FFAS The way forward

Shipping companies are increasingly using forward freight agreements (FFAs) to manage their spot exposure. Freight derivatives provide a means of hedging exposure to freight market risk

Today, products and services are sourced from where they are available suitably and cheaply; and sold where they fetch the best possible price. Even in this day and age, the primary channel of international trade has changed little with more than 90 per cent of total trade transported by sea. The increased complexities of modern trade have led to a larger amount of risks (and profits) both for ship-owners and their clients.

The capital-intensive nature, long durations of sea-voyages, demand-supply volatilities, fluctuating crude oil prices (most ships run on diesel), seasonal and cyclical variations and fluctuations in intra-currency rates all increase uncertainties in shipping.

Thus, on account of these uncertainties, risk management has a key role in the
growth of the industry. Ship owners and charterers have increasingly turned towards financial derivative products for their risk mitigation needs. Through derivative operations, the industry can today secure and normalise their future
income or costs and reduce the extent of uncertainty and volatility.

One of the key developments in the area is the introduction of Forward Freight Agreements or FFAs in 1992. FFAs are principal-to-principal contracts between a seller and a buyer to settle a freight rate, for a specified quantity of cargo or type of vessel, for one of or a combination of the major trade routes of the dry-bulk or wet-bulk sectors of the industry. For instance, one of the parties (usually the charterer) buys the FFA contracts and protects himself against the risk that the price of an agreed trade route will be higher than the current level.

The other party (the ship-owner) takes an opposite position and sells the FFA contract.

In a heterogeneous market such as shipping, FFAs have the advantage that they can be tailored to meet individual needs, are completely flexible in terms of the route, size and time period. Being purely financial transactions, they involve no delivery of cargo or ships. In their earlier form, FFAs were ‘over the counter’ products made on a principal-to- principal basis and as such, were not traded on any exchange.

Settlement is determined by the difference between the agreed upon FFA price and the actual price as on a day (derived from a common price benchmark such as the Baltic Exchange Index or Platt’s indicative prices). In the case of dry bulks, voyage-based contracts are settled on the basis of the difference between the contracted price and the average spot price of the route selected in the index over the last seven working days of the month. In tanker FFA contracts, a freight rate is fixed in world scale units on a predetermined tanker route, over a time period, at a mutually agreed price. Settlement takes place at the end of each month, where the fixed forward price is compared against the monthly average of the spot price of the tanker route selected.

In response to demands to address issues of credit risks, a new set of hybrid derivatives contracts appeared that are OTC agreements, but avail of the services of clearing houses. For an additional fee, the credit risk was eliminated and the market participants could focus wholly on their primary business. In 2001, the Oslo based Imarex (www.imarex.com) commenced the trading of both tanker and dry routes linked to the clearing capabilities of the Norwegian Futures and Options Marketplace. In 2005, both Nymex’s ClearPort (www.nymex.com/ cp_overview.aspx) and London’s LCH. Clearnet (www.lchclearnet.com) began listing freight forwards. The deals done with the intermediation of a clearing house are subject to margining rules of the clearing house. The introduction of the clearing facility also helped in increasing operational and capital efficiency. FFAs volumes shot up subsequently. With the entry of more players in the market, electronic or ‘screen based’ trading also gained in popularity.

By themselves, freight rates have no value. The demand for commodities and finished goods is what determines the demand for shipping services. With the galloping economic growth witnessed globally since 2003, shipping began to look increasingly attractive for financial investors too.

Over time, FFA options also started gaining in popularity. OTC options are currently available on individual routes as well as on baskets of timecharter routes. The advantage is that that downside cost is known in advance (equal to the option’s premium) while the upside potential is unlimited.

Looking forward, the success of a derivatives contract is a function of its ability to perform economic functions efficiently. If the derivative contract is unable to aid in price discovery or risk management, the market participants do not really have any reason to trade in them. As FFAs have so far proven to be the most effective in hedging risks, they are bound to thrive. A current limitation is that not all the trade routes are being offered in the derivative markets. With increased liquidity, better coverage can be offered to all stakeholders. As the industry expands, the importance of clearing operations will become more relevant.

If FFAs are to be truly global and attract more trading firms to enter, credit and counterparty risk concerns must be addressed. The entry of larger numbers of participants would also help in an increase in the width of the market.