However much the politicians in Washington, D.C. rail against swaps and derivatives, it amounts to about as much as the legends of Xerxes ordering his retainers to whip the ocean for disobeying him. Amidst the debate about how to limit the exposure of U.S. banks to derivatives, a brand new market is taking shape. This is not a new derivative, but rather applying old tricks to a new market - iron ore.

The global iron ore trade is huge, totaling about 840 million metric tons and $100 billion a year. Oddly enough, though, it was a market that for 40 years was managed by the major iron producers holding once-a-year negotiating sessions with major buyers (steel companies, mostly) to set the price for the year.

This approach has worked well enough for the major producers, names that include Brazil's Vale (Nasdaq:VALE) and Anglo-Australian giants BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RTP). Customers, though, have been less pleased with this arrangement in recent years and the Chinese in particular have been looking for alternatives. Bowing to this pressure, the major companies began ditching the annual pricing concept earlier this year in favor of quarterly pricing.

IN PICTURES: 20 Tools For Building Up Your Portfolio

Enter The Swap
With quarterly resets to be based on sometimes-volatile spot markets, the need for a derivatives market in iron ore became more apparent. The first in line was the swap. In simple terms, a swap is an agreement between two parties to exchange cash flows, typically centered around some sort of variable like an interest rate or currency exchange rate. In this case, an iron ore swap allows one party to "lock in" a fixed price for iron ore while the other party assumes the risk of a floating price - if prices rise, the fixed price swap holder "wins" and the floating swap holder loses, and vice versa if prices decline. (For a refresher on this topic, check out An Introduction To Swaps.)

Not surprisingly, major banks were more than happy to step up to the plate and offer these services - for a fee, of course. Deutsche Bank (NYSE:DB) and Credit Suisse (NYSE:CS) have emerged as the early leaders in the market, but American banks like Morgan Stanley (NYSE:MS) are looking to get into the game as well.

The Next Logical Step
While swaps and other derivatives have entirely legitimate uses, they suffer from a pronounced lack of transparency. Because there is no exchange, no clearing house, and no formal clearing or margin process, nobody really knows the positions (and risk) held by the other counterparties. This opacity is a part of the reason we saw the big panics back in 2008 and even into this year with the European debt crisis - when you cannot see your counterparties books and times get tough, you may assume they are no longer a safe partner and pull your business away. (For more, see Finding Your Margin Investment Sweet Spot.)

Moving on, the CME Group (NYSE:CME) is now lending an even greater air of significance to the global iron ore derivatives market, creating an iron ore futures contract that will trade on the New York Merc starting next week and offering trading and clearing services. Although having an active futures market does not relieve the opacity of the swap market, it does at least represent another alternative for those looking to hedge their exposures. (To learn more, check out How Do Futures Contracts Work? from Investopedia Video.)

Who Wins?
It is hard for me to see how this is anything but a "win" for the financial services companies involved - it gives the banks another derivative to trade, it gives the CME another futures product and it gives more price transparency to those who finance projects relating to iron ore.

For the companies, it is a normal evolution to the market. The iron ore companies would probably rather have the certainty of annual pricing, but that was just not in the cards anymore (not many global commodities trade on that basis). The biggest potential side-effect here is greater volatility in the market. Clearly, almost anything would be more volatile than once a year price-setting, but open future markets can certainly lead to speculation here and there that decouples prices from economics (look at markets like oil in recent years).

For the steel companies it is likewise a mixed blessing - perhaps it breaks the price-setting power of the iron ore companies, but it adds a level of input price volatility that will make financial projections more difficult for the likes of POSCO (NYSE:PKX) and Arecelor Mittal (NYSE:MT) unless they get involved in these derivatives. (To learn more, check out Futures Fundamentals.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Stock Analysis

    Is Now the Right Time to Buy Brazilian Stocks?

    Examine the current state of the economy of Brazil, and learn why there may be some reasons for investors to look for a rally in Brazilian stocks.
  2. Stock Analysis

    Will WYNN Continue to Rally?

    Wynn Resorts has experienced a rally recently. Will it remain a good bet?
  3. Stock Analysis

    Don't Be Fooled by the Market's Recent Rally

    The bulls won for a bit in early October, but will bears have the last laugh?
  4. Stock Analysis

    Will Twitter's Stock Find its Wings Soon?

    Twitter is an enigma to many investors, but its story is pretty straightforward.
  5. Investing Basics

    How to Think About Seasonality Trends

    Investors benefit when company research incorporates seasonality trends that predict relative strength and weakness throughout the calendar year.
  6. Chart Advisor

    These 3 Charts Say Now Is Not The Time To Buy Commodities

    Traders are turning their attention to the charts of commodity stocks to get a better idea of the future trend. We'll take a look at three stocks from different segments of the basic materials ...
  7. Stock Analysis

    8 Solid Utility Stocks for a Bear Market

    If you're seeking modest appreciation, generous dividend payments and resiliency, consider these eight utility stocks.
  8. Stock Analysis

    Why Phillips 66 (PSX) is a Solid Long-Term Bet

    Here's why Phillips 66 will likely remain one of the world’s largest and most profitable companies for a long time to come.
  9. Stock Analysis

    The Biggest Risks of Investing in Chipotle Stock

    Learn about some possible risks for Chipotle, one of America's most popular and fastest-growing food chains and leader of the "casual dining" experience.
  10. Stock Analysis

    3 Resilient Oil Stocks for a Down Market

    Stuck on oil? Take a look at these six stocks—three that present risk vs. three that offer some resiliency.
  1. Can a company's working capital turnover ratio be negative?

    A company's working capital turnover ratio can be negative when a company's current liabilities exceed its current assets. ... Read Full Answer >>
  2. Does working capital measure liquidity?

    Working capital is a commonly used metric, not only for a company’s liquidity but also for its operational efficiency and ... Read Full Answer >>
  3. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  4. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>
  5. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  6. How do I use discounted cash flow (DCF) to value stock?

    Discounted cash flow (DCF) analysis can be a very helpful tool for analysts and investors in equity valuation. It provides ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!