Here’s a neat little snipped from Credit Suisse describing how an iron ore trader would be forced to liquidate his arbitrage play in the iron ore inventories that are fueling the meteoric rise in Chinese port stocks:
- If the trader paid 20% upfront and borrowed the rest on a 180-day LC at 6-month libor +280bps it would owe the bank $105.20.
- After investing or lending on the remaining 80% cash at a yield of 12% p.a., for example, that would return 37RMB/t. 27 February 2014
- Now the inventory being used as collateral is worth $117.8/t or 721RMB/t. Assuming no further changes, and adding in the investment profit, after six months the position would be worth $123.80/t or RMB758/t.
- If the trader now sold the physical iron ore position it could still repay the bank but would have reduced equity in the deal. Essentially, losses are incurred below RMB745/t.
- Assuming no further moves in the currency, the trader is only eating into its own 20% deposit until around $100/t for spot. Beyond this point, the trader would need to find additional funds to repay the debt of $105.20.
- Note that, unlike a copper interest-rate arbitrage, this is unlikely to be a hedged transaction, in part because the negative carry on the hedge from iron ore’s backwardation can make it prohibitively expensive.
It would be a temporary collapse in price effectively driven by a margin call. But very nasty nonetheless and any rebound wouldn’t reach yesteryear’s highs without stimulus support.
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