Container Swaps Introduction (with Notes)

This comment has been prepared by FIS for the purpose of trading and may have been acted upon by FIS and its officers, employees and associated companies. It is distributed to customers and to the general public for information purposes only and cannot be relied upon as a trading recommendation and does not constitute a solicitation to trade. FIS is regulated by the FSA. © 2010 Freight Investor Services

Welcome to the Freight Investor Services (FIS) Introduction to Container Swaps

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Arthur WorsleyContainer Freight Derivatives Broker

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FIS Introduction to Container Swaps

Slide 1Arthur Worsley, Freight Investor Services (FIS)

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This Presentation Will Cover the Basic Principles of Container Swaps

1. A basic introduction to physical containerized transport markets

2. Some underlying theory and uses of container swaps

3. Role and specific construction of the Shanghai Containerized Freight Index (SCFI)

4. Importance of clearing houses (such as LCH.Clearnet) in fostering market liquidity and eliminating counterparty risk

5. A case study showing how “ABC” supermarket might use container swaps in controlling its freight costs

6. How Freight Investor Services (FIS) can help you...



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The Seaborne Containerized Transportation Markets are Vast

Slide shows distribution of 2010 seaborne containerized trade (data from worldshipping.org)

• Almost all consumer goods are shipped in 20ft (x 8ft x 8.5ft) and 40ft (x 8ft x 8.5ft) containers. These are measured in TEUs, twenty-foot equivalency units, and FEUs, forty-foot equivalency units, respectively.

• FACT: The world’s largest container liners can carry upward of 14,000 TEUs at any one time.

• In 2009, 133.9 million TEUs were traded globally.

• In 2010, an estimated 144.2 million TEUs will be traded globally.

• FACT: Placed end-to-end they would circle the equatorial circumference of the earth 31 times.

• FACT: Stacked together they would build over 5,250 scale models of the Empire State Building.

• Global seaborne containerized transportation accounts for over 56% of seaborne freight value (compared to dry bulk at only 6%).

• Conservative estimates put the transport costs of 2010, East >> West containerized transport at over $40 billion USD.



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The Seaborne Containerized Transportation Markets are Highly Volatile

Slide shows the China (Export) Containerized Freight Index (CCFI) between Jan ‘07 and July ‘10. This index is a representative indicator of the strength of 15 top global liner operators. By volume, these 15 liner’s account for

over 80% of global containerized trade.

• Over the last 4 years the CCFI, which provides an indicative measure of the general health of containerized trade, has seen significant volatility.

• Over 4 months (Sep ‘09 – Jan ‘10) the operating strength of these liners fell by over 50%.

• Over 12 months (Jul ‘09 – Jul ‘10) the operating strength of these liners rallied by over 220%.

• In 2009, liner operators are thought to have collectively lost over $15 billion USD.

• In 2010, end-users have collectively paid over twice their predicted budget for containerized transportation.



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The Seaborne Containerized Transportation Markets are Highly Volatile

Slide shows box-rates on Shanghai containerized exports to Europe and Mediterranean ports between Oct ‘09 and Jul ’10 (Shanghai Containerized Freight Index)

• Over 4 months (Oct ‘09 – Feb ‘10) the cost of shipping a container from Shanghai to Europe rose over 179%.

• Over 8 months (Oct ‘09 – Jun ‘10) the net increase remained at 152% of Oct ‘09 prices on European import costs.

• Global economic uncertainty and the abolition of the cartel-like liner conferencing system has generated unprecedented box-rate volatility.

• Has led to a new age of “Casino Shipping”.

• Neither end users nor shipping lines are able to accurately predict movements of freight rates next month let alone next quarter or next year.



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Containerized Transportation Markets Clearly Require a Mechanism for Price Discovery and Risk Management

• Macro and microeconomic shifts in consumer spending lead to volatile shifts in containerized transportation prices across the globe.

• This is problematic for businesses and shipping lines who are forced to respond reactively, either absorbing these fluctuating costs in to bottom lines or extending additional forward cost to consumers.

• Given the volumes traded and volatility of freight costs there is a clear requirement for some from of risk management.

• Container swaps fulfil this role.



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Container Swaps Finally Allow for Risk Management of Volatile Box-Rates

• How can principals with physical exposure to box-rates manage endemic box-rate volatility in order to prevent upsets to their bottom lines?

• Container swaps provide a flexible, simple and long overdue risk-management solution that tackles the balance sheet risks of freight rate volatility



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Container Swaps are Wagers Between Two Parties that Box-Rates will Move in a Particular Direction

• Container swaps allow market principals to take a theoretical paper position on changes in container box-

rates on a particular shipping route that is complementary to their physical position

• Whilst not strictly accurate, for those new to swaps it might be helpful to initially think of container swaps as

‘insurance’ against changes in box rates in an unfavourable direction

• At the end of the specified period, the swap is settled and the counterparties exchange the cash difference

between

1. The benchmark box-rate agreed on the date of the initial trade (also known as the strike price)

2. The average index-measured box-rate on the physical market over the swap period

• N.B. For those experienced with freight derivatives, container swaps are traded and cleared almost exactly

like traditional Forward Freight Agreements (FFAs)

• Time charter days and charter rates are replaced by container units and box-rates



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Container Swaps have the Net-Effect of Fixing Box-Rates Relative to the Spot Market

Slide shows how the profit/loss profile of a paper, container swap position can be engineered to be the exact opposite of a physical position. The net effect is to fix box-rates at the strike price of the container swap,

relative to the spot market.

• For an end-user, the negative effects of a rising market to their physical position (increased container shipping costs) are offset by purchasing container swaps; a position that benefits from increasing freight rates.

• This fixes the end-user’s net box-rate costs between their physical and paper positions. The result is a net reduction of containerized transport costs relative to a rising spot market.

• N.B. Since the net box-rate paid is fixed, this position also eliminates benefits to the end-user should the spot box-rates fall below the contract’s strike price.

• The end-user can, at any time, quickly and flexibly reverse (close out) their swap position by taking a second paper position that effectively cancels out the first.

• In this example, an end-user wishing to close out a long paper position would sell an equal number of container swap contracts to those originally purchased. The two paper positions cancel each other out and the end-user quickly re-exposes their physical position to movements of spot market box-rates.

• The above scenario is reversed for shipping operators. By selling container swap contracts they are able to crystallize margins in a softening market. In this way, should box-rates fall, the loss in revenue from the liner’s physical position is compensated by gains on paper.



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Container Swaps have a Wide Array of Uses and Attract a Range of principals

• The primary use of container swaps is by parties whose bottom line is exposed to movements in box-rates in the physical market.

• The act of reducing one’s exposure to the risk of spot market volatility is called hedging.

• Secondary speculators use complex trading systems to expose themselves to the risk of market volatility in a controlled and profitable manner

• This act of increasing one’s exposure to the risk of spot market volatility is called speculation.

• Container swaps also have a wide array of less direct but equally interesting applications...



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Container swaps are a Direct Investment in our Global Economy

Slide shows the extraordinarily high correlation (84%) between the composite SCFI index (left axis) and AP Moller Maersk’s Share Price (right axis)

• EXAMPLE: Dutch pension funds with large exposure to the share price of AP Moller-Maersk could sell container swaps to hedge against falling Maersk share prices without the need to sell off equity

• Containerized box-rates provide one of the purest and most faithful economic indicators of consumer spending, perhaps even more so than the Baltic Dry Indices (BDIs)

• Businesses order containerized consumer goods in order to replace stock purchased by consumers

Strong consumer spending >> increased demand for consumer goods >> increased demand for containerized shipping

- So, box-rates rise in response to strengthening consumer spending

- Weak consumer spending >> stock is not consumed >> goods are not re-ordered >> decreased demand for containerized shipping

- So, box-rates fall in response to softening consumer spending

• Container swaps can be traded as a direct investment in our global economy



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A Trusted Index is the Most Important Part of Any Swap Contract

• So, how are a container swap’s strike and settlement price agreed by two counterparties?

• Both prices are based on a universally accepted index.

• An index is a statistical composite that measures changes in financial markets.

• In order to function as a benchmark for financial products it must be trusted to provide a trustworthy and faithful representation of a market’s condition, at the time of the index’s publication.

• If accepted as such by the market community, the index provides benchmark figures against which principals in the market universally agree to clear their swap agreements.

• For container swaps the index used as an indicative measure of box-rates on major Shanghai export routes is the Shanghai Containerized Freight Index (The SCFI).



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The SCFI Provides a Benchmark against which all Container Swaps are Settled

• The SCFI is administered by the SSE and was first published on 16 Oct 2009.

• Each week the SCFI’s 15 individual route indices are compiled from the average box-rates of the actual transactions by the index’s 30 panellists during the preceding week.

• For any index, there exists some risk that a panellist may attempt to distort data by providing misleading figures for publication. Such deception is both carefully monitored by the SSE and highly illegal.

• Further, the SCFI has argued that the index is highly unlikely to be artificially manipulated since:

1. It is comprised of 30 panellists (more than any index of the Baltic Exchange) each of whom exercises equal influence over the value of the index.

2. The index’s panellists are comprised equally of 15 principals who are net long the underlying (Shipping Companies) and 15 principals who are net short the underlying (Freight Forwarders).

• Market representative box-rates for each route are published in USD / FEU (for US routes) and USD / TEU for all other routes at 15:00 Shanghai time.

• The box-rates published by the SCFI include and omit several taxes and surcharges. For a full list of these taxes please see http://bit.ly/scfi-intro.



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The SCFI is a Reliable and Representative Indicator of Box-Rates on the Physical Spot Market

Slide shows logos of ten of the SCFI’s thirty panellists.

Shipping Liner Panellists Freight Forwarder PanellistsCosco Container Lines CNSFTC LogisticsCMA CGM UBI LogisticsChina Shipping Container Lines YRC LogisticsHanjin Shipping SIPGLHapag-Lloyd Shipping GDE Orient Express“K” Line HuasingMaersk Line JC LogisticsMOL ShangtexNYK Line ViewtransOOCL RICHHOOD LogisticsPacific International Lines Ever Leading InternationalHasco ADP LogisticsJin Jiang Shipping Sunshine LogisticsSinotrans Container Line Cosco LogisticsSITC Container Lines Sinotrans Logistics

For the full, official SSE list of SCFI panellists please see http://bit.ly/scfi-info



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The SCFI Measures Containerized Box-Rates on all Major Shanghai Export Routes

Slide shows all routes and associated base ports whose box-rates are measured by the SCFI.

• The SCFI principally measures box-rates on exports from Shanghai to the rest of the world.

• Inclusion of several geographically proximal ports within a route’s data set allows for a more reliable box-rate data to be generated.

• Whilst 15 routes are covered in total, it is the overwhelming volumes on the European, Mediterranean and US routes that have drawn the most initial attention with regards to the trading of paper container swaps.

• This is largely due to the fact that the top 5 Shanghai export routes (Europe, Mediterranean, US West Coast, US East Coast and Persian Gulf) account for almost 22% of the volume of global containerized trade.



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The SCFI Measures Containerized Box-Rates on Shanghai Exports

Slide shows some sample historical raw data from the SCFI.

• The SCFI is published each week on a Friday at 15:00 Shanghai time.

• Routes from Shanghai to the USA (US West Coast/US East Coast) are measured in USD / FEU.

• All other routes are measured in USD / TEU.

• The composite index is constructed from a weighted average of the SCFI’s 15 constituent routes.

• N.B. Without a subscription to the SCFI, access to individual route data is delayed until the following Monday.

• FIS publishes an updated spreadsheet of SCFI data to its clients each week on a Friday.

• To get this free update go to http://bit.ly/get-reports



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Clearing Houses Foster Trading Liquidity and Eliminate Counterparty Risk

• Each container swap contract requires two counterparties to the trade, a buyer and a seller

• Trading directly between two counterparties, also known as Over the Counter (OTC) trading, is possible but introduces a significant risk of counterparty default.

• I.e. There is a risk that the a counterparty might fail to honour its financial obligations should the swap move strongly in the other's favour.

• Trading through a clearing house provides a mechanism by which counterparty risk can be eliminated. This encourages trusting, liquid trading of container swaps among market principals.

• There are four main, globally operating clearing houses:

• LCH.Clearnet (based in London)

• SGX (based in Singapore)

• NOS (based in Norway)

• NYMEX (based in New York)

• Currently, both LCH.Clearnet and SHX have arrangements in place to clear container swaps.



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Container Swap Clearing Services are Provided by Registered Members of the Clearing House

Slide shows five of LCH’s GCMs. LCH has 125 clearing members, 25 of whom are active on EnClear, LCH’s OTCclearing service for commodities. For a full member list see http://bit.ly/lch-members

• Principal’s wishing to trade cleared container swaps must trade through one of LCH.Clearnet’s GCM’s.

• It is the clearing members, not the principals directly, who interact with the clearing house

• Since LCH ensures that its general clearing members adhere strictly to a demanding check list of credit and capital requirements, the chances of counterparty default by one of these members is extremely small.

• LCH.Clearnet acts as a central counterparty to both clearing members.

• There are two main advantages to this system:

1. Counterparty risk is almost completely eliminated.

• The chance of (for example) UBS or Goldman Sachs defaulting on a trade is small

2. The anonymity of both original counterparties is maintained since the clearing members act as their proxies.



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A Clearing Account is Essential to the Liquid Trading of Container Swaps

Slide shows the progressive trend from Over the Counter (OTC) towards cleared trading observed in FFAs between 2007 and 2009

• There are two main reasons why a clearing account is essential to the liquid trading of container swaps

1. The standardized contracts enforced by clearing houses allow for consistency across the market. Contracts can thus be traded at face value without the need for independent valuation of each trade. This makes the contracts easier to trade, increasing market liquidity significantly.

2. The main, liquidity-generating, market makers are usually financial institutions such as investment banks. The trading protocols enforced by the risk management departments of these institutions require a cleared market for their participation. It is therefore in the interests of market principals to trend towards a cleared system of trading as this promotes liquidity.

• In order to trade through a clearing house, market principals must be registered with a suitable clearing house.

• FIS works with all of the major and smaller clearing houses on a daily basis. Should you feel it convenient I would be happy to recommend a suitable clearing partner based on your individual requirements.



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LCH Ensures that the Simple, Linear Flow of a Container Swap Trade is Efficiently and Consistently Executed

1. Two parties execute a bilateral (two way) trade through a broker at Freight Investor Services

2. Price and quantity of contracts are confirmed by FIS with each counterparty on a recorded line to ensure full compliance

3. FIS enters the details of the trade in to the LCH.Clearnet Clearing System (ECS), preferably within 15 minutes of execution.

4. The trade is accepted in the ECS for clearing by both clearing members

5. The clearing members assume counterparty responsibility to the principals

6. LCH.Clearnet becomes central counterparty to the clearing members



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Four Major SCFI Routes Currently Enjoy Cleared Trading Contracts at LCH

• Each cleared contract represents one TEU / FEU and has a specified route and period against which it is cleared

• Subject to market demand, additional SCFI routes and extended contract periods may be introduced by LCH

• When a quarter or calendar year are traded, it is important to note that is not the unitary period that is settled.

• Instead, an equal number of contracts for each of the months within that period is traded . The equally distributed composition of the contracts creates a net position that is thus for the whole quarter or year.

• For example, a trade of 24 TEUs on CNW in Cal 11 is registered by LCH.Clearnet as independent trades of 2 TEUs on each of the 12 Cal 11 months, January to December 2011.

• By extension, instead of settling in its entirety at the end of Cal 11 the position is settled in 12 stages; 2 lotsat a time on the natural settlement date at the end of each Cal 11 month.

• Quarters and calendars must therefore be traded in clip sizes (contract volumes) that are multiples of 3 and 12 respectively . This ensures that the contracts can be split equally between the constituent months.

• Once the first month of a Quarter or Calendar is settled it can no longer be traded. This is because the contract period is no longer complete.



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A Margin Deposit and Some Administrative Clearing Fees are Payable on Each Contract

• When trading container swaps each counterparty places an initial margin as a guarantee against the trade

• The margin is updated on a daily basis to reflect to what extent the spot market indicates that each counterparty is correct (in the money) or incorrect (out of the money)

• Should a counterparty default, this margin is used to secure the other counterparty’s exposure to the position

• A small, one-off, administrative clearing fee is charged to each counterparty for each contract traded

• LCH charges its clearing members a fixed rate of $3 per contract

• It is up to each clearing member to decide what charge to extend to individual counterparties (although this is usually no more than double LCH’s fee)

• It is definitely worth shopping around with a couple of clearing members. Comparing, contrasting and negotiating clearing fees can quickly amount to many thousands of saved dollars

• Some clearing members are happy to discuss the extension of credit to their clients so as to soften the cash-flow impact of maintenance margining issues



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A Margin Deposit and Some Administrative Clearing Fees are Payable on Each Contract

• When trading container swaps each counterparty places an initial margin as a guarantee against the trade

• The margin is updated on a daily basis to reflect to what extent the spot market indicates that each counterparty is correct (in the money) or incorrect (out of the money)

• Should a counterparty default, this margin is used to secure the other counterparty’s exposure to the position

• A small, one-off, administrative clearing fee is charged to each counterparty for each contract traded

• LCH charges its clearing members a fixed rate of $3 per contract

• It is up to each clearing member to decide what charge to extend to individual counterparties (although this is usually no more than double LCH’s fee)

• It is definitely worth shopping around with a couple of clearing members. Comparing, contrasting and negotiating clearing fees can quickly amount to many thousands of saved dollars

• Some clearing members are happy to discuss the extension of credit to their clients so as to soften the cash-flow impact of maintenance margining issues



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Container Swaps are Best Summarised in a Worked Example



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Brokers are Integral in Facilitating the Swap Trading Process

• At FIS, our brokers are highly specialised in container swap trading and play an integral role promoting liquidity within the market



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FIS are the World Leaders in the Brokering of Freight and Commodity Derivatives

• Freight Investor Services was founded in October 2002 by John Banaskiewicz and Andy Lucey

• FIS is proud to represent the largest global FFA market share of any brokerage in the world



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Next Actions Checklist

Find out a bit more about container shipping

Glance over Wikipedia article on Containerization (http://en.wikipedia.org/wiki/Containerization)

Flick through the excellent World Liner Shipping website (http://www.worldshipping.org/about-

the-industry)

Read back through FIS presentation and note down questions/concerns to ask Arthur

Sign up for the free FIS container market reports and price curves (http://bit.ly/get-reports) (Free Info!)

Discuss Merits and Operational Application of Container Swaps Internally

Logistic Department

Finance Department / CFO

( Compliance Department )

Call Arthur at FIS (+44 207 090 1120 / +44 7595 657 672)

Run through list of questions

Discuss Clearing House Recommendations

Draw up next checklist of actions



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http://en.wikipedia.org/wiki/Containerization

http://www.worldshipping.org/about-the-industry





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Container Swaps Introduction (with Notes)