What is a Forward Freight Agreement?

Freight derivatives allow physical shipping market participants (ship owners, traders and shippers of bulk commodities and crude oil/petroleum products) to exchange a floating freight rate exposure (the index or spot rate) with a fixed price of the future freight index (the freight futures curve), commonly referred to as a financial swap agreement.

All contracts are cash settled (no physical delivery) at the end of the month, with settlement determined as the simple average of the month’s daily prices. The net effect of a forward freight agreement is that charterers, ship owners and other physical market participants receive a fixed price guarantee in the future, which will make or lose money depending upon the movement of the index, and the swaps price.

Charterer buys a forward freight agreement to hedge (protect) against the market rising (i.e., hedge against rising cost of sea-borne freight) and will earn money if index price (i.e. the floating price) rises above the fixed price (i.e. the swap price) with daily mark-to-market adjustments, and will lose money when index (floating price) falls below the fixed (i.e. swap price).

Conversely, a ship owner, concerned with falling vessel revenue on unemployed ships in the future, will look to lock in earnings predictability and be a seller of FFAs.

Profit or loss on the freight futures contract is the difference between the buy price and the sell price or the average price of the contract over its lifetime, with trade settling either under a stop-loss (closing out trade) or held until contract expiry/settlement.

Traders, and investors (via investment banks and exchange-traded funds can now trade the highly volatile freight market without owning physical assets (ships and cargo) by pursuing perceived value trades (exploiting arbitrage between shipping routes, shipping baskets, time periods, or inter-commodities) based on seasonal, momentum, informational, political/economic and structurally motivated movements which effect both the supply and demand of cargoes ships (dry bulk carries and tankers).

Tanker forward freight agreements (Tanker FFAs) routes are centralised around the biggest physical routes for shipments of crude oil, known as ‘TD’ (Trade dirty) followed by a numeral to designate the vessel size (or cargo carrying capacity in Dwt) and cargo (i.e. TD3 – represents 260,000 dwt cargo of crude oil shipped from Arabian Gulf (Ras Tanura) to Chiba (Japan) and serves as a proxy for all routes in between (discharge and load ports within proximity), with participants trading off between liquidity and basis risk (and volume adjustments) to manage freight rate exposure cost effectively and efficiently.

In addition to petroleum products such as naphtha, jet fuel, gasoline, etc known as TC or trade clean; with futures prices quoted in Worldscale (a unified measure of establishing a payment rate for a given oil-tanker’s cargo, with annual flat rate assessment derived by Worldscale Association based upon Sept to November average port charges, canal dues, regional bunker costs and quoted as a $USD/per tonne flat rate for the ensuing calendar year) and traded as multiples of the flat rate (i.e. ws 100 = 100% of yearly flat rate, ws200 = 200% of yearly flat rate) in the volume (in 5kt tradable lots, with minimum lot size of 1kt). Flat rates (value and forecast estimate in forward calendar years) largely rise (or fall) year on year based upon expected world crude oil prices.

Dry bulk forward freight agreements (Dry FFAs) trade as an average time charter basket based upon vessel size with prices quoted in US$/day. The basket average is designed to capture the global spirit of that asset class, whilst controlling for regional trade lane variations.

Trading is centralised during London business hours, but there is now a noticeable shift in trading towards Asian time-zone.

International Maritime Exchange is the world’s only regulated market for freight derivatives: freight forward agreements for tanker and dry bulk in addition to bunker fuel oil derivatives.