1. Developments in Freight Derivatives and Shipping Risk Management
Nikos Nomikos
Cass Business School

2. Current Developments in Shipping Markets
Freight as a new commodity
High volatility in the shipping markets
Sharp fluctuations and sudden changes in the market
Emergence and growth of a paper market on Shipping Freight
More extensive use of risk management techniques and instruments
Entrance of new players in the shipping markets
trading houses and energy companies as well as investment banks and hedge funds

3. Fundamentals of the Bulk Shipping Markets
Freight rates reflect the cost of transporting bulk commodities by sea across different parts of the world
Market Segmentation
Across Type of Commodity
Wet Market: Transportation of Crude Oil and Oil products
Dry Market: Dry Bulk Commodities – Grains and agricultural, Coal, Iron Ore etc.
Across Sizes
Commodities are transported in different sizes according to their Parcel Size Distribution Function

4. Freight Market Volatility - Baltic Tanker Indices

5. Freight Market Volatility - Baltic Dry Indices

6. Freight Rate Formation in the Physical Market
Spot freight rates are determined through the interaction of supply and demand for shipping services at any point in time
The demand for sea transportation is a derived demand, which depends on world economic activity and international trade
The world economic activity
Seaborne commodity trade
Average haul
Demand
Political events
Transportation cost
The supply of shipping services is the amount (ton-miles) of transportation service offered by shipowners’ fleet based on the optimisation of their revenue
Stock of the fleet
Shipbuilding production
Scrapping and losses
Supply
Fleet productivity
Freight rates

7. Freight Rate Formation
Spot freight rate determination through interaction between supply and demand curves for shipping services
supply
demand
new demand
ton-miles FR

8. Freight Market Volatility – Coal Routes

9. Risk management options in shipping
Option A:
Do nothing & fix spot
High risk / Unpredictable
Option B:
Timecharter, COA or long term management
Inflexible / inefficient pricing
Option C:
Hedge with FFA and use profit / loss to pay for spot physical deal
Opportunities to cover requirements, quickly fixed and flexible to allow you to alter your position should it change

10. Forward Freight Agreements (FFAs)
“An agreement made between a buyer and seller to settle the difference between a freight rate agreed today and the future price of the freight rate on a specific voyage”
Cash settled
Standardised contracts and lot sizes – opportunity to close out positions quickly & easily
Suitable for hedgers– ability to take significant cover quickly and simply
Flexible periods
Tradable on different routes and vessels
Over The Counter and Cleared markets
Cleared market is “OTC Cleared” i.e. not exchange listed
Anonymous, rapid and cost effective execution

11. Forward Freight Agreements – Underlying Routes
Dry Market
Baltic Capesize Index (BCI) (150,000+ dwt)
Baltic Panamax Index (BPI) (70,000+ dwt)
Baltic Supramax Index (BSI) (52,000+dwt)
Wet Market
Baltic Tanker Index (Dirty and Clean)
Baltic LPG Index (44,000cbm)
Platts Assessments
Arithmetic average taken of worldwide shipping panel & published at 1300pm GMT

12. Baltic Capesize Index (BCI)
Routes 8 to 11 are based on a standard 172,000 mt dwt “Baltic Capesize” vessel with certain clearly defined performance measures
FFAs can be traded against any of these individual routes or against the averages of Routes 8 to 11
Most trades concentrate on C4, C7 and the average of C8-C11

13. Baltic Dirty Tanker Index (BDTI)
Most trades concentrate on TD3, TD4, TD5, TD7 and TD8

14. FFA Trading in the OTC market - Practicalities
Broker establishes trading interest and obtains a firm ‘Bid’ and ‘Offer’
Full trade confirmation agreed verbally with both counterparts.
Recap of trade issued detailing main terms.
Full contract issued for signing. Original kept by broker
On settlement day, the settlement price is calculated and a settlement statement is issued.
Settlement funds paid no later than 5 London banking days after each settlement date

15. FFA Trading in the OTC Market - Practicalities
OTC FFAs are traded through a network of specialist FFA brokers. The brokers are members of the Forward Freight Agreement Brokers Association (FFABA)
Contract used is either FFABA or ISDA® contract
Counterparties can be anonymous until just before trade terms are concluded
Hedges can be offset prior to expiry
Settlement is between the counterparties in cash within five days following the settlement date.
The broker, acting as an intermediary only, is not responsible for the performance of the contract. Typically, brokers get commission of 0.25% from each party on the fixed (or expected) freight rate but that may differ between contracts

16. FFA Volume in the OTC Market
Number of lots traded in FFA market
200000
400000
600000
800000
2006e
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
wet
dry
FFA Volume in the OTC Market
Notional Market
Value (dry) 05
Cape: $8bn
Pmx: $15bn
Supra: $5bn
Coal: 500m tons
Wet: $8bn
Source: FIS
Graphic demo of growth
Volume exponential growth on dry & tanker – tanker lag dry 2-3years
Are we at bottom of exponential growth curve
Increase volume, more liquidity, encourage trading increasing volume
High market prices & growth – huge increase in nominal value – $20bn + dry $ 5bn wet
Coal routes show how european industrial players grown market
Figures best guess

18. Uses of FFAs Hedging Market information Speculation
Cargo owners (power utilities, oil companies) are buyers of FFAs
Market information
Forward curves
Speculation
FFAs give the possibility to profit from falling freight markets
Enhanced trading opportunities
Arbitrage trades (e.g. API2 vs API4)
Spread trades (TD3 vs TD5, Cape vs Panamax)
Collateral in ship finance transactions

19. Uses of FFAs: Tanker Hedging
It is early April 2001, and TD7 (80,000mt North Sea to Continent) is trading at WS 125 for June.
An energy trading company is worried that freight rates will increase over the following 12 weeks, and decides to use FFAs to cover this risk. The company thus buys 80 TD7 June 2001 WS 125 (each contract being for 1,000 tons)
At the end of June, the settlement price is WS (calculated as the average of TD7 freight rate assessments over June)
The charterer will incur higher freight rates in the physical market, but, at the same time, he has made a profit in the FFA market:
Net WS = – 125 = WS31.15
Settlement = Contracts x Lot Size x Flat Rate x net WS
= 80 x 1,000mt x $4.30/mt x 31.15% = $107,156

20. Uses of FFAs: Forward Curves
Forward curve is a ’snapshot’ of current market forward price expectations.
An implied market forecast – based on all market participants
A method of comparing FFA opportunities against physical options.
Used for position and portfolio valuations.
In all, a key tool for freight market users

21. Forward curves: Dry
Source: FIS

22. Forward curves: Tankers
Source: IMAREX

23. Forward Curves: RBay – Rdam Coal Route
Source: Baltic Exchange

24. Uses of FFAs: Trading Opportunities
Good liquidity in FFAs – position tradability- ‘buy’ and ‘sell’
High volatility – position taking opportunities
Easier to trade than physical
More trading players than physical
Investment banks, trading houses, hedge funds
Physical Asset Swaps – Diversification
Spread Trades
Inter route spread, e.g. C4 v C7, TD3 v TD5
Inter month spread, e.g. 3rd Q06 v 4th Q06
Inter-size spread, e.g. P-4TC v C-4TC

25. FFAs: What are the risks?
Credit Risk (Netting Clause)
Volatility of market
Limited forward period
Usually up to 2-4 years
Hedging and speculation are different approaches
Basis risk
Liquidity risk
Overall, less risky than
physical market
Do we need clearing?
FFA do has risks: credit volatility, liquidity and period over which you can hedge
Physical has all of these risks and risks from physical operations and a less efficient market
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Shipping markets are used to risk.
Clearing key however with more none shipping entering market & less well known counterparties

26. Credit Risk in the Freight Derivatives Market
Credit risk is particularly relevant for the shipping derivatives market since most of the paper trades are done on a principal to principal basis
Trading cleared contracts
IMAREX with NOS in Oslo offer cleared FFAs and Options
London Clearing House, NYMEX and Singapore Exchange also provide clearing services
Cleared FFAs provide protection against counterparty default, however
Margin requirement and initial deposits tie-up a lot of capital
Margining and marking to market may create a cash-flow mismatch between the paper and physical markets

27. Imarex – Tanker Margin Curves

28. FFAs – Future Trends
The market has grown sharply following deregulation and liberalisation in the European Energy market as energy and other traders seek to manage freight risk
Recent high volatility in the market has also attracted interest from investors outside shipping such as hedge funds
Credit Risk and Clearing
Clearing will also attract new players in the markets as it also facilitates and speeds up negotiations
Electronic Trading
Emergence of Freight Options
Asian Options on Freight Rate
Create opportunities for asset owners
Pricing and risk management issues

29. Conclusions Freight as a new commodity
High volatility in the shipping markets
Growth of a paper market on Shipping Freight
More extensive use of risk management techniques and instruments
Concerns regarding credit risk
Entrance of new players in the shipping markets
trading houses and energy companies as well as investment banks and hedge funds