Spread trades

According to market sources, freight derivatives are described as the “missing link” between disparate markets in the underlying commodities, creating hedging and arbitrage

Table 6.12 Daily FFA and spot prices of the time-charter route P2A of BPI

Note: Route P2A is the Skaw Passero-Gibraltar to Taiwan-Japan time-charter mute of the BPI.

opportunities. To see how such arbitrage opportunities may arise, consider the following cases. The differential between the Brent and WTI may be used for spread trades; oil markets are linked together by several Europe and North Sea/US East Coast tanker routes. Likewise, Atlantic and Pacific coal markets are linked together by chartered Cape- size vessels. For instance, there may be arbitrage possibilities between CIF (Cost, Insurance, Freight) and FOB (Free On Board) Richards Bay coal prices, as the CIF element is included in the commodity (coal) trade price, while the FOB freight prices are paid separately. Traders can lock in the implied freight element between the two prices and then switch out through an FFA trade.

The differential between the All Publications Index, API 2 CIF (coal delivered into northwest Europe — ARA) and API 4 FOB (coal loading price at Richards Bay, South Africa) swap contracts can be traded against the cost of the C4 (Capesize — Richards Bay to Rotterdam) FFA contract. The fact that coal can be shipped from multiple origins into Rotterdam causes the differential between delivered coal (API 2) versus FOB Richards Bay (API 4) to deviate, at times, from the price of freight on the C4 freight route. A typical trade is where an arbitrageur sells the implied freight differential of the two coal swaps (API 2 minus API 4) and buys the FFA on the C4 route. The inflows of coal from other origins can lower the delivered price in Rotterdam, enabling a trader to gain on the short position in implied freight, while the FFA price remained unchanged. Besides geographical reasons, there are also technical reasons for the existence of arbitrage opportunities; they include: (i) the settlement of the two API contracts and the FFA are based on quotes from different market sources. For instance, settlement of API 2 is based on information from Argus,³ for API 4 from Argus, the IHS Markit (McCloskey Group)⁴ and the South African Coal Report and for FFA settlement, information comes from the Baltic Exchange; (ii) Capesize refers to vessels hauling 130,000mt to 180,000mt of bulk cargo; (iii) lot sizes differ. For both API 2 and API 4, the lot size is 5,000mt for nearby months. The lot size of the ECC C4 FFA contract is l,000mt lots. These discrepancies create basis risk. Therefore, there is a trend towards an even more integral relationship between the freight and coal businesses, as freight rates may determine a trader’s choice of where to buy coal from.

Consider next a numerical example of a spread strategy. Suppose that a trader believes that during the following months freight rates will increase and wishes to get advantage of it by entering the FFA market. On 10 October, Q1 is trading at $32,000/day, Q2 is trading at $32,850/day and Q3-Q4 is trading at $26,000. As shown in Table 6.13, the trader buys the cheap Q3—Q4 (184 days) contract at $26,000/day and simultaneously sells Q2 (91 days) at S32,850/day. On 30 December he sells Q3-Q4 at $31,000 and buys Q2 at $39,000. The outcomes of these transactions are the following: On the Q3-Q4 position there is a profit of $920,000 [= ($31,000/day — $26,000/day) x 184 days], while on the Q2 position there is a loss of S560,000 [= $32,850 — $39,000) x 91 days]. Combining the two positions results in a net profit of $360,000.

Consider yet another example. Suppose that during May a coal producer has fixed a deal with a shipowner on an un-priced contract for November and that the October FFA settlement of route C4 of the BCI will establish the cost of this vessel s freight. As shown in Table 6.14, today (May) the coal producer buys a Q4 (92 days) at $23,500/day. During July the producer sells freight (55,000mt) at $55/mt for November. On 1 September, he sells (closes out) his Q4 position at $30,000/day and buys a route C4 (60 days) FFA at $35,000/ day. Finally, on 31 October he sells a route C4 FFA at $41,000/day and buys freight, by fixing a vessel, at $64/mt. The outcomes of these transactions are the following: On the Q4 position there is a profit of $598,000 [= (S30,000/day — $23,500/day) ^x 92 days]. On

Table 6.13 FFA quarters spread speculation strategy

Table 6.14 Spot and FFA spread speculation strategy

the C4 FFA there is a profit of $360,000 [= ($41,000/day — $35,000/day) x 60]. And on the spot freight position there is a loss of—$495,000 [= ($55/mt — $64/mt) x 55,000mt|. Combining the three positions results in a net profit of $463,000.