Processor

Parcels

End

pro

duct

Customer

Customer

Residual price risk – the cost of business

Almost all businesses in the iron & steel supply chain will carry residual long or short positions, resulting in exposure to price risk.

The first step in developing solutions to manage these risks is to identify and prioritise exposures.

Additionally, different units within a business will have different exposures to risk:

• Purchase units will be exposed to fluctuations in substrate pricing.

• Sales units will be exposed to changes in spot sales market pricing.

The processor recovers its costs and margin through sale of finished products, so should benchmark all three exposures – purchase, unsold and sales – against a relevant finished products index

In most cases, the business will have an overall exposure to one market.

In the example:

Purchasing from multiple suppliers, the processor’s purchasing function is exposed to fluctuations in the price for substrate. These purchases should be benchmarked against the most relevant index for this market.

The processor sells to a number of different customers, exposing the sales function to fluctuations in the price of finished products. In order to ensure best performance, these sales should be benchmarked against a finished products index.The processor recovers its costs and profit margin through the sale of finished products. As a result the overall business exposure is to finished product sales prices, and should be benchmarked as such.

3

Identifying price risk

Note: The processor purchases substrate in small parcels over time, storing as unsold inventory for servicing at a later date. This creates an exposure to falling substrate prices.

Note: Once the processor has added value to substrate to create its finished products, it consolidates parcels for sale to customers over time. This creates an exposure to falling FP prices.

Benchmarking purchases against an index that reflects market prices for substrate will enable the processor to ensure best execution.

The processor should use the same index to mark its unsold to market and demonstrate resale value.

Utilising an index for finished products provides the processor much greater sales transparency and the ability to benchmark its sales relative to the market.

Exposure Exposure Exposure 1 2 3

Additionally……

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Should achievable sales price for unsold material fall below the purchase cost, a traditional steel reporting structure does not automatically alert management, who instead tend to take provisions based on their view of the market.

This can lead to a disconnect between the actual value of unsold positions and the value perceived by the business in question, significantly hindering management’s ability to deploy successful mitigation strategies, where necessary. (Product groups have been simplified for the purposes of example)

MARKET VALUE

SALES ABILITY Measured based on unit’s recent sales performance relative to the rest of the market.

Measured by change in the market value for unsold since purchase.

M2M VALUE

Flat productsSALES ABILITY

MARKET VALUE

Rolling average vs. index

Index @ purchase +/- spotFP M2M VALUE

Long productsSALES ABILITY

MARKET VALUE

Rolling average vs. index

Index @ purchase +/- spotLP M2M VALUE

Semi-finished productsSALES ABILITY

MARKET VALUE

Rolling average vs. index

Index @ purchase +/- spotS-F M2M VALUE

Scrap/MetallicsSALES ABILITY

MARKET VALUE

Rolling average vs. index

Index @ purchase +/- spotS/M M2M VALUE

Iron oreSALES ABILITY

MARKET VALUE

Rolling average vs. index

Index @ purchase +/- spotIO M2M VALUE

CoalSALES ABILITY

MARKET VALUE

Rolling average vs. index

Index @ purchase +/- spotC M2M VALUE

OVERALL M2M VALUE

Two key components

A business’s mark-to-market model should comprise two key measurement of value for unsold, updated regularly:

Theoretical example

Market price

Unseen P&L discrepancy

Held as unsold

Rationale

Measuring the performance of steel and raw materials tradeflowutilising a mark-to-market system enables management to easily understand the performance of a business’s transactional function and positions.

Additionally, a de-centralised approach to performance reporting does not provide the flexibility for a business to identify potential offsets elsewhere within the business or to utilise external hedging strategies.

Mark-to-market reporting

Mark-to-market reporting utilises available material and product indices to benchmark the actual market value of unsold positions and the business’s ability to recover value.

An effective mark-to-market appraisal provides management full visibility of trade performance and paves the way for a coherent hedging strategy

Marking to market

Successfully applying indices

Delta +/-= BASIS RISK

Index

Actual transactions

Establishing basis

For example: CRC

Using relevant indices to benchmark the core value of unsold positions will enable management to closely monitor changes in market values, while premiums and discounts will reflect the relative value of specific products (much less volatile).

• In some cases, businesses should identify core substrate indices to benchmark exposure, because they provide services without significantly altering the value of the underlying product.

• In other cases, business should identify finished product indices as M2M benchmarks, because they significantly enhance the value of inputs and recover this through the sale of finished products.

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Specific CRC CRC index + basis

Inde

x

Basis

All-

in

Reflects the value of the size and grade of the particular CR product.

Because these extras often reflect fixed costs, they tend to be less volatile than ‘All-in’ market prices.

The index reflects the value of generic CRC products being traded in the market.

This provides increased transparency of the market value of the material while it is held as ‘unsold’

Understanding basis

Despite being less volatile than outright market prices, as determined by spot transactions, the implied basis between relevant indices and specific products still fluctuates over time. Hedgers need to understand these movements and the exposure that arises.

Utilising fewer product indices to track changes in value makes it easier to mark positions to market, but increases the potential basis risk being run by each business. In order to provide maximum flexibility, as many indices as possible should be hedgeable. For example:

Move to…

CRU HRC - hedgeable

CRC

HDG

Basis

Basis

Rationale

In order to operate an efficient m2m model, a potential hedger should move away from an ‘all-in’ price reporting model and instead utilise an ‘index +/-’ model, whereby the core market value of products is reflected by a relevant index, with specific sizes, grades and brands reflected by premiums or discounts.

Reference type Product Index Type Internal function Hedge

Market reference HDG CRU Midwest HDG Basis 3Informs HDG purchase & sales

targetsBasis reported as sales

performance, once realised

Market reference CRC CRU Midwest CRC Basis 2Informs CRC purchase & sales

targetsBasis reported as sales

performance, once realised

Market reference Plate CRU US Midwest Plate Basis 1Informs HRP purchase & sales

targetsBasis reported as sales

performance, once realised

HEDGEABLE HRC CRU US Midwest HRC HEDGEABLEInforms HRC purchase & sales

targetsM2M Benchmark

Reference proxy Slab ProxyPurchase & sales targets tied to

proxies

HEDGEABLE Scrap AMM Midwest #1 Busheling HEDGEABLEInforms Metallics purchase &

sales targetsM2M Benchmark

M2M REFERENCE INDICES

Iron Ore Coking Coal Other metallics Semi-finished LP Semi-finished FP Long products Flat products

EMEA TSI IO 62% cfr China Platts PLVM fob Aus TSI scrap cfr TurkeyPlatts FOB Black Sea

billetTSI NE HRC

Platts FOB Black Sea billet

TSI NE HRC

Americas TSI IO 62% cfr China Platts PLVM fob Aus AMM #1 Busheling AMM #1 Busheling CRU Midwest HRC AMM #1 Busheling CRU Midwest HRC

Asia TSI IO 62% cfr China Platts PLVM fob AusPlatts scrap cfr East

AsiaPlatts FOB Black Sea

billetSBB East Asia slab SHFE rebar M3* TSI ASEAN HRC

EXPLANATION

Identifying indices

Mark-to-market benchmarks – Headline indices

In order to provide an accurate M2M appraisal, suitable benchmarks need to be identified that reflect the real market value of unsold positions. Hedgers should seek to identify a sufficient number of indices to provide this transparency without over-complicating the system by including too many indices at an overly granular level.

This matrix of indices has been selected to best reflect the value of individual product segments while providing maximum flexibility to take action to lock in profit or stem further losses, where required.

Indices highlighted in purple are also utilised to settle price risk management tools that can be utilised to offset exposure.

Those in white provide a better reflection of market value, but still correlate well with hedgeable indices.

Purchase & sales performance – underlying indices

Example – US flat products

Within individual product segments specific sizes, grades and qualities command values that fluctuate over time. While the basic value of these products can be hedged utilising the headline indices, individual divisions need to be aware of the residual basis risk so as to understand their access to physical sales liquidity properly and tailor their approach accordingly:

Measuring market performance

Judging performance based on overall P&L does not allow businesses the flexibility to judge the performance of individual functions (purchases & sales) or the vale created by particular services.

Upward and downward price movements can erode or create profits, while masking the competency of functions or undermining the core value created by the business’s core services.

Full transparency can only be provided through benchmarking to clearly identify value creation, isolated from volatility.

Purchase

Services

Sales

Value created

masked by market

volatility

Judging functional performance – the status quo

Purchase

Services

Sales

Purchase performance +/-index

Sales performance +/-index

Value Isolated

Benchmarking – judging functional performance

Judging purchases, sales and services against a relevant index provides management much greater transparency of their performance.

As a result, management is able to judge the underlying business not just on overall profitability, but also on the value each function and service contributes.

Increased visibility of functional performance provides a clear path to improvement and paves the way for more coherent business incentives.

Assessing purchase & sales ability

In order to assess the performance of sales, isolated from the wider trading strategy and market moves, individual transactions should be measured against a relevant index:

saleIndex

sale

purchasesale

purchase

purchase

Three different measures:

Transparency of the performance of sales over time, relative to the market, isolated from price changes, the purchase price and value created through services.

Transparency of the performance of purchases over time, relative to the rest of the market and isolated from price changes, the purchase price and the value created through services.

Transparency of the value created by group services, such as stockholding, isolated from the group’s ability to purchase and sell material and from fluctuations in wider market prices.

Sales performancePurchase performance Overall performance

Sales price minus indexIndex minus purchase priceSales performance minus

Purchase performance

Physical sales liquidity

Closely monitoring these benchmarks will provide a business a clear view of its access to physical market liquidity, and therefore the true value of unsold positions.

End-to-end service

Sales marketPurchase market

Sales marketPurchase market

TraderSupplier

Physical

Customer

$ Special Purchase

Physical

$ Special Purchase

Fixed margin –limited participation

Distributor/StockistSupplier

Physical

Customer

$ Spot MINUS

Physical

$ Special Purchase

End-to-end service

Customer

Customer

Traditional Trader Business

Traditionally, traders have sought to profit from inter-regional arbitrage through back-to-back transactions, structuring a fixed cfrprice for customers in exchange for a small fixed margin.

This model leaves the customer fully exposed to the risk that local market prices will fall by the time the material arrives.

As a result, customers are reluctant to commit to purchases unless the available discount to local market levels is sufficiently large to provide comfort for the risks arising from the longer lead times.

Additionally, this strategy limits potential customers to those that are comfortable purchasing large consignments and, usually, financing these positions for long periods of time.

Hedged for gradual distribution – full participation

Stemcor’s strategy of providing customers index-linked pricing and prompt availability in suitable markets means our offering more closely matches customer requirements, providing all the advantages of traditional arbitrage, without exposing customers to market risk.

Additionally, once consignments have been delivered to customers (or nearby locations) Stemcor is able to continue offering customers pricing services according to its commercial requirements, so that the risk of market-driven inventory-related writedowns and other similar trading losses is extremely low.

Customers also have full flexibility to adjust their exposure to market risk independently of Stemcor and without basis risk, but participating in the relevant swaps market.

This provides a limited-risk means of taking first steps into the world of market risk management and derivatives.

Monitors and Controls

PROPRIETARY PAPER HEDGE PAPER PHYSICAL UNSOLD

Q2 short

Q3 short

Q4 short

Cal short

Q2 short

Q3 long

Q4 flat

Cal long

offset

offset

Internal transaction

s

PAPER MARKET PAPER MARKETINDEX-LINKED

PHYSICAL SUPPLY

PURCHASE FUNCTION

SALES FUNCTION

SPOT PHYSICAL SUPPLY

INDEX-LINKED PHYSICAL SALES

SPOT PHYSICAL SALES

BASIS RISKMARKET RISK FULLY-HEDGED - NO RISK

P/L from transactional performance

P/L from value created through service provisionP/L from market exposure

Management view Core business – Services Commercial ability

WAREHOUSING RISK

As a combined system, these new structures provide management full oversight of market-related risks the business is running and the tools to adjust the company’s exposure without disruption to its underlying supply chain.

Thanks to the new system, shareholders and financiers can take greater confidence that a business’s core commercial logic is not being impacted by outside influences, and that the businesses’ market exposure is more closely aligned with their interests.

Understanding exposure

In order to provide full transparency and identify key performance motives, individual risks are reported seperately and are the responsibility of different business functions.

As well as providing full visibility, this also enables management to provide performance targets to each individual business that are more closely tied the unit’s core competencies.

Management view

All exposure to directional market risk (long or short) is reported in isolation and is the sole responsibility of management to monitor and adjust.

Because exposure to price risk is isolated from the other components of the business, management is able to adjust the group’s exposure through paper transactions, without disturbing the industrial logic of the underlying physical business.

Core business

The core services provided by the physical component of the business (distribution, CMA etc) is isolated from the effects of market pricing.

This provides clear incentives for this business unit to focus fully on delivering the maximum value through these services, without the complication of market volatility.

Physical purchase & sales

Although isolated from the directional changes in the wider market direction, purchase and sales functions are incentivised to provide the best result relative to the rest of the market.

Removing the incentive for these divisions to go long or short in order to beat market volatility should build stronger relationships and deliver more efficient tradeflow.

Historical simulations

Hedged vs Unhedged – Historical Inventory Simulations

This simulation demonstrates that the same business style, with the same inventory cycle and executing the same physical spot market prices, would have realised a $1.40/st profit solely resulting from market-related P&L.

For the same hypothetical business over the same study period, this is equivalent to a total profit of $78,600 in addition to the value the business created through its core services.

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AVG 2011 to date

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Hedged market-related P&L

AVG 2011 to date

The following two simulations demonstrate the market-related P&L resulting from holding unsold inventory over a normal 2 month cycle, assuming this is the average time differential between purchasing feedstock and selling finished products. This model does not consider the additional value created by providing services or transforming material, just the impact of market price volatility on this tradeflow.

The first example demonstrates the P&L resulting from a two month inventory cycle with no hedge in place, assuming purchases and sales are made evenly in tonnage terms each month at the wider market price, with no special discounts paid or premiums received.

The second simulation shows the P&L resulting from the same tradeflow but on a hedged basis, with swaps sold simulatenously with purchases at market prices avaialble at the time for settlement coinciding with physical sales. This example also assums purchases and sales are made evenly in tonnage terms each month at spot market prices, with no special discounts paid or premiums received.

Example 1

This simulation demonstrates that a business purchasing fixed monthly quantities of HRC in the USA, holding this material unsold for two months, and selling fixed monthly quantities each month would have realised a $12.42/st loss solely resulting from market-related P&L.

For a business turning over 1kt of HRC each month over the study period, this is equivalent to a total loss of -$695,250.

Example 2

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Historical Trading Simulations

Opportunistic purchasing vs hedged carry trade – Historical simulations

This simulation demonstrates that, by adopting a strategy whereby purchases are only made in situations in which the US HRC forward curve exceeds a $5 Contango and purchases are hedged, a business holding required inventory for consistent sales can return a strong and consistent positive P&L from market moves over the study period.

For the same hypothetical business selling at the same rate using this strategy, the market-related P&L would have been $17.25/st

Unhedged market-related P&L, purchases below 5-month moving avg

AVG 2011 to date

Market-related P&L from purchases hedged in Contango > $5

AVG 2011 to date

The following two simulations demonstrate the P&L resulting from market moves incorporating an opportunistic approach to purchasing – attempting to call the optimum opportunities to purchase material for stock wit purchases being sufficient to facilitate consistent monthly sales.

The first example demonstrates the P&L resulting from a two month inventory cycle with no hedge in place, assuming sales are made evenly in tonnage terms each month at the wider market price, with purchases made when the spot price moves below the 5 month moving average, in an attempt to call the most attractive purchasing opportunities.

The second simulation shows the P&L resulting from the same tradeflow, but with purchases made on a hedged basis (swaps sold corresponding with the subsequent sales period) when the US HRC swaps Contango for the period in question exceeds $5/st. Both simulations are based on an average Cost of Goods Sold model.

Example 1

This simulation demonstrates that, even by weighting purchases to spot opportunities that fall below the five-month moving average, a business holding necessary inventory on hand to sell consistently on a monthly basis would have still realised a small loss related to market moves.

For a business selling over 1kt of HRC each month over the study period using this purchasing model, market-related P&L would have been -$4.75/st

Example 2

Thanks and questions

Further information

Phillip Price

Telephone: +44(0)20 7775 3677Cell: +44(0)7500 868 860Email: phillip.price@stemcor.com

Thank you for your kind attention