Client:
Producer of finished steel products who traditionally uses futures as a hedging mechanism to protect profit margin.
Challenge:
Budgeting for unknown variation margin outlay, while efficiently and effectively hedging known future purchases of processed steel.
Solution:
Use U.S. Midwest Domestic Hot-Rolled Coil Steel (CRU) Index average price options.
Overview
A risk manager at a producer of steel products is presented with the coming year’s processed steel purchasing needs, which is more than historical amounts. Steel prices, along with other commodities, have been influenced by many factors recently which have caused unprecedented volatility.
The current price of steel is $1,000 per short ton.
With uncertainty surrounding supply chains and geopolitical conflict increasing, the risk manager is faced with the need to hedge against potential rising prices.
Using futures contracts in past highly volatile markets has resulted in well- hedged portfolios that have protected profit margins, regardless of price direction.
However, knowing the need to have cash on hand to pay for the processed steel purchases, the risk manager is reluctant to hedge using futures, as there may be a need to post large variation margin if the futures price declines.
Illustration
In February, the risk manager is presented with purchase orders for processed steel totaling 1,000 short tons per month for the 2nd quarter. Instead of hedging using futures contracts and having variable cash outlay through posting margin, the risk manager decides to explore hedging with options.
The U.S. Midwest Domestic Hot-Rolled Coil Steel (CRU) Index average price option listed on COMEX allows participants to project the costs of hedging.
To hedge 1,000 short tons of steel per month over the second quarter, while locking in a fixed cost, they would need to buy a total of 150 call options spread out evenly over April, May and June.
Since this hedge is only for a short period of time, the risk manager would buy 50 lots each of April, May and June call options with a strike price of $1060.
The total cost of goods for the quarter will be $3,000,000:
- Steel price of $1,000 * 1,000 short tons * 3 months = $3mm
The below quarterly call strip would cost $150,000 and protect against steel prices rising above $1,060 in Q2.
- Call price $50 * 1,000 short tons * 3 months = $150,000
The cost of this hedge is approximately 5% of the notional underlying.
Conclusion
Volatility in the steel market has increased since the option hedge was initiated. Prices in the underlying steel market have increased by approximately 50%. Buying the 1060 upside calls gives the risk manager the right to be long the underlying Hot Rolled Coil Steel futures at $1,060 upon exercise, without having to post additional margin. The increase in cost of the processed steel is offset by the options hedge at fixed cost of 5%.
Had the price of steel decreased, the purchasing manager would have been able to buy processed steel at a lower price, but the capital outlay on the hedge remains fixed at $150,000 or 5% of the notional underlying.
This hedging strategy allows for protection against rising prices, as well as monetary participation when prices decline, while knowing the cost and capital dedication in advance.
Hedging with futures contracts would be effective as well, but the amount of margin needed to fund a futures hedge is variable depending on how the price of steel moves. In the previous example, purchasing Steel futures would hedge against rising prices. If the price of steel had declined, the outlay of funds for variable margin should have been mostly offset by the ability to buy processed steel at a lower price.
Summary
Futures and options provide greater flexibility to hedge exposure, and Steel options at CME Group are seeing significantly increased adoption. The ability to project for capital requirements in a hedging program allows risk managers to more accurately budget for needed resources. Option hedging has increased in prevalence as liquidity has grown, and both producers and consumers are finding value in being able to project the costs of hedging.
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