Freight (or shipping) derivatives

At times the volatility of rates in the freight markets is high, i.e. a high level of risk exists for commodity producers and traders, ship owners, ship operators and other participants in freight. This led to the creation of forward freight agreements (FFAs) in the early nineties. A FFA is a contract between two parties, which stipulates an agreed future freight rate for carrying commodities (wet and dry) at sea. The contract does not involve any actual freight or any actual ships. It is a financial agreement which is cash settled.

The underlying asset is a freight rate (the contract rate) for a specified route (the contract route) over a specified period (the contract period). The rates on the routes are "assessed" daily and published by the Baltic Exchange (there are also other smaller publishers of rates, such as Platt's). The rates are published as indices [e.g. the Baltic Exchange Panamax Index (BPI)] or rates. Thus, FFAs have four main terms:

• The agreed route.

• The settlement/expiry date.

• The contract size.

• The contract rate at which differences will be settled.

FFAs are OTC products made on a principal-to-principal basis, As such they are flexible and are not traded on an exchange. Brokers are involved in deals but:

• Settlement is between the principals (in cash usually within a few days after the settlement date).

• Commissions are agreed between the principal and the broker.

• The broker acts as an intermediary only, and is therefore not responsible for the performance of the contract.

There are two types of FFAs: OTC swaps and OTC "futures". The latter are actually forwards, but are called "futures" by market participants, because they enjoy clearing facilities [by the London Clearing House (LCH), the Norwegian Futures and Options Clearinghouse (NOS), the Singapore Exchange (SGX) and the Chicago Mercantile Exchange (CME)].

In essence FFAs are cash-settled, privately negotiated (via non-principal brokers) bespoke financial contracts between two parties in terms of which one party agrees to pay the other party an amount equal to the difference between the contract price of the underlying index / rate of a specified route and the settlement price of the index / rate of the route.

The participants in the freight derivatives market are the abovementioned commodity producers and traders, ship owners, ship operators, etc (i.e. those that wish to shed risk / hedge), as well as the speculators in the freight market (those that take on risk), including investment banks and hedge funds.

Variations of FFAs have emerged, including container-freight derivatives, options and spread dealing.

Energy derivatives

Energy derivatives is the term for forwards, futures, swaps and options on energy products, that is, the underlying assets of these derivatives are energy products, including oil, natural gas and electricity. The derivatives trade either on exchanges or OTC. We touched on the derivatives on commodities in the body of this text and present this section merely for the sake of completeness.

Summary

The mainstream derivative instruments are forwards, futures, options and swaps with which financial and commodity risk can be hedged. In addition to these there is a demand for hedging other risks such as weather risk, energy price risk and credit risk; the hence the development of weather, energy, credit, etc derivatives. Securitizations are not hedging products but the marketable liabilities of SPVs are derived from other non-marketable assets.

In conclusion, we present a summary of the derivatives covered in this course (excluding the exotic options) in Table 1.

Table 1: Spot markets and derivative instruments