NOTE 10—DERIVATIVE AND OTHER FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENTS

Derivatives

Real Alloy may use forward contracts and options, as well as contractual price escalators, to reduce the risks associated with its metal, natural gas, and certain currency exposures. Generally, Real Alloy enters into master netting arrangements with its counterparties and offsets net derivative positions with the same counterparties against amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral under those arrangements in our unaudited condensed consolidated balance sheets. For classification purposes, Real Alloy records the net fair value of each type of derivative position expected to settle in less than one year (by counterparty) as a net current asset or liability and each type of long-term position as a net long-term asset or liability.

Metal hedging

Primarily in our RAEU segment, London Metal Exchange (“LME”) future swaps or forward contracts are sold as metal is purchased to fill fixed-priced customer sales orders. As sales orders are priced, LME future or forward contracts may be purchased, which generally settle within six months. Real Alloy may also buy put option contracts for managing metal price exposures. Option contracts require the payment of a premium, which is recorded as a realized loss upon settlement or expiration of the option contract. Upon settlement of the put option contracts, Real Alloy receives cash and recognizes a related gain if the LME closing price is less than the strike price of the put option. If the put option strike price is less than the LME closing price, no amount is paid and the option expires. As of June 30, 2016, Real Alloy had 30.0 thousand metric tons of metal buy and sell derivative contracts.

Natural gas hedging

To manage the price exposure for natural gas purchases, Real Alloy may fix the future price of a portion of its natural gas requirements by entering into financial hedge agreements. Under these swap agreements, payments are made or received based on the differential between the monthly closing price on the New York Mercantile Exchange (“NYMEX”) and the contractual hedge price. Natural gas cost can also be managed through the use of cost escalators included in some long-term supply contracts with customers, which limits exposure to natural gas price risk. As of June 30, 2016, Real Alloy had 2.5 trillion British thermal unit forward buy contracts.

Currency exchange hedging

From time to time, Real Alloy may enter into currency forwards, futures, call options and similar derivative financial instruments to limit its exposure to fluctuations in currency exchange rates. As of June 30, 2016, no currency derivative contracts were outstanding.

Credit risk

Real Alloy is exposed to losses in the event of nonperformance by the counterparties to the derivative financial instruments discussed above; however, management does not anticipate any nonperformance by the counterparties. The counterparties are evaluated for creditworthiness and risk assessment prior to initiating trading activities with the brokers and periodically throughout each year while actively trading. As of June 30, 2016, no cash collateral was posted or held.

The table below presents gross amounts of recognized assets and liabilities, the amounts offset in the unaudited condensed consolidated balance sheets and the net amounts of assets and liabilities presented therein. As of June 30, 2016, there were no amounts subject to an enforceable master netting arrangement or similar agreement that have not been offset in the unaudited condensed consolidated balance sheets.

	Fair Value of Derivatives				Fair Value of Derivatives
	as of June 30, 2016				as of December 31, 2015
(In millions)	Asset		Liability		Asset			Liability
Metal	$	0.3	$	—	$	0.2		$	(0.3	)
Natural gas		0.5		—		—			(0.6	)
Total		0.8		—		0.2			(0.9	)
Effect of counterparty netting arrangements		—		—		(0.2	)		0.2
Net derivatives assets (liabilities) as classified in the consolidated balance sheets	$	0.8	$	—	$	—		$	(0.7	)

The following table presents details of the fair value of Real Alloy’s derivative financial instruments as of June 30, 2016 and December 31, 2015, as recorded in the unaudited condensed consolidated balance sheets:

		June 30,		December 31,
(In millions)	Balance Sheet Location	2016		2015
Derivative assets:
Metal	Prepaid expenses, supplies, and other current assets	$	0.3	$	—
Natural Gas	Prepaid expenses, supplies, and other current assets		0.3		—
Natural Gas	Other noncurrent assets		0.2		—
Total derivative assets		$	0.8	$	—
Derivative liabilities:
Metal	Accrued liabilities	$	—	$	0.1
Natural Gas	Accrued liabilities		—		0.6
Total derivative liabilities		$	—	$	0.7

Common stock warrant liability

On June 11, 2010, warrants to purchase an aggregate of 1.5 million shares of Real Industry’s common stock were issued (the “Warrants”). The aggregate purchase price for the Warrants was $0.3 million, due in equal installments as the Warrants vested, 20% upon issuance and, thereafter, 20% annually on the anniversary of the issuance date and, as of June 30, 2015, the Warrants are 100% vested. The Warrants expire in June 2020 and had an original exercise price of $10.30 per share. The Warrants were issued without registration in reliance on the exemption set forth in Section 4(a)(2) of the Securities Act of 1933, as amended.

The Warrants include customary terms that provide for certain adjustments of the exercise price and the number of shares of common stock to be issued upon the exercise of the Warrants in the event of stock splits, stock dividends, pro rata distributions and certain other fundamental transactions. Additionally, the Warrants are subject to pricing protection provisions. During the term of the Warrants, the pricing protection provisions provide that certain issuances of new shares of common stock at prices below the current exercise price of the Warrants automatically reduce the exercise price of the Warrants to the lowest per share purchase price of common stock issued. In February 2015, the Company issued shares of common stock in the Rights Offering at $5.64 per share, thereby reducing the exercise price of the Warrants to $5.64 per share. During the six months ended June 30, 2016, 20,000 Warrants were exercised on a cashless basis and, as of June 30, 2016, there were 1,448,333 Warrants outstanding.

The common stock warrant liability is a derivative liability related to the anti-dilution and pricing protection provisions of the Warrants. The fair value of the common stock warrant liability is based on a Monte Carlo simulation that utilizes various assumptions, including estimated volatility of 49.8% and an expected term of 3.9 years as of June 30, 2016, and 49.9% volatility and an expected term of 4.4 years as of December 31, 2015, along with a 60% equity raise probability assumption, and a 15% equity raise price discount assumption in the periods following the measurement date. The most significant input in determining the fair value of the common stock warrant liability is the price of our common stock on the measurement date. Significant decreases in the expected term or the equity raise probability and related assumptions would result in a minor decrease in the estimated fair value of the common stock warrant liability, while significant increases in the expected term or the equity raise probability and related assumptions would result in a minor increase in the estimated fair value of the common stock warrant liability. A 10% increase or decrease in any or all of the unobservable inputs would not have a material impact on the estimated fair value of the common stock warrant liability.

The following table presents changes in the fair value of the common stock warrant liability during the three and six months ended June 30, 2016 and 2015:

	Three Months Ended June 30,						Six Months Ended June 30,
(In millions)		2016			2015			2016			2015
Balance, beginning of period	$	7.5		$	4.9		$	6.9		$	5.6
Warrants exercised		(0.1	)		(0.1	)		(0.1	)		(0.1	)
Change in fair value of common stock warrant liability		(1.3	)		6.3			(0.7	)		5.6
Balance, end of period	$	6.1		$	11.1		$	6.1		$	11.1

Fair values

Derivative contracts are recorded at fair value using quoted market prices and significant other observable inputs. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below:

Level 1—Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2—Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates); and inputs that are derived principally from or corroborated by observable market data by correlation or other means.

Level 3—Inputs that are both significant to the fair value measurement and unobservable.

We endeavor to utilize the best available information in measuring fair value. Where appropriate, valuations are adjusted for various factors such as liquidity, bid/offer spreads, and credit considerations. Such adjustments are generally based on available market evidence and unobservable inputs. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The following tables set forth financial assets and liabilities and their level in the fair value hierarchy that are accounted for at fair value on a recurring basis as of June 30, 2016 and December 31, 2015:

		Estimated Fair Value
	Fair Value	June 30,			December 31,
(In millions)	Hierarchy	2016			2015
Derivative assets	Level 2	$	0.8		$	0.2
Derivative liabilities	Level 2		—			(0.9	)
Net derivative assets (liabilities)		$	0.8		$	(0.7	)
Common stock warrant liability	Level 3	$	(6.1	)	$	(6.9	)

Both realized and unrealized gains and losses on derivative financial instruments are included within losses (gains) on derivative financial instruments in the unaudited condensed consolidated statements of operations. The following table presents losses (gains) on derivative financial instruments during the three and six months ended June 30, 2016 and 2015:

	Three Months Ended June 30,					Six Months Ended June 30,
(In millions)		2016			2015		2016			2015
Realized losses:
Metal	$	0.2		$	0.8	$	0.4		$	0.7
Natural gas		0.2			—		0.8			—
Total realized losses		0.4			0.8		1.2			0.7
Unrealized losses (gains):
Metal		(0.8	)		1.3		(0.4	)		1.3
Natural gas		(1.1	)		—		(1.1	)		—
Total unrealized losses (gains)		(1.9	)		1.3		(1.5	)		1.3
Losses (gains) on derivative financial instruments	$	(1.5	)	$	2.1	$	(0.3	)	$	2.0

Other Financial Instruments

The following tables present the carrying values and estimated fair values of other financial instruments as of June 30, 2016 and December 31, 2015:

		June 30, 2016
(In millions)	Fair Value Hierarchy	Carrying Amount		Estimated Fair Value
Assets
Cash and cash equivalents	Level 1	$	40.2	$	40.2
Financing receivable	Level 2		40.9		40.9
Loans receivable, net (other noncurrent assets)	Level 3		1.0		1.0
Liabilities
Long-term debt:
Senior Secured Notes	Level 1	$	292.7	$	305.0
Asset-Based Facility	Level 2		22.1		24.0
Redeemable Preferred Stock	Level 3	$	23.3	$	21.3

		December 31, 2015
(In millions)	Fair Value Hierarchy	Carrying Amount		Estimated Fair Value
Assets
Cash and cash equivalents	Level 1	$	35.7	$	35.7
Financing receivable	Level 2		32.7		32.7
Restricted cash held in escrow (other current assets)	Level 1		3.9		3.9
Loans receivable, net (other noncurrent assets)	Level 3		1.1		1.1
Liabilities
Long-term debt:
Senior Secured Notes	Level 1	$	290.7	$	310.9
Asset-Based Facility	Level 2		19.6		22.0
Redeemable Preferred Stock	Level 3	$	21.9	$	18.7

The Company used the following methods and assumptions to estimate the fair value of each financial instrument as of June 30, 2016 and December 31, 2015:

Cash and cash equivalents and restricted cash held in escrow

Cash and cash equivalents and restricted cash held in escrow are recorded at historical cost. The carrying value is a reasonable estimate of fair value as these instruments have short-term maturities and market interest rates.

Financing receivable

Financing receivable represents the net amount due from the sale and transfer of trade accounts receivable under a €50 million factoring facility (the “Factoring Facility”). The Factoring Facility provides for the transfer and sale of eligible receivables to a counterparty, the settlement of which generally occurs within thirty days of transfer, which are accounted for as true sales, and are included in operating cash flows. During the three and six months ended June 30, 2016, $83.7 million and $173.5 million, respectively, of receivables were transferred on a nonrecourse basis and proceeds of $81.6 million and $170.0 million, respectively, were received. During the three months ended June 30, 2015, $117.2 million of trade receivables were transferred and $119.0 million of proceeds were received. Administrative fees and expenses associated with the Factoring Facility were $0.2 million in each of the three months ended June 30, 2016 and 2015, and $0.4 million in each of the six months ended June 30, 2016 and 2015.

The transferred receivables are isolated from Real Alloy’s accounts. Real Alloy maintains continuing involvement with the transferred receivables through limited servicing obligations, primarily related to recordkeeping. Real Alloy retains no rights to the transferred receivables, or associated collateral, and does not collect a servicing fee. Following transfer, Real Alloy has no further rights to any cash flows or other assets to any party related to the transfer.

The carrying value is a reasonable estimate of fair value as the financing receivable is generally outstanding for no more than thirty days and the counterparty is a large creditworthy financial institution.

Loans receivable, net

Loans receivable, net, consists of commercial real estate loans. The estimated fair value considers the collateral coverage of assets securing the loans and estimated credit losses, as well as variable interest rates, which approximate market interest rates.

Long-term debt – Senior Secured Notes

The estimated fair value of the Senior Secured Notes is based on observable market prices.

Long-term debt – Asset-Based Facility

The estimated fair value of the Asset-Based Facility is based on its market characteristics, including interest rates and maturity dates generally consistent with market terms.

Redeemable Preferred Stock

The estimated fair value of Redeemable Preferred Stock is determined based on a discounted cash flow analysis using the Hull & White model, with a remaining term of fifty months, assuming either the holder will put or the issuer will call at the redemption date. The cash dividend yield and the Redeemable Preferred Stock, including the payment-in-kind Redeemable Preferred Stock, were discounted at the spot rate plus a 17.0% credit spread adjustment to a zero coupon yield curve, based on similar market instruments.