SGX Commodities Newsflash: A Quantum Leap In Iron Ore Derivatives

• SGX Iron Ore derivatives reached record monthly volumes and open interest of 48.8 mil MT and 35.5 mil MT respectively on the back of higher volatility and more counterparties.

• Deeper liquidity along the entire SGX Iron Ore forward curve makes for more effective hedging.

• Potential convergence of SGX Iron Ore and DCE Iron Ore prices for the maturing contract, indicates spread trading opportunities.

As the SGX Iron Ore derivatives market becomes increasingly mature, an array of speculative, hedging, and arbitrage opportunities are opening up for the savvy investor—especially with the recent spike in 30-day annualized volatility from 17.9% in February to 34.1% in March.

When the TSI Iron Ore 62% Fines reference price fell 8% to US$104.70/MT on 10 March 2014, the market reacted in that week, setting consecutive daily record volumes, the final record being 3.79 mil MT for total SGX Iron Ore derivatives (swaps, options, and futures), beating the previous daily record of 3.61 mil MT (set previously on 6 June 2013) by 5%.

Trading on these price movements hitherto will be facilitated by the deepening liquidity and diverse mix of participants in the SGX iron Ore derivatives market. In addition, convergence of SGX Iron Ore and DCE Iron Ore prices at expiry also present spread trading opportunities.

Deepening Liquidity

In March 2014, SGX Iron Ore derivatives broke almost every monthly record across the board (most of them recently set in January) in both tonnage and contracts:

SGX Iron Ore Records as of March 2014

Compared to a year ago, SGX Iron Ore derivative volumes grew 159% while open interest grew 116%. Closer analysis reveals that volumes grew along the entire forward curve. Hence, there is not only greater liquidity in front months which makes for more effective hedging, but also in far months allowing participants to hedge further into the future.

  Volume by Contract Months Open Interest by Contract Months  

Diverse Participant Mix

Notably, the growth in volumes was also accompanied by steady growth in open interest.  This suggests that SGX Iron Ore derivatives are used not only for speculative purposes, but also to meet hedging needs. In fact, year-to-date, physical players (including Asian Steel mills/ Traders and International Trading House/Producers) account for at least 58% of total traded volumes. The remaining volumes are contributed primarily by Banks and Funds. Meanwhile, the pool of AsiaClear counterparties in March has also grown 39% year-on-year.

Convergence of SGX Iron Ore and DCE Iron Ore Prices

It was observed that when the DCE Iron Ore March contract expired on 14 March 2014, the settlement price was at RMB 838. After adjusting for port charges, value-added tax (VAT), and exchange rate, the price was US$111.58. Meanwhile, with the SGX Iron Ore price at US$111.00, it appears that the adjusted DCE Iron Ore price had settled very close to the SGX Iron Ore price at expiry. It is interesting that this eventual convergence had occurred even though the adjusted DCE Iron Ore price had traded as low as $6 discount to the SGX Iron Ore price (on 18 October 2013); to as high as US$11 premium (on 11 February 2014). This is a clear indication of the potential trading opportunity between the two contracts.

The May contract also appears to be following a similar trend of convergence with the adjusted DCE Iron Ore price trading at a premium as high as US$11 on 13 March 2013; and that spread narrowing to US$7 on 1 April 2014 as the adjusted DCE Iron Ore price moves towards the SGX Iron Ore price.

With the expectation that the SGX Iron Ore price and the adjusted DCE Iron Ore price would converge at expiry, trading opportunities in the spread between the two prices may exist by holding simultaneous and opposite positions of similar notional values in both contracts. However, due care should be taken with consideration that liquidity typically reduces as the contract approaches expiry and that the DCE contract requires physical delivery at expiry. Trading positions should be closed out well in advance to avoid the liquidity and delivery risks.

Additionally, since November 2013, the 30-day rolling correlation between SGX Iron Ore prices and DCE Iron Ore prices have risen substantially to as high as 96%. Meanwhile, 30-day annualized volatility is also rising at 32% (SGX Iron Ore) and 21% (DCE Iron Ore). During the penultimate trading month, a break in the 30-day rolling correlation between the SGX Iron Ore price and the DCE Iron Ore price can often mean a trading opportunity.

For illustration, when the 30-day correlation between SGX Iron Ore and DCE Iron Ore active month prices temporarily break in late February, the spread between the 2 prices was also significantly positive. A short position of 10 lots of SGX Iron Ore and a long position of 52 lots of DCE Iron Ore on 18 February 2014 could yield a theoretical profit of US$29,962 when unwound on 28 February 2014.