Applications of FFAs, pricing and risk management of FFA positions

Introduction

Building upon the previous chapter, which provided a comprehensive presentation and discussion of the freight derivative products available to shipping market participants, this chapter focuses on illustrating the effective use of shipping derivative contracts for managing freight rate risk through a wide set of practical examples. Furthermore, this chapter provides a comprehensive discussion of the uses and the development of freight derivatives over time. Freight derivatives enable shipping market participants to manage effectively their risk exposures to freight rate risk. This is achieved by providing their user the possibility to mitigate or offset completely the impact of the fluctuations of freight rates on her freight rate revenue for the shipowner or the cost for the charterer.

The rest of the chapter is organised as follows: Section 6.2 provides a number of practical applications of freight futures and FFA trading positions. These applications are designed to reflect realistic business decisions of shipowners and charterers, which include examples of the use of freight derivatives in the dry-bulk and tanker sectors, that involve both voyage and time-charter contracts and non-cleared versus cleared transactions. Section 6.3 presents freight derivative strategies for banks. Section 6.4 demonstrates that the use of freight derivatives for risk management purposes leads to more flexible business decisions in comparison to the traditional strategies analysed in Chapter 2 of this book. Section 6.5 discusses the important role of brokers in freight derivative trading. Section

6.6 explains the economics behind the FFA and freight future markets and reviews the most recent empirical evidence in the topic. Finally, Section 6.7 concludes the chapter.

Practical applications of freight futures and FFAs

This section demonstrates how FFAs and freight futures contracts may be used in practice to manage freight rate risk. Table 6.1 presents the buy (long) or sell (short) positions that potential users of freight futures/forwards would take according to their position and intentions. For instance, shipowners (charterers) in order to hedge a potential fall (rise) in the freight rate market need to sell (buy) freight futures/forward contracts. Similarly, speculators believing that currently it is a cheap (expensive) freight market need to buy (sell) freight futures/forward contracts, with the anticipation to sell (buy) them in the future at a higher (lower) price. In addition, shipbrokers in order to hedge their commission income in a falling market may sell freight futures/forward contracts; while operators and fund managers may buy or sell freight futures/forward contracts depending on their exposure in the spot market. A number of examples with calculations are examined in the following sections.

Table 6. i Summary of freight derivative trading positions for potential market players

Physical market

Derivatives market

Outcome

Shipowner

Hedging against potential market fall

Long

Short

Neutral

Charterer (trading houses)

Hedging against potential market rise

Short

Long

Neutral

Speculator

Believing markets to rise or “markets are cheap"

Long

Long paper

Speculator

Expecting markets to fall or “markets are expensive"

Short

Short paper

Operator

Hedging risk for cargoes and vessels

Long/Short

Short/Long

Neutral

FOB buyer of cargo at load port Needs to fix vessel

Short

Long

Neutral

CIF buyer of cargo at discharge port Has already fixed vessel at a freight rate

Long

Short

Neutral

Fund Managers and Private Investors

Technical analysis (patterns and trends)

Long/Short

Long/Short

paper

Note: FOB stands for Free On Board (price of the commodity, before insurance and freight costs). CIF stands for Cost, Insurance, Freight (included in the price of the commodity).

Dry-bulk voyage FFA, non-cleared

Suppose it is 18 May. A charterer wants to transport a cargo of 160,000 tons of iron ore from Brazil (Tubarao) to China (Qingdao) on 30 July. This is route C3 of the BCI as discussed in Chapter 4 of this book. He also wants to lock his transportation costs for this July cargo transportation at the current 18 May prevailing forward rate of $10/ton. At the same time, a shipowner owns a Capesize vessel of 170,000 dwt and is aware of the seasonality results presented in Chapter 1 of this book, which showed that freight rates are likely to be significantly lower in July due to lower demand for dry-bulk transportation in Summer. Thus, the shipowner wants to be protected against his anticipation of a potential drop in freight rates in July. He can achieve this protection of his future freight income, by selling today (18 May) to the charterer, an OTC FFA contract with maturity in July for an agreed FFA price of $10/ton and for a cargo size of 160,000 tons. Note that the size of the physical exposure for both parties is $1,600,000 (= $10/ton x 160,000 tons). Under this setting, the shipowner is the seller of the July FFA contracts and the charterer is the buyer of July FFAs. The contract is issued by an OTC FFA broker, such as Clarksons, SSY or FIS, among others, who facilitates the agreement by matching the charterer and the shipowner interests and going through the relevant paperwork, but does not guarantee the payments emanating from the OTC FFA contract due to be cash-settled at maturity. The price is fixed at $10/ton (strike price), and brokerage fees are agreed to be paid equally by both parties to the FFA broker; that is, S4,000 (= 0.25% x SI,600,000) is paid by the charterer and the same amount is paid by the shipowner, amounting to $8,000 income to the broker, which is paid at the settlement of the contract at maturity.

On 30 July when the FFA contract expires (settles), the two parties compute the settlement price for this OTC FFA contract as the average price for the business days of the expiry month (July) for route C3 of the BCI (the underlying asset), which is found to be equal to $15.50/ton. Since the settlement price is higher than the fixed price ($10/ton), the shipowner must pay the difference (S5.50/ton = $15.50/ton — SlO/ton) times the contract size to the charterer, that is, $880,000 (= $5.50/ton x 160,000). The shipowner also pays his share of OTC FFA broker fees equal to S4,000, for a total net cash outflow $884,000 (= 880,000 + 4,000). Then, the charterer’s total cash inflow from the OTC FFA deal amounts to $876,000 (= 880,000 — 4,000). The charterer’s expectation about an increasing freight rate in July for route C3 of the BCI proved accurate, so he profits from the FFA deal while the shipowner loses as the seasonality effect did not take place on this particular July for dry-bulk freight rates. Notice that, ignoring brokerage fees for a moment, the profit of the charterer is exactly equal to the loss of the shipowner out of the OTC FFA deal, therefore such deals are called zero-sum games.

This example has made several implicit assumptions. If these assumptions do not hold in reality, then they introduce hedging error, i.e. the “protection” of the freight income offered by the FFA contract may not be complete. For instance, we have assumed that the gain of the charterer in the FFA market is expected to be completely offset by his “loss” in the physical market, as he will need to pay the higher prevailing freight rates to transport his cargo. In this way, the charterer achieved his original goal in May, which was to stabilise his transportation costs for a voyage trip in July, but at May’s forward freight levels (SlO/ton). This is because he pays in the physical (spot) market the prevailing freight rate being $15.50/ton, but in the FFA (paper) market he receives S5.50/ton from the shipowner. The same result holds for the shipowner, receiving $15.50/ton in the spot market by chartering his vessel but paying $5.50/ton in the FFA market to the charterer. Thus, the shipowner has also achieved his primary goal to “lock” his freight income for a trip in July by entering this OTC FFA back in May at SlO/ton. Flowever, it is uncertain whether the shipowner and the charterer will be able to make charter agreements in the physical market at the prevailing freight rates. This uncertainty introduces the following sources of hedging error:

Basis risk: The shipowner is assumed to be able to charter his vessel at the prevailing freight rate in July in the spot market (S15.50/ton) and the charterer also was able to find a vessel for the transportation of his cargo in July at the exact same prevailing freight rate. If this is not achieved in practice, then basis risk is present, introducing hedging error.

Size differences: The shipowner is expected to own and operate a Capesize vessel of 170,000 dwt that is assumed to have an age of five years, as these are the characteristics of the standard vessel used by the Baltic Exchange when publishing the freight rate assessment for C3 of the BCI. However, if the vessel of the shipowner is slightly different, i.e. 175,000 dwt and 15 years old, then the freight rate that it will achieve in the physical market (fixture) will be away from the benchmark freight rate assessment of the C3 route of BCI. Since the assessment of freight rate for route C4 is used as the underlying asset and its monthly average is used to calculate the settlement price, the payments emanating from the FFA will be affected at settlement, introducing hedging error.

Timing mismatch: Due to the quickly changing dynamics of the business environment in shipping, the shipowner may decide to charter his vessel in the physical market on a different date rather than the cash-settlement date of his FFA contract. This introduces the possibility that the freight rate achieved in the physical market (spot) deviates significantly from the settlement price (average of the month) that is used for the FFA to be cash-settled, introducing hedging error.

Low liquidity: If there are only a few counterparties willing to trade in the FFA market for the route C3 of the BCI, then establishing or unwinding an FFA position in this market becomes more difficult. This may come at a cost, affecting, for example, the negotiated strike price of the FFA.

 
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