Elsevier

Resources Policy

Volume 38, Issue 4, December 2013, Pages 621-627
Resources Policy

Iron ore spot price volatility and change in forward pricing mechanism

https://doi.org/10.1016/j.resourpol.2013.10.002Get rights and content

Highlights

  • We apply the test of structural breaks to identify the date of forward pricing change in the volatility of iron ore spot price.

  • We find the evidence of long memory and asymmetric effect on the volatility of the iron ore spot price.

  • We find that the change in the forward pricing may reduce the volatility of the iron ore spot price.

  • We find that only negative shocks have an effect on the volatility of the iron ore spot price.

Abstract

To examine the impact of the change in forward pricing mechanism on the volatility of iron ore spot prices, we model the iron ore daily price of Platts IODEX from October 7, 2008 to September 21, 2012. The identified iron ore spot price tends to be less volatile after the introduction of quarterly pricing mechanism. Our main approaches are as follows: (i) to decompose the spot price of Platts IODEX into two subsamples and relate the result of the structural break to the date of the switch in the iron ore forward pricing mechanism; (ii) to apply the EGARCH (1, 1) model to simultaneously capture the long memory and the asymmetric effect on the volatility of the iron ore spot price; and (iii) to delineate the news impact curve to further interpret the asymmetric effect.

Introduction

High volatility of spot prices in the global iron ore market has been widely observed and reported by the press, especially following the global financial crisis. Sellers and buyers facing high volatility of iron ore spot prices are apt to be affected by the exposure to large risks in the economic activity. The economic instability may be severe in some countries, affecting iron ore trading partners (such as Australia, India, China and Japan). Moreover, concern about high volatility of iron ore spot prices appears to be compounded by the previous annual benchmark pricing mechanism (annual price).

The annual benchmark pricing mechanism1 in the global iron ore market lasted as long as thirty years until the end of 2009. After the global financial crisis, this annual price was criticized as rigid and failed to rapidly reflect market demand (Musacchio et al., 2010). The rigidity of the iron ore annual price may intensify the concern about volatility of spot prices. To mitigate the volatility of spot prices, in the first quarter of 2010, the two iron ore giants Vale and BHP Billiton (accounting for 40% of global exports) announced that the annual benchmark pricing mechanism was abandoned and was replaced by a quarterly pricing mechanism (quarterly price) (UNCTAD, 2010). More importantly, this quarterly price is primarily determined by the three-month average spot prices of Platts IODEX.2 However, the effect of the new pricing mechanism on the volatility of the iron ore spot price remains to be empirically investigated.

Economic studies of price volatility and the change in pricing mechanism have primarily focused on the oil market. While it is not clear in the global iron ore market, the nature of price volatility in the oil market has been indicated in a number of empirical papers. In particular, papers to explain the link between the volatility of the iron ore spot prices and the change in the forward pricing mechanism are still sparse.

The goal of this study is to empirically test whether or not the change in the forward pricing mechanism has a significant impact on the volatility of the iron ore spot prices. To the best of our knowledge, this study is the first to use daily data to document volatility of the iron ore spot prices. Considering sudden changes in the iron ore spot price of Platts IODEX and its volatility, we used the algorithm of Inclan and Tiao (1994) (iterated cumulative sum of squares (ICSS)) to detect structural breaks. In terms of structural breaks, the most relevant date for the change in the iron ore forward pricing and consequently the two subsample periods were identified. Over the two subsample periods, the performance of unconditional variance was immediately obtained, and that of conditional variance may be accurately estimated by the EGARCH (1, 1) model. Furthermore, by the analysis of the long memory, the asymmetric effect3 and the news impact curve, the relationship between the volatility of the Platts IODEX and the change in the forward pricing mechanism was detected. The proposed econometric models may be useful for market participants and policy makers to study volatility of the iron ore spot prices and its corresponding pricing mechanism.

The study has some distinguishing features. (i) The test of the structural break is applicable for detection of the date of the sudden change in the volatility of the iron ore spot price, which may be triggered by the presence of the new forward pricing mechanism. (ii) Over the two subsample periods, the use of the EGARCH (1, 1) model seems to be appropriate to quantify the long memory and the asymmetric effect on the volatility of the iron ore spot price. (iii) The asymmetric effect on the volatility of the iron ore spot price is illustrated by the news impact curve.

This paper is organized sequentially as follows. The next section stresses the background of the global iron ore market and the iron ore prices, followed by the related empirical literature. Then empirical models are discussed. The penultimate section explores the results of empirical analysis. The final section concludes the paper.

Section snippets

The global iron ore market and the change in the forward pricing mechanism

This section presents an overview of the global iron ore market and the underlying reasons for the change in the forward pricing mechanism. In particular, the iron ore market structure and some striking changes in the global iron ore market are highlighted. The fundamental factors, including the asymmetric effect and the persistent effect on volatility of the iron ore spot prices, may help in forming the basis for further empirical test.

Literature review

The extended generalized autoregressive conditional heteroscedasticity (GARCH) model has been widely used to measure price volatility in the empirical papers (Engle, 1983, Bollerslev, 1986, Caporale and McKiernan, 1997). Most papers are interested in finding the most appropriate model to fit and to forecast price volatility in the full sample period. Our study aims to examine the impact of the change in pricing mechanism on the volatility of the iron ore spot price over the different subsample

Empirical method

We used a two-step empirical procedure to examine the impact of the change in the forward pricing mechanism on the volatility of the iron ore spot price. Firstly, a return of the daily iron ore spot price was collected, and was split into two subsamples after the test of the structural break. Secondly, the EGARCH (1, 1) model was adopted to measure the volatility of the iron ore spot price return in the subsamples. In terms of the two subsamples, the performances of the EGARCH (1, 1) models

Empirical analysis

This section examines the impact of the change in the forward pricing mechanism on the volatility of the iron ore spot price. Firstly, the observed data series is separated into two subsamples in terms of the date of the change in the forward pricing mechanism, which is supported by the result of the structural break. Then, the volatility of the iron ore spot price for the different subsample periods is estimated and is compared by using the EGARCH (1, 1) models.

Conclusion

Examining the impact of the change in the forward pricing mechanism on the volatility of the iron ore spot price is important for both the market participants and the policy makers. The results of this study show that the implementation of the quarterly pricing mechanism seems to alleviate the volatility of the iron ore spot price. In the light of the empirical procedures applied to the two subsample periods, a significant decrease is found in both unconditional variance and conditional

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