As we are well aware, Shipping is a very risky and volatile industry. In the past, both the dry bulk and the tanker markets have highly dropped or increased within a few days only and any projections are very difficult (short term) or even impossible (long term). In order to manage their market risks, the market players may use various instruments. Fixing a vessel on period time/bareboat charter is a traditional solution which is used in order to lock your earnings (shipowner) or your transportation costs (charterer) for a certain period of time. However, this measure is not flexible at all since the vessel is tied up for a long period and getting out of a period contract can be costly. Fleet diversification is another traditional instrument which is used by shipowners. By diversifying the fleet, a shipowner participates in several markets, where the market risks are shared. In order to overcome the disadvantages of the traditional strategies for managing the market risks, recently a more advanced tool is developed: The Freight Derivatives. Let’s see what the freight derivatives are, their history and use in the shipping industry as well as the way they work.
What is a derivative?
A derivative is an instrument/contract which specifies the terms of a transaction that will take place on a future date. The parties buy and/or sell a derivative basis their expectations on the direction of the market. The terms “buy” and “sell” are, of course, shorthand since the participants do not buy or sell a physical asset but they just buy or sell a financial contract; a position related to the direction of the market. In shipping, this means that the Shipowner and the charterer will not have an actual fixture between them – they will not have the obligation to deliver an actual vessel or load a specific cargo – but they just take a market position in a future period. Derivatives may be traded in Exchanges or Over-the-Counter (OTC). Exchange traded derivatives are standardized contracts which are traded in a central marketplace and guaranteed through a clearing house. OTC traded contracts are negotiated directly between the buyer and the seller (or their brokers) and the counterparties may be exposed to credit risk since not all the trades are cleared (however recently clearing of the OTC bookings is also developed). There are two types of derivatives used in Shipping:
— Futures/Forward Contracts (FFAs) and
We also meet swaps, however in other aspects of the shipping industry (finance, accounting) in order to manage the risk from the interest rate fluctuations (interest rate swaps). Derivatives are used for hedging where hedgers take a futures/forward contract which is opposite to their position in the physical market and this way any changes in the value of the spot position are countered by offsetting changes in the value of the derivative. They are also used for freight projections. By looking into the derivatives transactions, one can take a picture of the future movements of the physical market. Studies have shown that FFAs can be used to predict the direction of the spot market for up to about 2 months forward. Finally, derivatives are also used for speculation purposes since the transaction costs are much lower than in physical markets. Speculators –who are not necessarily shipping professionals – help the derivatives market since they provide market liquidity.
BIFFEX: Derivatives enter Shipping
Freight derivatives first appeared in shipping during the 1980’s when Baltic Exchange introduced BIFFEX (Baltic International Freight Futures Exchange) in 1985. BIFFEX was an official exchange where one could buy and sell futures contracts. BIFFEX was based on an index called BFI which was the result of the daily brokers’ assessments and a mathematic formula, while it operated the same way as any other futures market (e.g. oil). All trades were anonymous and guaranteed by the London clearing house while the contracts, the dates and times of trading and other financial and legal requirements were all laid down in detail. As soon as the trading account had been opened and all requirements were in place, the client could buy or sell future contracts. BIFFEX operated until 2002 since while it experienced some very busy times for almost 15 years, finally the interest dropped since the Forward Freight Agreements (FFA) were used instead of BIFFEX.
Forward Freight Agreements
Forward Freight Agreements, as we know them today, were initially appeared in shipping in 1991 (developed by H. Clarkson and Co. Ltd) but their use was increased after the 2000 and they are very popular nowadays. FFAs were initially negotiated Over the Counter (OTC) and not in an official exchange market and this made FFAs more popular since these contracts were more specific and tailor-made than setting against a specific index only, as happened in BIFFEX. However, after a few years of their use, organized exchanges and trading platforms were also appeared, therefore we now see both exchange-traded and OTC-traded FFAs. For buying or selling FFAs, there are broking companies who specialize in this service and have registered staff. But how FFAs work? A Buyer and a Seller agree to trade an FFA contract and through their broker, they will agree on the route, period and negotiate a price. Trades are not published and all deals are done on trust. When the contract expires (settlement date), if the agreed price is higher than the settlement price, the seller will compensate the buyer for the difference. On the other hand, if the fixed price is lower than the settlement price, the buyer will compensate the seller for the difference. The settlement price is usually the average of the month for the T/C average routes of BCI, BPI, BSI and BHSI or the average of the month for tanker routes, while in some cases/routes, the average of the last seven days of the month may be used. The difference between the contract price and the settlement price is multiplied by the cargo size (in case of voyage) or voyage duration (in case of T/C) to determine the payoff of the contract.
At this point, let’s see an example in order to understand how it works: On February 2016 a trader buys three grain cargoes from NOPAC to Japan, of which the transportation is going to take place when the grain season starts: One cargo in August, one in September and one in October. The trader fears that the shipping market will go up in August and wants to secure his freight against such a potential increase. On the other hand, a panamax shipowner who has fixed his vessel in time chartering opening mid July in Far East is afraid that the market may keep on softening and for this reason, he is looking to sell a FFA. The Owner and the Charterer negotiate and fix at USD 8,000/day forward in August for a duration of 50 days (estimated duration of the voyage) and the settlement price to be based on the BPI route 3a (which is the transpacific route for panamax bulkers) as the average of the last 7 indices published in August 2016.
The settlement price (7 days average) was finally USD 8,500/day, therefore, the FFA Seller (Owner) pays the FFA Buyer (Charterer) the difference for 50 days ($500/day * 50 = $25,000). In fact, no party loses money since the charterer takes back the $500 that paid to the Owner in the physical market, while the Owner does not pay anything out of his pocket since the $25,000 is part of the total freight that he earned (since he earned 8,500/day in the physical market).
Since the FFAs were initially traded Over-the-Counter, there was a counterparty risk which was borne by each party. This was the main problem when trading FFAs during these early years, since the losses from counter-party defaults were high. For this reason, a clearing system was developed by which the FFA contracts (either exchange traded or OTC traded) are guaranteed. With this clearing system, upon fixing an FFA contract, each counterparty deposits on his account with a clearing member an initial margin (deposit). This initial margin is in form of cash or securities and it is usually about 5-10% of the open position. If the margin account falls below a pre-determined point (“maintenance margin”) which is about 3-5% of the open position, a top-up is required (“variation margin”) in order to raise it to the Initial margin level. Due to the large losses which may be suffered in case of a default the FFA market has been totally transformed within a period of 10 years and while more than 90% of the trade in 2004 was not cleared, we now see that more than 95% of the FFA transactions pass through a clearing house with the process analyzed above.
FFA trading volume in Shipping
FFA trading volume was increasing from 2005 to 2008 when they reached the 2 million lots (1 lot is equal to 1,000 mt of cargo or 1 day of charter hire) for dry bulkers. However, after the financial crisis of 2009, there was a high drop. Since 2009 it has remained steady at about 1.00-1.30 million lots for dry bulkers and about 150,000 - 160,000 lots for tankers. In 2013, the dry FFA volume was estimated at 1.15 million lots with almost the 80% of it being traded in capesize or panamax sectors, while only a very small proportion of less than 5% was placed in the handysize market. This happens since the market risk and volatility is much higher in the capesize and panamaxes while minimum to handies. In the wet FFA volume, almost 87.50% was attributed to clean trades while only about 12.50% was attributed to dirty trades.
FFA trading is taking place either on OTC via FFABA brokers or on Exchange/ Trading screens which have appeared since the beginning of 2000. Most of the OTC trades are also cleared by major clearing houses (LCH, SGX, CME or NOS).
Two main FFA exchanges/trading screens which are used in shipping are:
— Baltex: Baltic Exchange’s organized marketplace for trading dry FFAs. In 2015 traded more than 500,000 lots which represented almost the 40% of the total dry FFA trade.
— Imarex: It is an exchange based in Oslo which is trading both tanker FFAs (started trading in 2001) and dry FFAs (started trading 2002) and it is quite popular mainly for the tanker FFA trades. Its contracts are cleared from the Norwegian Futures and Options Clearing House.
Options are the most modern derivative products which are used more and more in shipping recently. This happens since, as we will see below, they give even more flexibilities than the common FFAs. In contrary to the forward and future contracts which impose an obligation on the counterparties to trade, the option allows the buyer to choose whether or not to exercise same and then trade. However, the seller of the option has no choice if the buyer chooses to exercise same. Options are also traded both in exchanges or OTC. There are two types of options. The call options and put options. Call options give someone the right to buy an asset at a specified price while the put options give someone the right to sell an asset. For buying an option, one pays the premium while no margin is required to be placed by the buyer since he has the option to exercise same and therefore there is no risk for its counterparty. On the other hand, a margin is required to be placed by the seller as a security. There are 4 main strategies which are commonly used in Options trading:
— Buy Call option: Buyer has the right to buy the asset.
— Buy Put option: Buyer has the right to sell the asset.
— Sell call option: The seller has the obligation to sell (if the option is exercised by the buyer).
— Sell put option: The seller has the obligation to buy (if the option is exercised by the buyer).
Again, in this case, the sale or purchase does not refer to a physical asset but a market position. Let’s see an example of how the trade of options works. We have December 2016 and a shipowner of a panamax bulker is afraid that the market will experience a decline in February 2017 due to the Chinese holidays. Today’s market for panamaxes is at $8,000/day while he has the chance to purchase a put option for 2 months (60 days) at an exercise price of $7,500/day. The cost of the put option is $1,000 per day. This means that the shipowner needs to pay $60,000 (60*$1,000) as a premium in order to buy the put option and in case the market falls below $7,500/day on February he will exercise the option otherwise, he will let it go. Therefore, in case the average of the BPI 4 TCs is $5,500/day, the shipowner will get paid the difference of ($7,500 - $5,500) * 60 days = 120,000. Therefore, if we deduct the premium, we see that the shipowner has ensured that his minimum TCE is $6,500/day. If the physical market is higher than $7,500 he will not exercise the option and his only cost was the payment of the premium.
Therefore, we see that in options trading the parties lock their minimum earnings (their downside) while they keep the upside. While in FFAs they lock their earnings/costs and both their upside and downside are zero. Of course, the buyer of an option has to pay a premium which is not the case in FFAs however even in FFAs the parties should place a deposit.
OpenSea team understands the importance for Shipowners and Charterers to manage their market risks. For this reason, we have built a transparent marketplace where both parties can see the available vessels and cargoes and they can take an idea of the market trends. Notwithstanding this, after you fix your vessel or cargo in our platform, you may visit an online exchange or a specialized FFA broker and fix a derivative contract in order to hedge your future market risks, in case you are afraid of same. In any case, we strongly encourage all our users to get a clear picture of how FFAs and other derivative products work, in order to avoid getting exposed to further risks instead of managing their current ones.