How Does A Forward Freight Agreement Work
Freight derivatives include exchange-traded futures, futures, futures contracts, futures contracts (FFAs), container freight swap agreements, container cargo derivatives and physical delivery derivatives. In this case too, the sale or purchase is not about a physical asset, but about a market position. Let`s see an example of how options trading works. We have December 2016 and a Panamax Bulker owner is concerned that the market will decline in February 2017 due to the Chinese holidays. The current Panamax market is $8,000/day, while it has the chance to purchase a 2-month (60-day) put-in option for an exercise price of $7,500 per day. The cost of the put option is $1000 per day. This means that the shipowner must pay $60,000 (60 -1,000) in bonuses to purchase the put option, and if the market falls below $7,500 per day in February, he will exercise the option, he will drop it. Therefore, if the average of BPI 4 TCs is 5,500 USD/day, the shipowner will be paid the difference of (7,500 – 5,500 USD) 60 days – 120,000. So when we deduct the premium, we find that the shipowner has ensured that his minimum TCE price is $6,500 per day.
If the physical market is greater than $7,500, it will not exercise the option and its only cost was the payment of the premium. As marine markets are more at risk, freight derivatives have become a viable method for shipowners and operators, oil companies, commercial enterprises and grain companies to manage freight interest risk. The settlement price (7 days average) was finally USD 8,500/day, which is why the FFA seller (owner) pays the difference to the FFA buyer (charterer) for 50 days ($500 per day – $50-$25,000). Indeed, no party loses money, since the charterer takes back the $500 paid to the owner in the physical market, while the owner pays nothing out of his own pocket, since the $25,000 is part of the total freight he earned (since he earned 8,500/day on the physical market). As we know very well, shipping is a very risky and volatile sector. In the past, both dry matter and oil and oil markets have fallen sharply or increased in a few days, and forecasts are very difficult (short-term), if not impossible (in the long run). To cope with their market risks, market participants can use different instruments. Fixing a temporary charter ship/naked hull is a traditional solution used to block your income (owners) or your transport costs (charterer) for a certain period of time. However, this measure is not flexible at all, as the vessel is bound for a long period of time and the exit of a contract can be costly. Fleet diversification is another traditional instrument used by shipowners. By diversifying the fleet, a shipowner participates in several markets where market risks are shared.
To overcome the disadvantages of traditional market risk management strategies, a more advanced instrument has recently been developed: Freight derivatives. Let`s look at freight derivatives, their history and use in the marine industry, and how they work.