A Short Guide on Freight Derivatives
Freight derivatives get their value from freight rates and these instruments enable shipowners and operators to control the freight rate risks. In this article, we will some light on how freight derivatives work and protect against freight rates decline. We will also deep dive into Forward Freight Agreements (FFAs) and how its helps in hedging.
Freight derivatives are contracts that derive value from the future levels of freight rates. They are typically used by end-users and suppliers to curb risks and hedge against price uncertainty in the supply chain. Market speculators in this case also can buy or sell freight contracts, thereby enabling a more liquid and better marketplace. It all started in the mid-1980s when freight derivatives were traded by bulk shipping companies. In today's world, they are typically used in dry bulk and tanker sectors. Dry bulk is a term for freight, which is shipped in huge, unpacked parcels and is measured in “tons of deadweight” (dwt). Some dry bulk consists of commodities like coal, grains, cement metal ore, etc.
How does it work?
Freight derivatives encompass various financial instruments, such as exchange-traded futures, forward freight agreements, swap futures, container freight swap agreements, and container freight derivatives. They serve the crucial purpose of stabilizing shipping rates, mitigating risks associated with future rate fluctuations. This is of utmost significance for stakeholders like shipping line operators and cargo owners.
- Underlying asset: The underlying asset for freight derivatives is generally a particular shipping route or index.
- Contract types: There are several types of freight derivatives contracts, such as FFAs and freight future contracts. The latter is mainly exchange-traded contracts, which aid in standardizing the terms of freight agreements, thereby making them more feasible and accessible.
- Participants: Participants in the freight derivatives market such as charterers, commodity traders, shipowners, and financial institutions.
- Hedging and speculation: Hedging is the major purpose of freight derivatives. For instance, a shipowner might get into an FFA to lock in a freight rate for a future cargo shipment, thereby safeguarding from potential rate decrease. Speculators can enter the market for making a profit from price movement without any kind of underlying exposure to the physical shipping market.
- Settlement: This can be done either via cash or physically owing to the terms of the contract.
- Market data: Indices like BDI and BCTI are relied upon by participants to understand the value of freight derivatives contracts.
- Market dynamics: Freight rates are generally influenced by so many factors like supply and demand for weather conditions, economic factors, geopolitical trends, etc. All these factors can lead to price volatility.
- Regulation: Freight derivatives are subject to certain financial market regulations on the basis of jurisdiction. Participants need to be compliant with certain rules and reporting requirements.
How are the freight rates determined?
The Baltic Exchange and the Shanghai Shipping Exchange publish freight rate indexes. On the other hand, cleared contracts are margined daily through clearing houses like NASDAQ OMX Commodities, Chicago Mercantile Exchange (CME), and European Energy Exchange. Investors receive or owe the difference between a paper contract’s price and the market index. Notably, the Baltic Dry Index, released by the London-based Baltic Exchange, provides valuable insights to investors regarding the shipping expenses associated with raw materials. This, in turn, streamlines the pricing of freight derivatives. The index includes a comprehensive dataset of 20 shipping routes tracked over time, covering a range of dry bulk carriers, including Handysize, Supramax, Panamax, and Capesize vessels.
The index is generally used by shipowners to track and control when there is a decline in freight rates. Now when it comes to charters, they use it to curb the risks of rising freight rates. The Baltic Dry Index is known to be a leading indicator of economic activity as an increase in dry bulk shipping can lead to an increase in raw production materials.
Now let us address some of the FAQs.
What are Forward Freight Agreements (FFAs)?
On the basis of terms of the Forward Freight Agreement Broker Association (FFABA) standard contracts, the most common freight derivative, FFAs are traded over the counter. FFAs, which are now traded exchange-traded and also OTC, first came into existence in the 1990s.
The terms of the agreement include the agreed-on route, contract size, rate, and the time of settlement.
The seller needs to make a payment of the difference to the contract buyer if the price agreed upon is more than the settlement price. On the other hand, if the predetermined price is lower than the settlement price, then the buyer needs to pay the seller. Then you need to multiply the voyage duration or the cargo size by the difference between the settlement and contract price.
Now you must be wondering how freight derivatives are traded. Well, they are traded over the counter as mentioned before, and are becoming more available on exchanges. FFAs can now be traded on the UK's Baltic Exchange and all-electronic Intercontinental Exchange (ICE).
By allowing firms to lock in shipping rates. These prevent them from future fluctuations, which is helpful for freight forwarders, shipping line operators and cargo owners.
To cut it short, freight derivatives are a method for shipping industry participants to manage exposure to price fluctuations. They are typically used for hedging and other speculative reasons. If you belong to this industry, doing some research on the same will help you get some protection from freight rates decline.