NOTE 17—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 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 the 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 noncurrent asset or liability.

Metal hedging

As metal is purchased to fill fixed-price customer sales orders at RAEU, London Metal Exchange (“LME”) future swaps or forward contracts may be sold. As sales orders are priced, LME future or forward contracts may be purchased, which contracts generally settle within six months. Real Alloy can 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 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. Real Alloy had 27.1 thousand and 24.6 thousand metric tonnes of metal buy and sell derivative contracts as of December 31, 2016 and 2015, respectively.

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 costs 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. Real Alloy had 1.8 trillion and 1.9 trillion British thermal unit forward buy contracts as of December 31, 2016 and 2015, respectively.

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 December 31, 2016 and 2015, 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 December 31, 2016, no cash collateral was posted or held.

The table below presents gross amounts of recognized assets and liabilities, the amounts offset in the consolidated balance sheets and the net amounts of assets and liabilities presented as of December 31, 2016 and 2015. As of December 31, 2016 and 2015, there were no amounts subject to enforceable master netting arrangements or similar agreements that have not been offset in the consolidated balance sheets.

	December 31, 2016					December 31, 2015
(In millions)	Asset		Liability			Asset			Liability
Metal	$	—	$	(0.4	)	$	0.2		$	(0.3	)
Natural gas		0.6		—			—			(0.6	)
Total		0.6		(0.4	)		0.2			(0.9	)
Effect of counterparty netting arrangements		—		—			(0.2	)		0.2
Net derivatives assets (liabilities) as classified in the consolidated balance sheets	$	0.6	$	(0.4	)	$	—		$	(0.7	)

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

		December 31,
(In millions)	Balance Sheet Classification	2016			2015
Derivative assets:
Natural Gas	Prepaid expenses, supplies and other current assets	$	0.6		$	—
Derivative liabilities:
Metal	Accrued liabilities	$	(0.4	)	$	(0.1	)
Natural Gas	Accrued liabilities		—			(0.6	)
Total derivative liabilities		$	(0.4	)	$	(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 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 were 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.

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, which is the exercise price of the Warrants as of December 31, 2016.

The common stock warrant liability is considered a derivative liability as a result of 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 47.1% and an expected term of 3.4 years as of December 31, 2016, along with a 60% equity raise probability at a 25% discount to the 10-Day volume weighted average price (“VWAP”) assumption in the periods following December 31, 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 at a 15% discount to the 10-Day VWAP assumption in the periods following December 31, 2015. Significant decreases in the expected term or the equity raise probability and related assumptions would result in a 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 an increase in the estimated fair value of the common stock warrant liability. However, 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. 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.

In April 2016 20,000 Warrants were exercised on a cashless basis, resulting in the issuance of 7,552 shares of common stock; in May 2015, 15,000 Warrants were exercised, including 7,500 on a cashless basis, resulting in the issuance of 9,360 shares of common stock and gross proceeds of $0.1 million; and in September 2015, 16,667 Warrants were exercised on a cashless basis, resulting in the issuance of 6,969 shares of common stock. Upon exercise, the fair value of the Warrants exercised are reclassified to additional paid-in capital. As of December 31, 2016, 1,448,333 Warrants remain outstanding.

The common stock warrant liability is the only asset or liability measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as of December 31, 2016 and 2015. The following table presents changes in the fair value of the common stock warrant liability during the years ended December 31, 2016, 2015 and 2014:

	Year Ended December 31,
(In millions)		2016			2015			2014
Balance, beginning of period	$	6.9		$	5.6		$	9.3
Warrants exercised		(0.1	)		(0.2	)		—
Change in fair value of common stock warrant liability		(2.4	)		1.5			(3.7	)
Balance, end of period	$	4.4		$	6.9		$	5.6

Fair values

Derivative contracts are recorded at fair value using quoted market prices and significant other observable inputs. 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 December 31, 2016 and 2015:

		Estimated Fair Value
	Fair Value	December 31,
(In millions)	Hierarchy	2016			2015
Derivative assets	Level 2	$	0.6		$	0.2
Derivative liabilities	Level 2		(0.4	)		(0.9	)
Net derivative assets (liabilities)		$	0.2		$	(0.7	)
Common stock warrant liability	Level 3	$	(4.4	)	$	(6.9	)

Both realized and unrealized gains and losses on derivative financial instruments are included within losses on derivative financial instruments in the consolidated statements of operations. The following table presents losses on derivative financial instruments during the years ended December 31, 2016 and 2015 (there were no derivative instruments held in the year ended December 31, 2014):

	Year Ended December 31,
(In millions)		2016			2015
Realized losses:
Metal	$	0.6		$	2.9
Natural gas		0.6			0.5
Total realized losses		1.2			3.4
Unrealized losses (gains):
Metal		0.3			—
Natural gas		(1.3	)		0.8
Total unrealized losses (gains)		(1.0	)		0.8
Losses on derivative financial instruments	$	0.2		$	4.2

From time to time, we are required to measure other assets and liabilities at estimated fair value, typically from the application of specific accounting guidance under GAAP and are referred to as nonrecurring fair value measurements. These adjustments to fair value generally result from the application of lower of cost or market accounting or impairment charges of individual assets. The following table presents the Company’s assets measured at estimated fair value on a nonrecurring basis as of December 31, 2016 based on the fair value hierarchy:

(In millions)	Fair Value Hierarchy	Estimated Fair Value on Measurement Date
Goodwill - RANA	Level 3	$	33.6
Identifiable intangible assets - Cosmedicine	Level 3		—
Inventories - Cosmedicine (Prepaid expenses, supplies and other current assets)	Level 3	0.1

The following table summarizes losses on assets recorded at fair value on a nonrecurring basis for the year ended December 31, 2016:

	Year Ended December 31,
(In millions)	2016
Goodwill impairment - RANA	$	61.8
Identifiable intangible assets impairment - Cosmedicine		0.1
Inventories impairment - Cosmedicine		0.7

Other Financial Instruments

The following tables present the fair value hierarchy, carrying values and fair value estimates of other financial instruments as of December 31, 2016 and 2015:

		December 31, 2016
(In millions)	Fair Value Hierarchy	Carrying Value		Estimated Fair Value
Assets
Cash and cash equivalents	Level 1	$	27.2	$	27.2
Restricted cash and restricted cash equivalents	Level 1		5.5		5.5
Financing receivable	Level 2		28.4		28.4
Loans receivable, net (other noncurrent assets)	Level 3		0.8		0.8
Liabilities
Long-term debt:
Senior Secured Notes	Level 1	$	294.9	$	307.5
Asset-Based Facility	Level 2		55.5		57.0
Term Loan	Level 2		1.5		1.5
Redeemable Preferred Stock	Level 3	$	24.9	$	26.8

		December 31, 2015
(In millions)	Fair Value Hierarchy	Carrying Value		Estimated Fair Value
Assets
Cash and cash equivalents	Level 1	$	35.7	$	35.7
Restricted cash and restricted cash equivalents	Level 1		7.5		7.5
Financing receivable	Level 2		32.7		32.7
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

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

Cash, cash equivalents, restricted cash and restricted cash

Cash, cash equivalents, restricted cash and restricted cash equivalents 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 the Factoring Facility. 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 as of December 31, 2016 and 2015 is based on observable market prices.

Long-term debt – Asset-Based Facility and Term Loan

The estimated fair value of the Asset-Based Facility and Term loan as of December 31, 2016 and 2015 is based on market characteristics, including interest rates and maturity dates generally consistent with market terms.

Redeemable Preferred Stock

The carrying value of Redeemable Preferred Stock is based on the estimated fair value of the instrument at issuance, calculated using a discounted cash flow analysis using the Hull & White model, with an original term of sixty-six 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 17.5% credit spread adjustment to a zero coupon yield curve, which is being accreted to redemption value over the period preceding the holder’s right to mandatorily redeem the instrument, or sixty-six months from issuance, using the effective interest method. An increase in the discount rate would result in a decrease in the estimated fair value of the Redeemable Preferred Stock, while a decrease in the discount rate would result in an increase in the estimated fair value of the Redeemable Preferred Stock. There have been no significant changes in the fair value of the Redeemable Preferred Stock subsequent to issuance.

The Company’s Level 3 assets and liabilities are determined using valuation techniques that incorporate unobservable inputs that require significant judgment or estimation. The following tables present quantitative information about the valuation techniques and unobservable inputs applied to Level 3 fair value measurements as of December 31, 2016 and 2015:

	December 31, 2016
(In millions)	Estimated Fair Value		Valuation Technique	Unobservable Input	Input Value
Common stock warrant liability	$	4.4	Monte Carlo Simulation	Volatility		47.1	%
				Expected term	3.4
				Equity raise probability		60	%
				Issue price discount to fair value		25	%
Redeemable Preferred Stock	$	26.8	Discounted cash flow	Credit spread		15.0	%
				Redemption period	44 months

	December 31, 2015
(In millions)	Estimated Fair Value		Valuation Technique	Unobservable Input	Input Value
Common stock warrant liability	$	6.9	Monte Carlo Simulation	Volatility		49.9	%
				Expected term	4.4 years
				Equity raise probability		60	%
				Issue price discount to fair value		15	%
Redeemable Preferred Stock	$	18.7	Discounted cash flow	Credit spread		17.5	%
				Redemption period	56 months

Significant unobservable inputs used in the fair value measurement of the common stock warrant liability include volatility, expected term, the probability of an equity raise, and the offering price discount to fair value, presuming the equity raise is a rights offering. The estimated fair values were determined using a Monte Carlo simulation. Significant decreases in volatility, expected term or the equity raise probability would result in a decrease in the estimated fair value of the common stock warrant liability, while significant increases in volatility, expected term or the equity raise probability would result in an increase in the estimated fair value of the common stock warrant liability. The primary driver in the estimated fair value of the common stock warrant liability is the measurement date common stock price.

Significant unobservable inputs used in the fair value measurement of the Redeemable Preferred Stock include the estimated credit spread and redemption period. The Company used these unobservable inputs in a discounted cash flow analysis using the Hull & White model to estimate the fair values presented. Management increased the estimated equity raise issue discount from 15% of the 10-Day VWAP to 25%. The increase is primarily the result of our lower stock price and current market expectations for similar equity raises. Decreases in the redemption period and credit spread would result in an increase in the estimated fair value of the Redeemable Preferred Stock, while increases in the redemption period and credit spread would result in a decrease in the estimated fair value of the Redeemable Preferred Stock.