Developments in Freight

Derivatives and Shipping

Risk Management
Nikos Nomikos
Cass Business School
 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
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
 Index points

500

0
1000
1500
2000
2500
3000
3500
04/01/2000
04/03/2000
04/05/2000
04/07/2000
04/09/2000
04/11/2000
04/01/2001
04/03/2001
04/05/2001
04/07/2001
04/09/2001
04/11/2001
04/01/2002
04/03/2002
04/05/2002
04/07/2002
04/09/2002
04/11/2002

Dirty Tanker Index

04/01/2003
04/03/2003
04/05/2003
04/07/2003
04/09/2003
04/11/2003
04/01/2004

Clean Tanker Index

04/03/2004
04/05/2004
04/07/2004
04/09/2004
04/11/2004
04/01/2005
04/03/2005
04/05/2005
04/07/2005
04/09/2005
04/11/2005
Freight Market Volatility - Baltic Tanker Indices

04/01/2006
 Index points

1,000.00
2,000.00
3,000.00
4,000.00
5,000.00
6,000.00
7,000.00
8,000.00
9,000.00
10,000.00

0.00
04/09/2000
04/11/2000
04/01/2001
04/03/2001
04/05/2001
04/07/2001
04/09/2001
04/11/2001
04/01/2002
04/03/2002
04/05/2002
04/07/2002
04/09/2002

Panamax (70k dwt)

04/11/2002
04/01/2003
04/03/2003
04/05/2003
04/07/2003
04/09/2003

Capesizes (150k dwt)

04/11/2003
04/01/2004
04/03/2004
04/05/2004
04/07/2004
04/09/2004
04/11/2004
Supramax (52k+ dwt)

04/01/2005
04/03/2005
04/05/2005
04/07/2005
Freight Market Volatility - Baltic Dry Indices

04/09/2005
04/11/2005
04/01/2006
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
Demand

world economic activity and international trade

 The world economic activity
 Seaborne commodity trade
 Average haul
 Political events
 Transportation cost

• The supply of shipping services is the amount (ton-miles) of

transportation service offered by shipowners’ fleet based on
Supply

the optimisation of their revenue

 Stock of the fleet  Fleet productivity
 Shipbuilding production  Freight rates
 Scrapping and losses
 Freight Rate Formation
Spot freight rate determination through interaction between supply and demand
curves for shipping services

FR demand new demand

supply

ton-miles
 US$/ton

0
5
10
15
20
25
30
35
Date
04/05/1999
06/07/1999
07/09/1999
08/11/1999
17/01/2000
17/03/2000
23/05/2000
25/07/2000
26/09/2000
27/11/2000
31/01/2001
03/04/2001
08/06/2001
09/08/2001
11/10/2001
12/12/2001
19/02/2002
24/04/2002
28/06/2002

150k mt Coal RichardsBay to Rotterdam

30/08/2002
31/10/2002
09/01/2003
increase

12/03/2003
1.5 months
16.13 $/ton

(135%) over

16/05/2003
18/07/2003
19/09/2003
20/11/2003
29/01/2004
31/03/2004
07/06/2004
06/08/2004
150k mt Coal Bolivar to Rotterdam
15.3 $/ton
Freight Market Volatility – Coal Routes

08/10/2004
09/12/2004
over 3 months
decrease (51%)

17/02/2005
22/04/2005
Aug-05: 9.2$/ton

27/06/2005
26/08/2005
28/10/2005
Apr-05: 24$/ton

06/01/2006
Risk management options in shipping
Option A:
High risk /
Do nothing & fix spot Unpredictable

Option B:
Timecharter, COA or Inflexible /
long term management inefficient pricing

Option C:
Hedge with FFA and Opportunities to
use profit / loss to cover requirements,
pay for spot physical quickly fixed and
deal flexible to allow you
to alter your position
should it change
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
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
Baltic Capesize Index (BCI)
Route
Description
Number
C2 160,000lt Iron Ore Tubarao to Rotterdam
C3 150,000mt Iron Ore Tubarao to Beilun & Boashun
C4 150,000mt Coal Richards Bay to Rotterdam
C5 150,000mt Iron Ore W Australia to Beilun - Baoshan
C7 150,000mt Coal Bolivar to Rotterdam
C8 Trip-charter Trans-Atlantic Round Voyage (Cont-US-Cont)
C9 Trip-charter Europe to Far East
C10 Trip-charter Trans-Pacific Round Voyage (China-Aus-China)
C11 Trip-charter Far East to Europe
C12 150,000mt DWT Coal Gladstone / Rotterdam

• 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
Baltic Dirty Tanker Index (BDTI)
Route Route description Indicative Route
TD1 280,000mt PG to US Gulf Ras Tanura to LOOP
TD2 260,000mt PG to Singapore Ras Tanura to Singapore
TD3 260,000mt PG to Japan Ras Tanura to Chiba
TD4 260,000mt West Africa to US Gulf Bonny to LOOP
TD5 130,000mt West Africa to USAC Bonny to Philadelphia
TD6 130,000mt Black Sea / Mediterranean Novorossiysk to Augusta
TD7 80,000mt North Sea to Continent Sullom Voe to Wilhelmshaven
TD8 80,000mt Kuwait to Singapore Mena al Ahmadi to Singapore
TD9 70,000mt Caribbean to US Gulf Puerto la Cruz to Corpus Christi
TD10D 50,000mt Caribbean to USAC (DH) Aruba to New York
TD11 80,000mt Cross Mediterranean Banias to Lavera
TD12 55,000mt ARA to US Gulf Antwerp to Houston
TD14 80,000mt SE Asia to EC Australia Seria to Sydney
TD15 260,000mt West Africa to China Bonny to Ninqbo
TD16 30,000mt Black Sea to Med Odessa to Augusta
• Most trades concentrate on TD3, TD4, TD5, TD7 and TD8
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
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
 FFA Volume in the OTC Market
Number of lots traded in FFA market

1600000
Notional Market
wet
1400000
dry Value (dry) 05
1200000

Cape: $8bn
1000000
Pmx: $15bn
800000
Supra: $5bn
600000

Coal: 500m tons

400000

200000
Wet: $8bn
0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006e Source: FIS
 $/ton

10
15
20
25
30
35

5
08/09/2004
22/09/2004
06/10/2004
20/10/2004
03/11/2004
17/11/2004
01/12/2004
15/12/2004
29/12/2004
12/01/2005
26/01/2005
09/02/2005
23/02/2005
09/03/2005
23/03/2005
06/04/2005
20/04/2005

Spot
04/05/2005
18/05/2005
01/06/2005
15/06/2005

1-Month
29/06/2005
13/07/2005
27/07/2005

2-Month
10/08/2005
Spot, 1 and 2-Month BFA on BCI C4

24/08/2005
07/09/2005
21/09/2005
05/10/2005
19/10/2005
02/11/2005
16/11/2005
30/11/2005
14/12/2005
28/12/2005
11/01/2006
25/01/2006
08/02/2006
22/02/2006
 Uses of FFAs
• Hedging
• 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

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 contracts @ WS 125 (each contract being for 1,000 tons)
• At the end of June, the settlement price is WS 156.15 (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 = 156.15 – 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
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
 Forward curves: Dry
Spot prices vs forward curve

50000 Cape T/C

Cape FFA curve
45000 Pmx T/C
Pmx FFA curve
40000
Supra T/C Avg
Supra FFA curve
35000
$ / day

30000

25000

20000

15000

10000
Mar-06

May-06

May-06

May-06
Mar-06

Mar-06

Mar-06

Jun-06

q34 07
q4 06

q4 06

q12 07

q12 07

q12 07

q34 07
q3 06

q3 06

q3 06

2008

2008

2008

2008

2008

2008
Apr-06

Apr-06

Source: FIS
 Forward curves: Tankers
Spot Prices vs Forward Curve
350
TD3: AG -East

300 TD7: North Sea to Continent

TD3 - FFA

TD7 - FFA
250

200

150

100

50

03 r-03 -03 l-03 -03 -03 -04 r-04 -04 l-04 -04 -04 -05 r-05 -05 l-05 -05 -05 -06 r-06 -06 l-06 -06
n- ay v n ay v n ay p ov Jan Ma ay
Ja M
a
M Ju Sep No Ja M
a
M Ju Sep No Ja M
a
M Ju Se N M Ju Sep

Source: IMAREX
 Forward Curves: RBay – Rdam Coal Route
35

30

25

20

15

10

0
7 8 9 0 1 2 1 2 3 4 5 6 7 8 9 0 1 2 1 2 3 4 5 6 7 8 9 0 1 2 1
3 -0 3-0 3-0 3-1 3-1 3-1 4-0 4-0 4-0 4-0 4-0 4-0 4-0 4-0 4-0 4-1 4-1 4-1 5-0 5-0 5-0 5-0 5-0 5-0 5-0 5-0 5-0 5-1 5-1 5-1 6-0
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20

BCI 4 Sep-04 Oct-04 Nov-04 Dec-04 Apr-05 May-05 Jun-05 Jul-05

Source: Baltic Exchange

 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
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
 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
Imarex – Tanker Margin Curves
 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
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