Freight Derivatives Market - Frequently Asked Questions

1. What is a freight derivative?
2. Are freight derivatives similar to financial derivatives?
3. What is an FFA?
4. Why would anyone want to buy or sell freight for the future?
5. Do people really sell airline seats on a forward basis?
6. Why wouldn’t a ship owner just lock into a contract – or put his ships out on time-charter?
7. How is a paper trade more seamless?
8. But what if you put on a paper trade and lost money?
9. But if your ship is out on time-charter – you are not actually losing any money.
10. So you are effectively earning the rate you sold the paper at?
11. If the results are the same, why bother with FFAs?
12. So you are saying that no one should charter out their ships? Should everyone just trade paper?
13. Who trades forward freight agreements (FFAs)?
14. Do owners and charterers speculate?
15. With the sub-prime crisis still fresh in our minds – and with the Nick Leeson and Long Term Capital debacles not too distant in our rear view mirror – don’t people view the FFA market as a form of gambling?
16. So forward freight agreements (FFAs) are not risky?
17. Are the speculators hedging – or simply speculating?
18. Let’s say I decide to buy a tanker FFA? Who am I buying it from?
19. How are freight futures and freight options different from stocks?
20. What if the seller does walk away, or goes bankrupt and cannot deliver?
21. What is a clearing house and how can they guarantee that I get paid?
22. Has anyone ever defaulted?
23. What else does the clearing house do?
24. Can you explain margin?
25. That doesn’t seem like much. How you can trade a $1,000,000 FFA contract with only $150,000?
26. How does a clearing house determines how your margin levels change each day?
27. Does that means that they should also either credit or debit your account for the change in value that day? So if you own a contract that increases in value, they should move money into your account in order to show the appropriate gain.
28. How would I execute a trade? Do I call a broker? Or is this done online?
29. What routes can I trade? What are the contracts available?
30. What is Worldscale? 
31. What about the dry bulk market?
32. Are there other dry routes?
33. Are the trading patterns the same for dry bulk and tankers?
34. Do you think the futures prices can accurately predict the market?
35. Is the FFA market growing?
36. Other than dry bulk and tankers – is there anything else I can trade on IMAREX?
37. What about volatility?
38. The freight futures market sounds a lot like insurance.
39. Freight options? This sounds complicated.
40. Are freight options really that simple?
41. What about the guy who sells the FFA option? Is his downside limited?
42. Before we get to some examples – can you tell me how Imarex got started?
43. Time for some examples. Let’s say I was a Charterer who wanted to hedge a VLCC shipment 3 months from now. What would I do?
44. But neither contract is exactly what you want.
45. So which FFA contract would you choose?
46. Do I have to buy a whole ship?
47. Let’s say I want to do a whole ship. Do I have to buy it all at once?
48. Let’s say I get my price and I get the quantity I wanted. Then what?
49. Can I sell before the FFA contract expires?
50. What if I want to hold the FFA contract until it expires?
51. Why would you buy the January contract when your cargo ships in February?
52. How does it work if I do hold the contract to settlement?
53. So it’s not settled against the closing price on the 3rd Friday of the month?
54. So there is no physical delivery like there are in other futures markets?
55. Are you seeing any new trading styles, or trading ideas, being implemented by the speculators?
56. How do you see this market in 5 years?

What is a freight derivative?

A freight derivative is a financial contract between two parties, which sets an agreed future price for carrying commodities at sea. The contract does not involve any actual freight or any actual ships. It is purely a financial agreement - much like that found in other commodity futures markets. At Imarex you can trade Freight Futures, Freight Options and OTC Freight Forwards (FFAs)

Are freight derivatives similar to financial derivatives?

Shipping markets are large commodity markets and all characteristics for financial derivatives are present. Tanker and Dry bulk chartering both have a significant underlying market size. Both markets experience very high volatility in spot and long term prices. Exceptionally high volatility in the price of freight, means that in the physical underlying markets - which are the world shipping markets, natural buyers (refiners, importers, traders etc) have to take into account a high risk of price movements in freight when calculating the cost of transport. At Imarex, Principals (those trading directly for their own account) trade freight derivatives electronically on screen in real time, or via an Imarex Exchange Broker. All principals trade anonymously, and with the security of "Straight through Clearing".

What is an FFA?

An FFA is a forward freight agreement. It allows ship owners, charterers as well as speculators to buy and sell the price of freight for future dates.

Why would anyone want to buy or sell freight for the future?

The same reason that people book airline flights months in advance. Sometimes they might want to ensure that they are guaranteed a seat on the plane. Sometimes they spot what they consider to be a cheap fare, so they lock in the rate. In addition to this – speculators also participate in the freight derivatives market (FFA market). They might see a rate that they consider to be either to high or too low. They will then buy or sell at that forward price accordingly.

Do people really sell airline seats on a forward basis?

Well – people don’t, but the airlines do. You need to view the airlines position – and ask yourself why they would sell seats months in advance. The answer is that they want to be able to estimate forward demand – as well as lock in a certain percentage of their revenues. They are often willing to offer low forward prices – in order to ensure their planes will be full. It’s a simple trade off on their part. Ship owners occasionally view their market the same way.

Why wouldn’t a ship owner just lock into a contract – or put his ships out on time-charter?

Many times they do, but as more owners become familiar with the freight derivatives market – they realize they can hedge their position with a much more seamless transaction.

How is a paper trade more seamless?

With a freight forward agreement, you only pay commission of about .4% per trade. There are no delivery or redelivery issues. There are no bunker clauses. There is no off-hire. You don’t have to worry about cargo contaminations, drunk crew members or collisions. In other words, you can keep your ship under your own control – but effectively charter out its “equivalent” in the paper market.

But what if you put on a paper trade and lost money?

The way you would lose money on the paper trade would be if you sold on a forward (the equivalent of putting your ship out on time-charter) – and the spot market went up. When you went to buy back your position in the future, it would cost you more than you sold it for. You have basically sold low and bought high. The goal of course when selling forward is to sell high and buy low. But – you need to remember that had you put out your ship on time-charter, you would be locked into a revenue stream – and not enjoying the rising market.

But if your ship is out on time-charter – you are not actually losing any money.

You need to view it a different way. Let’s go back to the paper trade. You sold forward – and rates went up. When you go to buy back this contract at higher price – you lose money. But – and this is the key – you still have your ship trading in the spot market. So your physical position is making more money. The increased revenue from your spot ship can be used to offset the losses you incurred on the freight forward agreement (FFA) trade

So you are effectively earning the rate you sold the paper at?

Effectively – yes. There is always some “slippage” in any market – but you have been able to lock in an estimable revenue stream. This is the point of the hedge. Let’s go back to the time charter issue for a second. You had commented that if you put your ship out on time-charter, that you don’t actually lose money in a rising market. This is not true. You have lost the opportunity cost of having your vessel earning higher spot returns. You have effectively locked in at a given rate level – which brings us back to the paper trade you made when you sold the freight forward agreement (FFA). The paper trade and putting the ship out on time-charter amount to the same results.

If the results are the same, why bother with FFAs?

Well – first, keep in mind the results are not exactly the same. But more important – freight forward agreements provide for a cleaner transaction. While ship owners and charterers are quite adept at working the time-charter market, there will always be issues with one person owning the ship and another person operating the ship. Shell time 4 is 16 pages with appendices. Every potential contingency for the time-charter must be negotiated in advance – and is subject to differing interpretations down the road. The FFA offers you a flexible hedge, in that you can unwind your trade at anytime. You can even add to your trade if you like. With a time-charter, you are effectively committed to that position until it expires.

So you are saying that no one should charter out their ships? Should everyone just trade paper?

No, we are not saying that. Even with a fully transparent and liquid paper market – there will always be a need for a physical time-charter market. Ships still need to move cargo and the ships should be owned, operated and controlled by those parties best suited to control shipping risk management as well as the rewards of shipping. The freight derivatives market is another tool for owners and charterers to use.

Who trades forward freight agreements (FFAs)?

The freight derivatives market started with the players that had natural exposure in the shipping market – owners and charterers. They saw the need for this market to develop and some of them worked hard to ensure that it succeeded. From there, institutional money came on board, i.e. hedge funds and investment banks. Some of their trading might be speculative, where they buy or sell because they might forecast the market moving in a given direction. Other times they might have some sort of quantitative trade on, where one of their mathematical models tells them that they should buy or sell a certain contract. You never really know why a hedge fund or bank puts on a certain trade.

Do owners and charterers speculate?

Again – we don’t know why people put their trades on. We might see an owner buying forward space – which is the opposite of hedging. This is also called a Texas Hedge. The owner, in addition to already owning ships, is taking an additional long position. But with this said – we don’t know why. He might be covering a short position he took earlier (i.e. unwinding his hedge).

With the sub-prime crisis still fresh in our minds – and with the Nick Leeson and Long Term Capital debacles not too distant in our rear view mirror – don’t people view the FFA market as a form of gambling?

We get that comment on occasion, but – when used properly, forward freight agreements are actually the opposite of gambling. Owning 20 ships in the spot market could be considered gambling. If the market goes up, you win. If it goes down, you lose. With FFAs you can reduce your exposure to the spot market if you feel it is too great. From the charterer’s perspective, having 50 cargos to move in a year could be considered gambling. If rates go up, you lose. If they go down, you win. By using a freight forward agreement, the charterer can reduce the full exposure that 50 spot cargos represent.

So forward freight agreements (FFAs) are not risky?

 

We wouldn’t say that. They can be very risky. It all depends on how you use them. When used properly, they are a good tool for shipping risk management. If you have a significant long, or short, position – they allow you to “take some chips off the table”.

Are the speculators hedging – or simply speculating?

It’s the same answer we gave above for owners and charterers – we have no way of knowing exactly what they are trying to accomplish on a given trade. Speculators do put on directional trades. But they also might have a trade that involves multiple positions – and the FFA trade is just one component of a much larger trade. They might also be trading forward freight agreements in conjunction with the commodities market – oil, coal, ore. You really don’t know why they are doing it.

Let’s say I decide to buy a tanker FFA? Who am I buying it from?

Within Imarex – your trade is matched with a counterparty that is willing to sell you that tanker FFA at that price. It is similar to buying stocks, either online or through your broker. Two willing parties have come together to transact at a mutually agreeable price. But keep in mind, freight futures and freight options are different from stocks.

How are freight futures and freight options different from stocks?

With respect to the above, the buying and selling of stocks is based on the spot market. You buy the stock. It is yours. You pay the seller. He takes your money – and each party goes about their way. With freight futures – you are buying something which will be delivered at a forward date. Therefore, someone must be obligated to sell it to you at that forward date. So – the seller doesn’t necessarily “walk away” once the deal is concluded. The seller must in fact stick around – in order to deliver the contract he promised to sell.

What if the seller does walk away, or goes bankrupt and cannot deliver?

The outcome here depends on how the trade was executed. If the deal was done “over-the-counter”, then there could be some risk that you might not get paid. It would depend on how the deal was structured and if a clearing house was involved. When dealing with Imarex, you are dealing with a regulated exchange that owns their own clearing house. The clearing house therefore takes on the role of counterparty to your trade (FFA clearing). Your trade is therefore guaranteed.

What is a clearing house and how can they guarantee that I get paid?

The clearing house serves many purposes. First, it ensures that all trading members have the proper asset levels, credit history and liquidity to trade. Once this due diligence has been done, the clearing house is able to take on the counter-party risk mentioned above, meaning once you execute your trade, they become your counterparty. They have vetted all their members – and feel comfortable that there will not be any defaults. With that in mind, they are willing to guarantee their members that in the rare case that someone does default, the clearing house will make good on any trades that the defaulting member is responsible for.

Has anyone ever defaulted?

Last year there were several defaults in the over-the-counter markets. It is rare – but it can happen.

What else does the clearing house do?

They are responsible for ensuring that all accounts have proper margin levels in them. Margin requirements change as the price of any contract changes. So the clearing house ensures that proper margin levels are in place.

Can you explain margin?

Margin is the amount of money you have to put up to make a trade. If you want to put on a trade with a notional value of $1,000,000 – you don’t really have to put the full $1,000,000. Depending on the FFA contract you have traded, and depending on how far out the settlement date of the contract is – your margin requirement may only be 10 to 15% of the notional value.

That doesn’t seem like much. How you can trade a $1,000,000 FFA contract with only $150,000?

Most futures markets work this way, but even so – it’s not as simple as that. Recall that in order to trade you need to have a qualified credit history as well as certain asset and liquidity levels. One of the first things you do is put up collateral – maybe $250,000, which can be done through a letter of credit if needed. On top of this is the margin requirement. If your trade starts moving against you – you are required to put up more margin. This protects the clearing house. If you are unable to put up more margin, the clearing house still has the collateral you put up.

How does a clearing house determine how your margin levels change each day?

It’s called “mark-to-market” – and it works the same as it does in other futures markets. Each day the FFA contract is revalued to ensure it reflects the true market value – not just some outdated number. Even on days where the FFA contract may not trade, it is revalued to reflect the state of the freight derivatives market. The margin requirement is therefore reset based on the mark-to-market price.

Does that means that they should also either credit or debit your account for the change in value that day? So if you own a contract that increases in value, they should move money into your account in order to show the appropriate gain.

Correct. This also ensures that accounts that continue to lose money are “paying as they go”.

How would I execute a trade? Do I call a broker? Or is this done online?

You execute either way. Imarex offers a trading screen – which is similar to what you would see if you purchase your stocks through an online broker. We also have brokers you can call that will execute the trade for you. Many trades are done via a combination of the two. We might get a call from an owner looking to trade, but wants to make sure he is not missing anything. He will then execute the trade himself via the trading screen.

What routes can I trade? What are the contracts available?

On the tanker side, you have many contracts – but the most liquid are TD3, TD5, TD7 and TC2. This provides a range of different ship sizes and regions, and also allows for people to trade in both the crude oil and clean products segments. TD3 is the VLCC contract for the Middle East to Japan route. TD5 is the Suezmax contract for the West Africa to the US East Coast. TD7 is the Aframax contract for the North Sea region. TC2 is the contract for the gasoline trade from Europe to the US East Coast. The contracts are quoted in “Worldscale”, which is the standardized rate structure for the tanker business.

What is Worldscale?

Simply put – it is a standardized rate mechanism that allows you to compare apples to oranges. The concept goes back to World War II, when the US and British governments requisitioned merchant ships and needed a simplified rate scale. The details have changed since then, but the concept is the same.

You may have one ship that will transport cargo from Point “A” to Point “B”. Another ship may carry a slightly different amount of cargo from Points “A” and “C” to Point “B”. The Worldscale mechanism allows you to evaluate the profitability of the two voyages even though they are different, as it provides a simple comparison for net daily revenue for the ship. It can be more complicated than that – but it doesn’t have to be for sake of this conversation. The Worldscale website has a very good explanation (www.worldscale.co.uk).

What about the dry bulk market?

I think we all see that the dry bulk market is the hot segment these days. This sector trades a bit differently – although the original concepts mentioned above still apply. The dry bulk sector doesn’t trade in Worldscale, but in “dollars per day”. The dollars per day rate represents the equivalent hire rate – or in layman terms, the lease rate – per day. The other difference between a tanker ffa and a dry ffa is that the dry contracts are based on an average day rate on four to six of the most prevalent routes for each ship size. For example, the contract for the largest of the dry bulk ships – the Capesize – trades on an average of four routes. These four routes best capture the state of the Capesize market. This contract is CS4TC – which stands for Capesize Four Time Charter.

Are there other dry routes?

Yes – there are many – but the most prevalent, in addition to CS4TC, are the Panamax and Supramax. The Panamax contract also trades on an average of 4 routes (PM4TC), while the Supramax contract trades on an average of 6 routes (SM6TC).

Are the trading patterns the same for dry bulk and tankers?

No. I dry bulk we see fewer trades, but the underlying value of the trade is relatively large. On the tanker side – it is the opposite. We see more trades getting done, but each trade is relatively small.

Do you think the futures prices can accurately predict the market?

 

Not reliably – at least not yet. Currently the three month forward rate for TD3 has an average error of about 28% going back two years. It is interesting to note that last summer not many people foresaw the strong mid-summer surge. So the actual rates were higher than what had been predicted. When this physical rate increase occurred, the paper market followed suit – as people expected rates to continue their push into the winter market. Memories of November 2004 were fresh in our minds. So the paper market shot up, but then the winter market never developed – leaving the freight derivatives market on the high side of reality. TC2, the most liquid clean route, has the same 28% average error rate as TD3.

The dry bulk futures market side has shown a similar average error of about 28%, but in this case the futures have undershot the strong spot market all the way up to where we stand today. With both dry bulk futures and tanker futures, we feel that as the market becomes more liquid, that the futures price should become a better predictor of where spot rates go.

 

Is the FFA market growing?

Yes. The overall freight derivatives market is growing and Imarex is growing. There are many players who require a certain level of liquidity in a market in order to trade. They want to be able to get in and out of a trade without too much slippage (the difference between the bid and ask). What we are seeing is that liquidity begets liquidity. What this means is that as more people trade, liquidity increases. As liquidity increases, more people trade. You could call this the opposite of a “Catch-22”.

Other than dry bulk and tankers – is there anything else I can trade on Imarex?

Yes. We offer markets in fuel oil, carbon emissions, power – and of course salmon.

What about volatility?

Yes. The freight derivatives market can be volatile. A futures market can help direct risk towards those best positioned to shoulder it. In volatile markets, people might need protection against wild price swings. The risk can be transferred to some entity that is better suited to take it. It is the same concept outlined above for shipping. People can use the FFA market to limit (or increase) their shipping risk. The goal is to create a market where risk is placed upon the party that can handle that risk for the lowest price. This means a more efficient market for everyone. We have created that market.

The freight futures market sounds a lot like insurance.

It can be viewed that way. You might have 20 ships in the spot market. In order to protect yourself from a declining market, you can hedge some of those positions. Then your exposure might only be to 10 ships or so. You can view it in the same light as insurance, although the more appropriate insurance analogy would be a comparison to freight options.

Freight options? This sounds complicated.

It’s only as complicated as you need to make it. If you want to trade freight options, then yes – it can be complicated. But understanding options is not too difficult a task. The simpler explanation is that buying an option is similar to buying insurance. You pay a premium. With that premium, you are entitled to receive some form of compensation in case the event you are insuring against occurs. If the even occurs – you receive the compensation. If the event doesn’t occur, the seller of the FFA option keeps your premium – and both parties walk away. With this – you have protection against a given event – but your downside is limited to the premium.

Are freight options really that simple?

In theoretical terms, yes. You know your downside is limited to the premium, but you also know that you are protected if certain events occur. At the practical level, however, I wouldn’t say that it’s so easy “even a cavemen can do it”. There is some higher math involved in terms of pricing these FFA options.

What about the guy who sells the FFA option? Is his downside limited?

No. In fact, his position in the opposite of yours. His upside is limited to the premium, but his downside is unlimited. Remember he is on the hook to compensate you on your upside. Simply put, his upside is your downside and your upside is his downside.

Before we get to some examples – can you tell me how Imarex got started?

With the internet boom in the late 1990s all markets became more transparent. Tanker and dry bulk are largely homogenized, lending themselves to commodity pricing structures. Herman Michelet, a tanker broker at RS Platou, recognized that there was a need for a paper market for shipping. In 2000, Imarex was founded – and offered futures contracts for the tanker market. Since then, we have added contracts for dry bulk futures, as well as power, emissions, fuel oil and fish. We have offices in Singapore, Oslo, London and Houston – so we offer the twenty-four hour trading capabilities that today’s market demands.

Time for some examples. Let’s say I was a Charterer who wanted to hedge a VLCC shipment 3 months from now. What would I do?

First you would get cleared by the clearinghouse, which takes 3 to 7 days, all going well. Then, after posting collateral, you would be looking to buy a futures contract similar to the shipment you will need to make. If you are hedging a shipment from the Middle East to Japan, then the TD3 contract would cover you quite well. If you wanted to hedge a VLCC contract from West Africa to the US Gulf, you could choose between the same TD3 contract above, or you could consider the TD 5 contract, which is the Suezmax contract for the West Africa to US East Coast route.

But neither contract is exactly what you want.

Correct. You therefore have to decide whether you feel hedging the same ship size on a different route is better than hedging with a different ship size on the same route. You would look for a combination of the highest correlation with the most liquidity.

So which FFA contract would you choose?

That depends on how the buyer interprets the correlation and liquidity combination. For sake of the example, lets assume you chose the hedge with TD3.

Do I have to buy a whole ship?

You can, but you don’t have to. You can buy in 5,000 ton segments if you like. But from there, the process is the same. You have some price ideas – and you are looking to buy the forward contract at or below your ideas. This is where the freight derivatives market comes in. If you want to buy on a day when most want to sell, you will likely get your price. If you end up buying on a day when others also want to buy – you may have to out bid them – and pay more then what you had planned.

Let’s say I want to do a whole ship. Do I have to buy it all at once?

No. You can – but you don’t have to. You can buy a few thousand tons at a time. This is called scaling in. It is quite common in the trading world. If you come in with a big buy order all at once, the market might interpret this as a bullish sign – causing the sellers to raise their prices. Sometimes it is better to scale in. It helps prevent the market from thinking a big move is underway.

Let’s say I get my price and I get the quantity I wanted. Then what?

You will get a trade confirmation – and each day your trade will be marked-to-market.

Can I sell before the FFA contract expires?

Yes – you can turn around and sell it immediately after you buy it if that is in your best interest. The buying process is then reversed – and you sell at the highest price you can get.

What if I want to hold the FFA contract until it expires?

That is called holding until settlement. Let’s say in the example above you were hedging a VLCC lifting that you thought would occur in early February. You could buy either the January or the February.

Why would you buy the January contract when your cargo ships in February?

If you have an early February lifting to do, you will likely be concluding your charter party in January – so that is the month you are concerned with, as it will reflect the status of the spot market you will be dealing with. Another issue to understand is that the current month contract loses liquidity towards the end of the month. You need to put thought into which contract suits your needs.

It is also important to understand that as soon as you conclude your charter party to lift your cargo, you need to unwind your trade. If you don’t, you are effectively long twice – as you own the FFA trade – and you have purchased the services of the VLCC for the February lifting.

Ok. So how does it work if I do hold the contract to settlement?

Let’s say you bought the January contract – and didn’t want to unwind it. You hold it all the way through January. What happens is that the January settlement price is the average of the Baltic Index for TD3 for all the trading days in January. The difference between this average and the price you paid for it would be your profit/loss.

So it’s not settled against the closing price on the 3rd Friday of the month?

No – it’s the average of the daily Baltic rates for the month.

So there is no physical delivery like there are in other futures markets?

No. All contracts are paper settled. The Jahre Viking will not show up at your door.

 Are you seeing any new trading styles, or trading ideas, being implemented by the speculators?

We wouldn’t say that anyone is putting on new trades or new FFA trading ideas, but we would say we are always seeing some interesting ideas being applied to the freight derivatives market. Over the summer we saw some traders take positions based on the likelihood of hurricanes hitting the US Gulf. We see traders take positions in the FFA market in order to hedge a position they might have in the stock market with a publicly traded shipping company. Another trade we saw discussed was selling dry bulk contracts while buying tanker contracts. The idea was that the rates for these different segments would converge.

How do you see this market in 5 years?

We see much higher levels of liquidity and many more routes being traded. We see many more financial institutions getting involved. As mentioned above, we see risk finding its way to the party that can handle it the most efficiently. We see an extremely efficient market.