Freight derivative

Presented by

Shradha jhavar (B-7)Pritesh maniar ( B-10)Vishal kothari ( B-9)Viral mayani (B-11)

Roadmap

• What is freight derivative ?• Underling assets• Baltic index• Forward freight agreement (FFA)• process, uses, major players, benefits of FFA• Deal • Risk management in shipping industry• Freight derivative in India

Freight Derivatives

Financial instruments for trading in future levels of freight rates, for dry bulk carriers and tankers

Freight Derivatives …

• Settled against various freight rate indices published by the Baltic Exchange (for Dry and most Wet contracts) & Platt's (Asian Wet contracts).

• FFAs are often traded over-the-counter (through broker members of the Forward Freight Agreement Brokers Association - FFABA - such as Clarkson's Securities, SSY - Simpson, Spence and Young, Ifchor, FIS - Freight Investor Services, BGC Partners, GFI Group Inc, ACM Shipping Ltd, BRS, Tradition-Platou and ICAPHYDE)

NOS Clearing

LCH.Clearnet

NYMEX (NY Mercantile Exchange)

Singapore Stock

Exchange

• Existed since 1985 with the creation of the BFI (Baltic Freight Index), a basket of individual dry cargo routes

• Since 1992, the individual shipping routes can be traded “over the counter” (i.e. outside an organized exchange) in the form of Forward Freight Agreements (FFAs).

o The underlying market is the freight market of physical transportation of cargo

o Prices in the freight market are termed freight rates and are expressed in terms of $/day (“time-charter”) or $/tonne (“voyage charter”)

o The freight market is highly segmented and freight rates are specific to:

• Vessel type• Route• Duration of charter agreement

– Estimated annual dollar turnover: $25 billion in notional value of freight (dry)

– Estimated annual cargo turnover: 1.3 billion tonnes of cargo (vs. physical: 1.6 billion)

– Estimated volume of trades: 8,000 transactions (dry; up from 5,000 in 2003)

The role of the Baltic Exchange

• Responsible for standardizing a set of routes which serve as the underlying assets for the settlement of freight derivatives.

• Sets the rules and oversees the process of collecting and processing the brokers’ assessments of freight rates in more than 40 cargo routes

• The Baltic Dry Index (BDI) is a number issued daily by the London-based Baltic Exchange. Not restricted to Baltic Sea countries, the Index tracks worldwide international shipping prices of various dry bulk cargoes.

Ship

Classification

Dead Weight

Tons% of World Fleet

% of Dry Bulk

Traffic

Capesize 100,000+ 10% 62%

Panamax 60,000-80,000 19% 20%

Supramax 45,000-59,000 37% 18% w/ Handysize

Handysize 15,000-35,000 34% 18% w/ Supramax

forward freight agreement

Option contract on freight rates traded on Baltic exchange, through which shippers and ship owners hedge against the volatility of the ocean freight market

Freight route liquidity

Tanker freight market Dry cargo market

The highly cyclical shipping industry as seen in the BFI

Total

Demand

Shipowner　1

Shipowner　2

Shipowner　M

Charterer 1　

Charterer 2

Charterer　 N

shipper

shipper

shipper

shipper

shipper

shipper

shipper

shipper

shipper

Futures Markets

Spot Market

Total

Supply

Trading process

• To initiate an FFA transaction, one needs to specify: route (incl. duration or quantity),

• Maturity, and settlement formula• Price discovery through brokers• FFA price negotiation• Counterparty clearance• Documentation

How do FFAs work?

(1) When the agreed time has expired and the final settlement price is higher than the agreed rate, the seller compensates the buyer the difference between the agreed price and the settlement price; if the price is lower the buyer compensates the seller.

(2) The standard final settlement price is typically made up of the average of the last 7 Baltic Exchange published index days of the relevant month for trades on individual routes, and an average of all index days for period trades, although this can vary as agreed betweencounterparties.

(3) The party that owes monies at settlement produces an invoice with all bank detailsincluded. The payment between the two parties is made by telegraphic transfer in USDollars within 5 London business days following the settlement date.

(4) The commission is the percentage as agreed, payable by both counterparties

Major players

• Ship owners

• Charterers

• Banks

Uses of freight derivatives

• Traditional uses:Hedging, Speculation , Arbitrage (difficult due to lack of tradable underlying)

• Modern uses:Hedging (portfolio approach), Speculation

• Strategic uses : structuring in chartering

Benefits of FFA

• Risk Management (stabilize cash-flow)• Guarantees freight rate up to 3 years forward • Buy/Sell positions prior to expiry (flexibility) • Easy to fix and close out positions• Price Discovery• No restrictions to physical operation (retain control

of vessels and of specific types of cargos)• Easily understood and quickly traded• No re-negotiations from parties as in the spot market

Issues for consideration• Liquidity

FFAs is an OTC

• Pricing(Forward Price = Spot Price + Cost of Carry – Convenience Yield). Thisargument does not hold for shipping derivatives due to the non-storable nature of freight.

• Basis risk Imperfect hedging due to possible location, vessel, or time discrepancies.

• Credit risk there is no deposit or variation margin requirement

TRADING MECHANISM WITH FFA

KEY TERMS• TD stands for “Baltic Dirty Tanker Index”

• TC stands for “Baltic Clean Tanker Index”

• WS stands for World Scale

• Freight rates are expressed in $/day or $/tonne.

• Contracts are available for 30,90 or 365 days.

• Most of the contracts traded are of European types.

Standard practices in FFA trading

Usual practice Possible deviations

Commission 0.25% (dry), 0.50% (wet) Discount for (very) large volumes

Settlement average of last 7 days some other period (negotiable)

When due 5 London business days up to 7 days

Security / collateral no security asked Letter of Credit, NOS, Vessel mortgage

Trade Example

It is early January 2009 & Panamax vessel ship owner knows that his vessel will come open in June this month. The current freight rate is $40.01 per ton & he expects the prices to go down. To protect against this exposure he enters into an FFA contract.

• Buyer: TUV Operator

• Seller: XYZ Shipping Corporation

• Route: Avg of 2 BPI (US Gulf/Japan, 54000 lt, HSS) routes

• Price: $39.50 per ton

• Duration: June 2009

• Settlement: Average of all index days with monthly settlement.

• Price as on June : $ 36.50 per ton

HEDGING EXAMPLE

An owner knows he has vessels coming open early next year and is worried about securing employment at attractive rates especially over the Christmas & early new year period. He therefore decides to hedge this exposure from Jan to March 2001 by selling the t/c average for this period.

• FFA Time Charter Contract:

• Buyer: TUV Operator • Seller: XYZ Shipping Corporation

• Price: $11750

• Duration: Jan/Feb/March 2001 ‘00- 91 days

• Settlement: Average of all index days with monthly settlement.

• Results of Hedge

• January Average: $11000

• Trade Price: $11750

• Difference: $750 x 31days = $23250

• February Average: $11500

• Trade Price: $11750

• Difference: $250 x 29 days = $7250

• March Average: $12250

• Trade Price: $11750

• Difference: $500 x 31days = ($15500)

• Net Result = $23250 + $7250 - ($15500) $15000 profit

OPTIONS• You buy a TD3 Call Option , Spot W100

• Q4 ‘08 W120 Call - Cost WS 10

• Result.

• If the market goes above W130 in Q4 ‘08 you have all the profit.

• If the market falls you only lose 10 Worldscale points.

• You buy a TD3 Put Option , Spot W100

• Q4 ‘08 W 80 Call - Cost WS 10

• Result.

• If the market goes above W 70 in Q4 ‘08 you have all the profit.

• If the market rises you only lose 10 Worldscale points

.

Risk Management in Shipping

• Definition of Risk

• Types of Risks Business: Market: Credit: Operational: Other types:

Steps of Risk Management process

Risk Modeling Risk Measurement Risk Management

The Traditional Approach to Risk Measurement

• The Mean-Variance framework

• Portfolio Theory

VaR Approach

• The origin and development of VaR• VaR Basic

Justification for Risk Management in Shipping

• Business and market risk in shipping: the two faces of the same coin

• High market volatility

Freight Derivatives in INDIA

• MCX in strategic collaboration with the Baltic Exchange introduced freight futures contract in year 2004

• MCX would create India-specific freight contracts keeping into consideration India's large coastline

• India has been seeing a steady growth in industries leading to a surge in marine business. Freight derivatives will make the industry more competitive

Issues in freight derivatives

• IT is a still a two tier market• No Transparency• Lot Size of contracts• Education for Market Participants• Its is only traded via OTC market

Thank you