1 MS&T-NCL U-Mar8043 - Part1 NCL

NEWCASTLE UNIVERSITY
School of Marine Science and Technology

Module Code: MAR 8043
Financial Risk Management

in Shipping
Professor
Theodore SYRIOPOULOS
University of the Aegean
Shipping, Trade & Transport Dpt.
tsiriop@aegean.gr
Course Outline
Financial Risk Management in Shipping
Concept of Risk & Risk Management
Shipping Markets & Risk
Shipping Risk Management Basics
Forward Freight Agreements (FFAs)
Practical Cases on Freight Derivatives
Appendix: Recent Trends in the FFA Market
Options Contracts: Basic Positions
Freight Options
2
Course Objectives
to build a theoretical & practical understanding on a set of sophisticated techniques

for managing financial risk in shipping
Forward Freight Rate Agreements (FFAs)
hedging freight risk in shipping with FFAs
3
Learning Outcomes
By the end of this module, students should be able to:
understand a variety of core risk exposures of shipping firms - emphasis on financial risks
comprehend critical role, properties, operations of financial derivatives markets

to risk management
familiarize with function of key derivatives instruments (futures & options),

especially Forward Freight Agreements (FFAs), to protect against core shipping risks
implement modern risk management techniques, predominantly hedging, to control for

shipping financial risk exposures
4
Core Bibliography
Main Textbooks
Alizadeh, A. & Nomikos, N. (2009):

Shipping Derivatives & Risk Management
Palgrave, Macmillan Publications, London
Kavussanos, M. & Visvikis, I. (2006):

Derivatives and Risk Management in Shipping
Witherbys Publishing, London
Background Reading
Grammenos, C. (2010, 2nd ed.):

The Maritime Economics and Business Handbook
LLP Publications, London
Stopford, M. (2009, 3rd ed.):

Maritime Economics
Routledge, New York
Geman, H. (2008):
Risk Management from Shipping to Agriculturals and Energy
Wiley Finance, Chichester.
Hull, J. (2014, 9th ed.):

Options, Futures and Other Derivatives 5
Prentice Hall, New York.
More on Bibliography
Alizadeh, A. (2013), Trading volume and volatility in shipping forward freight market,
Transportation Research Part E, 49, 250-265.
Kavussanos, M., Visvikis, I. (2006), Shipping freight derivatives: A survey of recent evidence,
Maritime Policy & Management, 33(3), 233-255.
Kavussanos, M.G., Visvikis, I.D., Dimitrakopoulos, D.N. (2014), Economic spillovers between related
derivatives markets: The case of commodity and freight markets,
Transportation Research Part E: Logistics and Transportation Review, 68, 79102.
Li, K.X, Qi, G., Shi, W., Yang, Z., Bang, H.S., Woo, S.H., Yip, T.L. (2014), Spillover effects and dynamic
correlations between spot and forward tanker freight markets, Maritime Policy & Management, 41(7), 683-696.
Grammenos, C. (2010, 2nd ed.): The Handbook of Maritime Economics and Business, LLP Publications, London
Chapter 28 - Syriopoulos, T. (pp. 568-603):

Shipping Finance and International Capital Markets
Chapter 29 Thanopoulou, H. (pp. 605-630):

Investing in Ships: An Essay of Constraints, Risks and Attitudes
Chapter 30 - Kavussanos, M. (pp. 661-692):

Business Risk Measurement and Management in the Cargo Carrying Sector of the Shipping Industry
Chapter 31 - Nomikos, N. & Alizadeh, A. (pp. 693-730):
Risk Management in the Shipping Industry: Theory and Practice
6
Further Selected Academic Papers
Alizadeh, A., Kavussanos, M. and Menachof, D. (2004), Hedging against bunker price fluctuations using petroleum futures
contracts: Constant versus time-varying hedge ratios, Applied Economics, 36, 1337-1353.
Alizadeh, A. and Nomikos, N. (2004), Cost of carry, causality and arbitrage between oil futures and tanker freight markets,
Alnes, P.A. and Marheim, M.A. (2013), Can shipping freight rate risk be reduced using Forward Freight Agreements?,
MA Thesis, UMB School of Business and Economics, Norway.
Angelidis, T. and Skiadopoulos, G. (2008), Measuring the market risk of freight rates: A value-at-risk approach,
International Journal of Theoretical and Applied Finance, 11, 415-445.
Batchelor, R., Alizadeh, A. and Visvikis, I. (2007), Forecasting spot and forward prices in the international freight markets,
International Journal of Forecasting, 23, 101-114.
Koekebakker, S. and Adland, R. (2004), Modelling forward freight rate dynamics Empirical evidence from time charter rates,
Kavussanos, M. and Visvikis, I. (2004), Returns and volatilities between spot and forward shipping freight markets,
Journal of Banking & Finance, 28, 2015-39.
Kavussanos, M. and Nomikos, N. (2003), Price discovery, causality and forecasting in the freight futures market,
Review of Derivatives Research, 6, 203-230.
Kavussanos, M., Skielse, A. and Forrest, M. (2003), International comparison of market risks across shipping-related industries,
Maritime Policy & Management, 30, 102-122.
Nomikos, N., Kyriakou, I., Papapostolou, N. and Pouliasis, P. (2013), Freight options: Price modelling and empirical analysis,
Syriopoulos, T. and Roumpis, E. (2009), Asset allocation and value at risk in shipping equity portfolios,
7
The Concept of Risk
&
Risk Management
Definition of Risk
chance (probability) that a decisions (investment) actual outcome (return)

may be different than expected (loss / gain)
measurement: standard deviation of historical (or average) returns of a specific investment

St.d = square root of variance
standard deviation = high risk level = high (investments volatility)
fundamental relationship: risk return

higher risk compensated for higher return
9
Key Risk Components
key components: risk assessment & evaluation

understand business environment
a chance of bad consequences

uncertainty & its results
2 critical components to define risk:
probability (chance) of occurrence
consequence of occurrence
10
Adapted from Clarkson ,Demystifying Risk in Shipping
Major Types of Risk
Major
Categories of RISK
Market Risk
STRATEGIC RISK
Credit Risk
BUSINESS RISK
Liquidity Risk
FINANCIAL RISK
Operational Risk
Legal Risk
11
Strategic Risks Operational Risks
12
Financial Risks
13
Quantification of Risk
Some risks cannot be quantified

(e.g. strategic risk)
Risk is evolving permanently

measuring risk requires a dynamic approach
Risk is subjective
what is risky for someone is not risky for someone else
Models are only models

i.e. a simplified representation of reality
14
Quantification of Risk
Some risks can be quantified:
Market Risk
- chances of occurrence: volatility
- consequence of occurrence: variation of P&L
Credit Risk
- chances of occurrence: probability of default
- consequence of occurrence: loss given default
Not a single measurement can capture all aspects of risk !
15
Risk Management in Shipping
What RISK.. .. for what RETURN ?
Risk Management : set of approaches, techniques, instruments to

manage risks associated with
investment, financing, business decisions
Identify + Quantify + Manage Risks

Hedging
Insurance
Acceptable risks vs. Unacceptable risks
Diversification
16
Enterprise Risk Management (ERM) in Shipping
identification of all significant

risks affecting firms value
monitoring + evaluation of performance & suitability of risk assessment + analysis of potential

management methods & strategies on ongoing basis frequency + severity of losses due to those risks
development + implementation of
appropriate methods for risk management
Shipping Markets & Risk
Shipping Business Idiosyncrasies
Shipping business:
- capital intensive
- cyclicality
- seasonality
- highly volatile - highly risky
- business cycles - unstable
- market segmentation: - unpredictable
- across types of commodity
dry market grains, agriculturals, coal, iron ore etc.
wet market crude oil oil products
- across vessel sizes - types

different vessel sizes
different vessel types
Risk management = imperative !

http://www.worldshipping.org
20
Clarksea Index: avg earnings by
bulkers, tankers, containers, gas
21
Shipping Market Fundamentals
Shipping Market :
not 1 but sub-divided in 4 interrelated core market segments !
Newbuilding Market
Second-Hand Market
Demolition (Scrap) Market
Freight Market
22
Freight rate formation Demand vs. Supply
Spot freight rates determined by interaction of demand for & supply of shipping services at point in time
Demand for sea transportation - derived demand:
- world economic activity
- seaborne commodity trade
- average haul
- transportation cost
FR demand new demand - political events
supply
Supply of shipping services (ton-miles):
- stock of fleet
- fleet productivity
- shipbuilding production
- freight rates
- scrapping & losses
Source: M. Stopford (2009) ton-miles

24
25
26
27
Freight Rate Volatility
Freight Income primary ship-owners revenue

stable & predictable income: desirable
BUT.. sea-transport freight rates = extremely volatile

greatest risk component of shipping business
freight rates fluctuate

due to impact of external factors.
Freight Rate Volatility
Fundamental factors driving freight rates

(Baltic Exchange)
1. fleet supply
(available ships; new deliveries; ships for scrapping)
2. commodity demand
(industrial production; imports growth; different industries performance)
3. seasonal pressures
(weather conditions; agro-production; oil-demand etc.)
4. bunker prices
(bunker fuel: 25-35% of voyage costs; oil-price shifts)
5. choke points
(narrow canals: Panama & Suez canals; congestions)
6. market sentiment
(market opinions critical)
Market Cycles
Market cyclicality: well known phenomenon in various industries worldwide;
critical in shipping industry:

abrupt shifts in supply demand
Shipping cycles: irregular, with no firm rules about length or timing;

hence: shipping cycles = unique & hard to predict
Distinction between: long-term trend vs. short-term cycle

Index points
10,000.00
1,000.00
2,000.00
3,000.00
4,000.00
5,000.00
6,000.00
7,000.00
8,000.00
9,000.00
0.00
04/09/2000
04/11/2000
04/01/2001
04/03/2001
04/05/2001
Freight market volatility Baltic Dry Indices

04/07/2001
04/09/2001
04/11/2001
04/01/2002
Panamax (70k dwt)
04/03/2002
04/05/2002
04/07/2002
04/09/2002
04/11/2002
04/01/2003
Capesizes (150k dwt)
04/03/2003
04/05/2003
04/07/2003
04/09/2003
04/11/2003
04/01/2004
Supramax (52k+ dwt)
04/03/2004
04/05/2004
04/07/2004
04/09/2004
04/11/2004
04/01/2005
04/03/2005
04/05/2005
04/07/2005
04/09/2005
31
04/11/2005
04/01/2006
Index points
1000
1500
2000
2500
3000
3500
500
04/01/2000 0
04/03/2000
04/05/2000
04/07/2000
04/09/2000
04/11/2000
Freight market volatility Baltic Tanker Indices

04/01/2001
04/03/2001
04/05/2001
04/07/2001
04/09/2001
04/11/2001
04/01/2002
04/03/2002
Dirty Tanker Index
04/05/2002
04/07/2002
04/09/2002
04/11/2002
04/01/2003
04/03/2003
Clean Tanker Index
04/05/2003
04/07/2003
04/09/2003
04/11/2003
04/01/2004
04/03/2004
04/05/2004
04/07/2004
04/09/2004
04/11/2004
04/01/2005
04/03/2005
04/05/2005
04/07/2005
04/09/2005
32
04/11/2005
04/01/2006
Shipping Business & Risk Management
5 main risks in shipping:
- importance for ship-owners
- should be managed
freight rate risk

bunker price risk
exchange rate risk
interest rate risk
counterparty risk
34
Managing Financial Shipping Risks
most common approaches:
Hedging:
using derivative contracts
- futures - forwards - options - swaps
reduced costs of financial distress

lower exposure to short-term volatility
higher competitive advantage

(protected against adverse market conditions)
Time-Charter contracts
Insurance contracts
Risk management alternatives in shipping
Option 1:
Do nothing & fix spot high risk / unpredictable
Option 2:
Timecharter, COA of long term management inflexible / inefficient pricing
Option 3:
Hedge with Freight Derivatives
& use profit/loss to pay for spot physical deal
opportunities to cover requirements,
quickly fixed & flexible to allow you
to alter your position in market shifts
COA = contract of affreightment (or chartering agreement), the ship-owner commits himself to transport the goods against a set price per ton
without having to mention which ship he will use. 36
Spot - Forward transactions
Spot market : NOW

- buy low sell high capital gains (+ dividends)
Forward markets: FUTURE

- start trade now deliver in future
- virtually trading of underlying assets RISK (not of asset itself)
- transfer of risk to investors willing to undertake it
- risk management (hedging) - potential capital gains (speculation)
Spot vs. Forward Spot Transactions Forward Transactions
Deal agreement (trade date) immediately (on the spot) immediately (on the spot)
Payment immediately (on the spot) at a (specific) future date
Delivery (value date) immediately (on the spot) at a (specific) future date
37
What are Derivatives ? (1)
Derivatives instruments (legal) contracts
determined by reference to (derived from) underlying spot or physical.

... market, asset, security, reference rate, index, commodity
create rights & obligations between counterparties
Implications:
hedge risk of owning assets - subject to unexpected price fluctuations
transfer risk to some other party willing to bear it
38
Underlying assets include:

- commodities
(petroleum, metals, (bushels of ) wheat , gold, coffee, electricity)
- financial instruments
(equity securities, government bonds, interest rates, currencies)
- indices
(stock price indices, freight rates etc.)
- spreads
(between values of such assets)
key factor: premium protection
derivatives comparable to insurance policies
insurance premium pay for protection against a specific event
derivatives have a payoff contingent upon occurrence of some event

for which you must pay a premium in advance
(contingent claims)
39
3 main types of derivative instruments:
- futures - forwards
contracts for future delivery at a pre-specified price
40
- options *
contracts that give holder opportunity
to buy from or sell to the other party at a pre-specified price
Freight option contracts
American option can be exercisedat any time during its life
European option can be exercisedonly at maturity

41
- swaps
agreement between two or more parties to exchange a sequence of cash flows
over a period of time at specified intervals
Freight swaps
42
OTC markets vs. Organized Exchange markets
Key Contract Characteristics
Exchange - Traded Over-the-Counter (OTC)

Public price quote Private transactions
Limited credit risk - Clearing House Credit risk
Standard contracts & sizes Wide range of structures & contract sizes
Major currencies Many currencies
Standard expiration dates Any maturity
Exchanges Trading Futures Exchanges Trading Options
Chicago Mercantile Exchange Chicago Mercantile Exchange (CME)
Chicago Board of Trade Chicago Board Options Exchange
Euronext American Stock Exchange
Eurex Philadelphia Stock Exchange
BM&F (Sao Paulo, Brazil) International Securities Exchange
Eurex (Europe)
43
Financial Markets
Forward Spot
Markets Markets
Unconditional Forward Conditional Forward

Markets Markets
Futures / Forward Options

Contracts Contracts
44
Uses of derivatives
3 reasons for trading derivatives:
Hedging
(protect against risk undertaken similar to insurance contracts)
Speculation
(take a view on the future direction of the market,
provide market liquidity targeting profits)
Arbitrage
(gain profits at zero risk)
45
Core Trading Positions
Long position
party agreed to buy underlying assert opens Long (L +) position
charterer buys FFAs as protection against unexpected increases in freight rates
Short position
party agreed to sell underlying asset opens Short (S -) position
ship-owner sells FFAs as protection against unexpected declines in freight rates
46
The Sveriges Riksbank Prize in Economic Sciences
in Memory of Alfred Nobel 1997
Robert MERTON Myron SCHOLES
"for a new method to determine the value of derivatives"
47
Building on heritage of CME, CBOT, NYMEX & COMEX, CME Group serves the risk management
needs of customers around the globe. Provides widest range of benchmark futures & options
CME Group products available on any exchange, covering all major asset classes.
48
Imarex operates one of the worlds leading marketplaces for Forward
Imarex Freight Agreements (FFAs) and freight options.
49
Shipping Risk Management Basics
50
FUTURES / FORWARDS Contracts: Intro
Spot / Forward Contracts
Forward / Futures Contracts:
order vs. purchase date...
different fromdelivery date
Futures contracts: exchanged in Organized Exchanges
Forward contracts: exchanged in Over-the-Counter (OTC) markets

(popular in currencies & interest rates)
52
FUTURES / FORWARD contracts
a (legal) agreement (obligation) between buyer - seller

(futures contract)
to buy or sell an asset at specified quality & quantity

(underlying asset)
underlying asset: can be commodity, stock, freight (voyage charter) or hire (time charter)
at a specified /certain time in a future date

(delivery / final settlement date)
for a fixed (pre-set) future price

(futures price strike price)
(futures price spot price depends on maturity)
settlement price = price of underlying asset in delivery date

((average of) prices at which contract traded at end of day)
53
FUTURES obligations
Both parties (buyer & seller) legally obligated to fulfil contract terms
Holder (buyer) of futures contract:
obligation to accept delivery

party with long position agrees to buy the asset (freight rate)
Writer (seller) of futures contract:
obligation to deliver underlying asset
party with short position agrees to deliver the asset (freight rate)
a zero-sum game: loss of one party = gain of other party
Credit / Counterparty risk for a futures contract:

- one party may not have resources to honour contract terms on delivery date
- one party may terminate contract due to bankruptcy, market conditions,

54
fraud, legal issues, political issues
FORWARDS contracts
Forward contracts intro
- Forward contracts: similar characteristics as futures but also differences
- forwards can involve physical delivery of underlying asset
- in most cases, delivery of asset does not take place: then, forwards are settled in cash
- forward prices may deviate from futures prices

(due to differences in margin rules, transaction costs, tax treatments)
Futures vs. Forwards
Futures Forwards
Trading exchange-traded OTC
Credit risk guaranteed by clearing house counter-party risk
Deposit / Collateral initial margin deposit usually not required
P&L P&L realized daily through P&L realized at settlement of contract

marking-to-market
Contract terms highly standardized tailor-made
Closing position usually by closing contracts on the negotiated between counter-parties

exchange; offset or reversing trade or via offsetting trades
56
FUTURES contract
Long position
20
10
Profit & Loss
5
K = delivery price
0
ST = (underlying) asset price at maturity
K ST
-5
-10
Payoff = ST - K
contract holder obliged to:
buy an asset (worth ST) for K
57
FUTURES contract
Short position
20
10
Profit & Loss
5
K = delivery price
0
ST = (underlying) asset price at maturity
K ST
-5
-10
Payoff = K - ST
contract seller obliged to:
sell an asset (worth ST) for K
58
Interdependency of Spot Futures Prices
Basis = (Spot price Futures price)
Basis = 0 (S = F) at expiration date
Basis > 0 (S > F) futures discount (backwardation)
Basis < 0 (S < F) futures premium (contango)
Basis Risk: risk of varying fluctuations of spot - futures price between the moment
a position is opened and the moment it is closed
The risk that offsetting investments in a hedging strategy will not experience price changes
in entirely opposite directions from each other. This imperfect correlation between the two
investments creates potential for excess gains or losses in a hedging strategy, thus adding
risk to the position.
also: Basis = (Futures price Spot price) , when futures contract is on a financial asset
59
Futures contract
basis convergence
basis convergence
contango backwardation
F>S F<S
60
Contango - Backwardation
61
Futures Settlement
can be done in one of two ways:
(1) physical delivery
(2) cash settlement
62
Futures Settlement
(1) physical delivery
- amount specified of underlying asset is delivered
by contract seller to the Exchange by the Exchange to contract buyer
- common settlement with commodities & bonds
- in practice: only a minority of contracts is executed

(approx. 2.0% on annual basis)
63
Futures Settlement
(2) cash settlement
- cash payment made on the basis of an underlying reference rate (e.g. BDI)
- upon settlement, only difference between settlement price & agreed price
is being transferred, between counterparties
64
Futures Contract Pricing
NO cost-of-carry
Futures price (value):
continuous compounding F0 = S0erT
F0: futures or forward price today (theoretical, fair price)

S0: spot price today t0
T: time until delivery date
r: risk-free interest rate for maturity T
e: 2.71828
(assumption: no storage-transportation, insurance costs for the underlying asset)
annual compounding F0 = S0(1 + r )T
65
Futures Contract Pricing
WITH cost of carry
Futures price (value) of storable commodity:
continuous compounding F0 = (S0 + C)erT
F0: futures or forward price today

(= spot commodity price today + financial + other costs to carry it forward in time)
S0: spot price today t0
C: cost of carry
T: time until delivery date
r: risk-free interest rate for maturity T
e: 2.71828
Cost of carry = cost of carrying or holding a position

storage costs (as % of spot price) should be added to cost of carry for physical commodities
(such as corn, wheat, or gold) (+ transportation + insurance costs, if applicable)
66
What is Hedging ?
trading futures contracts - objective: reduce / control future spot price risk
Hedging: to protect oneself against possible loss
ALWAYS relates to underlying transaction / asset / interest

that is to be protected !
take a position in futures market
OPPOSITE to position already taken in spot market
for a futures contract to reduce spot-price risk effectively

any gains / losses in value of spot position (due to changes in spot prices)
should be countered by offsetting changes in value of futures position
i.e. offset any gains / losses made in physical (spot) market

by locking into a fixed forward price floor or price ceiling
67
What is Hedging ?
Perfect (textbook) hedge: ideal !
magnitude of changes in spot & futures positions = identical
any gain (loss) in physical position = offset fully by loss (gain) in forward position
hedging, in practice: some degree of risk
most important risk, due to: variations in level of basis (spot price futures price)
68
What is Hedging ?
basis risk: can cause futures prices deviate from cash prices
reasons: imperfect (low) correlation between futures spot prices
asset to be hedged underlying asset in futures contract
hedger uncertain of exact date buy/sell underlying asset
hedge may also require futures contract to be closed out

before its delivery month
consequence: hedgers position not covered (protected) completely !
69
Hedging in Shipping Business
most common exposures hedged through derivatives market.
- freight rates
- bunker prices
- interest rates
- exchange rates
- credit risk & liquidity risk

hedged by implementing specific policies in terms of intentional counterparties
or keeping certain amount of assets in cash
- other risks
may be managed by insurance contracts
71
Shipping Business Parties
parties involved in international shipping transaction:
- seller - buyer of goods agree who is to bear costs incurred in transporting the goods
- different contractual agreements
- Free-On-Board (FOB) contract: goods are to be delivered to nearest port

or pick-up point; buyer covers freight
- Cost, Insurance, Freight (CIF) contract: seller covers all expenses up until
delivery to buyer
- the party who bears transport costs makes a contract with the transporter
2 distinctive Markets: Physical vs. Paper
The Physical Market:
where provision of physical transport is bought & sold

(shippers, freight forwarders & carriers operate)
The Paper Market:

where financial instruments - derivatives of physical markets
. are bought & sold
contracts in this market do not result in physical delivery of transport;
nor do they directly influence the transport contract

(unless explicitly agreed by contracting parties)
Basic types of freight derivatives contracts:

(1) Freight Futures Contracts (cleared contracts)
(2) Forward Freight Agreements (FFAs) (OTC)
73
The Freight Derivatives Market
Freight Futures
- Baltic International Freight Futures Exchange (BIFFEX) contract 1st freight derivatives contract
-introduced in 1985 by London International Financial Futures & Options Exchange (LIFFE)
-contract clearing by London Clearing-House (LCH): guaranteed fulfillment of contracts;

counterparty-risk eliminated
- BIFFEX underlying asset: Baltic Freight Index (BFI) (based on basket of 13 dry cargo routes)
- BIFFEX withdrew in 2002; failed to capture fluctuations on individual routes & hedge efficiently
- hedging with BIFFEX similar to cross-hedging

- cross hedging with an index based contract is only successful when routes (or stocks) constituting the index & index.
move together
- when large number of routes compose the index, relationship between single routes & index will not be very strong.
poor hedging performance
Freight Futures
- freight futures contracts: available as launched by IMAREX (June 2006)
- contract is marked-to-market daily; is cash-settled; no physical delivery
- underlying indices - provided by BaltEx; contract fulfillment guaranteed by NOS Clearing ASA
- contracts are sold as index products; BDI = underlying index
- contracts on single-route products, with individual routes as underlying indices
- futures contracts also on:

Time-Charter baskets for Capesize, Panamax, Handysize & Supramax
- BDIFutures contracts - used for trading: - on directions

- as hedge against dry bulk equities
- as a spread against FFAs
Freight Forwards
Forward Freight Agreements (FFAs) (or Freight Swaps)
- Forward Freight Agreements (FFAs): more flexible & popular forward contracts;
can be written for freight (spot / voyage charter) & hire (TC routes) on individuals shipping routes
& freight indices
- FFAs available since1992, as alternatives to BIFFEX poor hedging performance

- introduced by Clarksons in association with BaltEx for efficient hedging
- OTC traded
- CME (NYMEX) exchange offers also freight futures since 2005
Most widely used OTC agreements are Principal-to-Principal master agreements, published by
the Forward Freight Agreement Brokers Association (FFABA) & ISDA.
FFA = principal-to-principal (buyer seller) financial agreement (contract) made

between two parties to settle the difference between a freight rate agreed today
and the future price of this freight rate on a specific voyage & cargo
Obligations: buyer accepts (receives) agreed sea transport services - freight rate
seller delivers (sells) agreed sea transport services - freight rate
Underlying asset freight rate of physical transportation of cargo

many of which assessed using one of Baltic Exchange Indices
for specific physical trade route (or basket of routes)
not a storable commodity (physically delivered);

not any physical exchange of freight involved; no actual ship is involved
freight rate in:

$ / tonne (voyage charter) or $ / day (time-charter)
77
FFA core objective:

hedging exposure to freight market risk, due to volatile freight prices
by providing for purchase / sale of a freight rate ('contract rate)
along a named voyage (or combination of) route (contract route)
for a specific cargo quantity (contract quantity) or type of vessel (contract vessel)
over a specified future date/period of time (contract period)
contract is settled in cash: on difference between actual spot rate vs. agreed rate
hedging: ship-owner takes opposite position in derivatives market

- compared to position taken in physical market
cash-flows from derivatives contracts will balance gains (losses) of physical contracts
speculation: take a bet on future direction of freight markets
78
FFA main terms example:
contract route: e.g. Tubarao, Brazil to Baoshun, China
contract rate: effectively the forward price (at which differences will be settled)
(e.g. USD40 per metric ton of transported cargo)
contract period: day, month, year of settlement (e.g. May 2015)
contract size: measured in number of lots traded
- contract maturity: possible to trade FFAs with monthly, quarterly or yearly maturities
shortest matures within current month - longest has 3 years maturity
1 lot = 1 day of charter or 1000 metric tons of cargo;

e.g. FFA contract for 60 days hire is considered as 60 lots;
FFA contract for transportation of 150,000 metric tons of cargo is considered 150 lots
Freight Futures-Forwards properties:
cash settled against various freight rate indices

published by Baltic Exchange (for Dry & most Wet contracts) & Platt's (Asian Wet contracts)
standardized contracts & lot sizes

(opportunity to close out positions quickly & easily)
suitable for hedgers

ability to take significant cover quickly & easily
flexible periods
tradable on different routes & vessels

(mainly: capesize panamax supramax handysize)
OTC & Cleared markets
anonymous, rapid & cost effective execution
low frequency trading

(5-1,000 trades/day)
electronic marketplaces /screens

80
- FFA rates: based on Baltic Forward Assessments (BFA) produced by Baltic Exchange
- similar to spot freight rates, BFAs are reported as average of assessments from FFA brokers panel
- FFAs traded either OTC or through hybrid exchanges (e.g. SSY, Marex Spectron, Imarex)
- in OTC market: FFAs negotiated through brokers similar process to physical market
- broker will try to find counterpart with opposite expectations for future path of freight rates
- in a hybrid exchange: FFAs traded on screen & cleared directly through one of clearinghouses
- OTC-traded FFAs can also be cleared
FFA clearing
- 99% of all positions cleared & margined daily through a clearinghouse (Baltic Exchange)
- clearinghouse guarantees that counterparty fulfils financial obligations
- clearing houses:
- London Clearing House (LCH)
- Norwegian Futures & Options Clearinghouse (NOS/NASDAQ)
- CME Clearport
- Intercontinental (ICE) Futures Europe
- Singapore Exchange (SGX)
- cleared FFAs share similar characteristics as exchange traded futures

- FFAs settled on basis of contracts for differences (CDF) principle;

meaning that contract price is agreed at initiation
- contracts are settled at end of each month on basis of average spot freight rate in current month
- in some contracts, settlement price is calculated as average of last seven days
- upon settlement, only difference between settlement price & agreed price is being transferred,
between counterparties
- core players: ship-owners: 20%

charterers & operators: 30%
trading companies: 40%
financiers: 10%
- usually, ship-owners are FFA sellers for hedging purposes;

if freight rates drop, reduction in freight income for owner will be compensated
through gain in forward position
FFA growth
FFA market exhibited exponential growth

- before 2008: total FFA market value = USD 125 bln
annual $ turnover (est.):

$ 25 bln. notional value of freight (dry)
annual cargo turnover (est.):

1.3 bln. tonnes of cargo
volume of trades (est.):

8,000 transactions
(dry: up from 5,000 in 2003)
market volatility excessive

cannot be handled by physical positions only
without freight derivatives...

many more shipping firms would have defaulted
84
main players-organizations involved:
several parties involved in freight derivatives market to make transactions efficient:
- Baltic Exchange
- NOS
- IMAREX
The Baltic Exchange, London
- BALTEX - privately owned company

- offers independent daily shipping market information
- responsible for standardizing a set of routes & producing relevant Indices,

which serve as underlying assets for settlement of freight derivatives
- first Baltic index: 1985 - consisted of 13 voyage routes,

covering bulk vessels from 14,000mt to 120,000mt
- also: weekly reports on sale - purchase & demolition assessments; daily forward rates
- professional ship-broking standards & resolves disputes
- facilitates indices used as underlying values for shipping derivatives
Baltic Exchange & BDI
- guidelines for determining BDI & other BaltEx indices established & monitored by
Freight Indices & Futures Committee (FIFC)
- sets rules & oversees process of daily collecting & processing international independent
shipbrokers panel assessments of freight rates in more than 50 major dry & wet cargo
routes - these prices are used for settlement of FFA transactions
- wide range of vessel & cargo types
- assessments based on recent fixtures, current negotiations & supply of ships - demand for transport
balance
- freight information reported to market at 13:00, London time
- arithmetic average of all received assessments on the day
87
Baltic Dry Index
- Freight Index (number) issued daily by BaltEx

- BDI tracks worldwide international shipping prices of various dry bulk cargoes
http://hypervolatility.com/quantitative-research/the-baltic-dry-index/ 88
http://www.container-transportation.com/baltic-dry-index.html
The Baltic Exchange, London
BaltEx indices
- dry bulk market segments: Capesize (BCI)

Panamax (BPI)
Handymax (BHMI)
Supramax (BSI)
Baltic Dry Index (BDI): avg of all 4 sub-segments
- tanker market: Baltic Dirty Tanker Index (BDTI)

Baltic Clean Tanker Index (BCTI)
- LPG market: Baltic Exchange LPG Index

BDI: Volatility & Crises
BDI: composite basket of global shipping costs for bulk commodities (such as grains, ore & coal);
on major shipping routes; for handysize, supramax, panamax & capesize vessels (BHSI, BSI, BPI & BCI);
constructed on daily professional assessments from panel of international ship brokers
90
Source: Baltic Exchange
BDI Composition
Route Description Weightings
4 Capesizes T/C routes (with 6 other voyage charter routes) to form BCI
C8 172000mt Gibraltar/Hamburg trans Atlantic RV 25%
C9 172000mt Continent/Mediterranean trip Far East 25%
C10 172000mt Pacific RV 25%
C11 172000mt China/Japan trip Mediterranean/Cont 25%
4 Panamax T/C routes to form BPI
P1A 74000mt Transatlantic RV 25%
P2A 74000mt SKAW-GIB/FAR EAST 25%
P3A 74000mt Japan-SK/Pacific/RV 25%
P4 74000mt FAR EAST/NOPAC/SK-PASS 25%
6 Supramax T/C routes to form BSI
S1A 54000 mt Antwerp - Skaw Trip Far East 12.5%
S1B 54000 mt Canakkale Trip Far East 12.5%
S2 54000 mt Japan - SK / NOPAC or Australia rv 25%
S3 54000 mt Japan - SK Trip Gib - Skaw range 25%
S4 54000 mt US Gulf - Skaw-Passero 12.5%
S4B 54000 mt Skaw-Passero - US Gulf 12.5%
6 Handisize T/C routes to form BHSI
HS1 28000mt Skaw / Passero - Recalada / Rio de Janeiro 12.5%
HS2 28000mt Skaw / Passero - Boston / Galveston range 12.5%
HS3 28000mt Recalada / Rio de Janeiro-Skaw / Passero 12.5%
HS4 28000mt US Gulf / NC South America - Skaw / Passero 12.5%
HS5 28000mt SE Asia via Australia - Singapore / Japan 25%
HS6 28000mt S Korea/Japan - S'pore/Japan range incl. China 25%
91
Number of component routes changes according to assessment a judging panel (Oct .2010)
FFAs underlying routes
Dry Market
Baltic Capesize Index (BCI) (150,000+ dwt)
Baltic Panamax Index (BPI) (70,000+ dwt)
Baltic Supramax Index (BSI) (52,000+ dwt)
Wet Market
Baltic Tanker Index (dirty & Clean)
Baltic LPG Index (44,000 cbm)
Platts Assessments
Asian settlement over arithmetic average of official index published by Baltic Exchange
(of worldwide shipping panel - published at 13.00 pm GMT)
Freight derivatives market:

immature as measured by contract value in multiples of underlying commodity
Dry Bulk Market Tanker market

Physical Derivatives Physical Derivatives
$ 420 bln. $ 860 bln. $ 160 bln. $ 180 bln.

Derivatives: average annual contract values.
Containers: not significant derivatives market yet
Source: Junge, A. (2012), Freight Derivatives Navigating Exotic Opportunities 92
Baltic Capesize Index (BCI)
Route Number Description Commodity Route Details
C2 160,000 mt Iron Ore Tubarao to Rotterdam
C3 150,000 mt Iron Ore Tubarao to Beilun & Baoshan
C4 150,000 mt Coal Richards Bay to Rotterdam
C5 150,000 mt Iron Ore W. Australia to Beilun & Baoshan
C7 150,000 mt Coal Bolivar to Rotterdam
C8 Trip-Charter Trans-Pacific Round Voyage (China-Aus-China)
C9 Trip-Charter Europe to Far East
C10 Trip-Charter Trans-Pacific Round Voyage (China-Aus-China)
C11 Trip-Charter Far East to Europe
C12 150,000 mt Coal Gladstone to Rotterdam
Routes 8 to 11 are based on a standard 172,000 mt dwt Baltic Capesize vessel with certain clearly defined
performance measures
FFAs can be traded against any of these individual routes or against the averages of Routes 8 to 11
Most trades concentrate on C4, C7 & average of C8-C11 93
Baltic Dirty Tanker Index (BDTI)
Route Number Description Route Description Indicative Route
TD1 280,000 mt PG to US Gulf Ras Tanura to LOOP
TD2 260,000 mt PG to Singapore Ras Tanura to Singapore

TD3 260,000 mt PG to Japan Ras Tanura to Chiba
TD4 260,000 mt West Africa to US Gulf Bonny to LOOP

TD5 130,000 mt West Africa to USAC Bonny to Philadelphia
TD6 130,000 mt Black Sea / Mediterranean Novorossiysk to Augusta
TD7 80,000 mt North Sea to Continent Sullom Voe to Wilhelmshaven

TD8 80,000 mt Kuwait to Singapore Mena al Ahmadi to Singapore
TD9 70,000 mt Caribbean to US Gulf Puerto la Cruz to Corpus Christi
TD10 50,000 mt Caribbean to USAC (DH) Aruba to New York
TD11 80,000 mt Cross Mediterranean Banias to Lavera

TD12 55,000 mt ARA to US Gulf Antwerp to Houston
TD14 80,000 mt SE Asia to EC Australia Seria to Sydney

TD15 260,000 mt West Africa to China Bonny to Ninqbo
TD16 30,000 mt Black Sea to Mediterranean Odessa to Augusta
Most trades concentrate on TD3, TD4, TD7 & TD8

(Clean Tanker: TC2: 37,000 MT Continent Europe (Rotterdam)/USA; TC5: 55,000 MT AG/Japan)
94
BALTIC DRY INDEX BALTIC DIRTY TANKER INDEX
14.000
2.500
12.000
2.000
10.000
1.500
8.000
6.000
1.000
4.000
500
2.000
0 0
95
IMAREX, Norway
International Maritime Exchange
- founded in 2000
- a freight derivatives market (market place & clearing)
- continuous growth to become a large diversified group
- acts as intermediary & clearer for physical & derivative commodity transactions
- worth over USD 200 bln annually
- provides market analysis, information services & training
- worlds only regulated market for maritime derivatives
- IMAREX offers tanker, dry bulk, bunker fuel oil derivatives

- Freight Forward Agreements, Futures, Options
NOS Clearing, Norway

Norwegian Futures & Options Clearing House
- IMAREX ASA fully owned subsidiary

- offers clearing services for derivatives traded via IMAREX
- purpose of reducing counterparty risk for market agents & intermediaries
- NOS operates under license of Ministry of Finance
- also approved by American Commodity Futures Trading Commission (CFTC)

to carry out clearing of IMAREX trades
in clearing process:
- NOS acts as counterparty between buyer & seller of a derivative contract
- guarantees contract fulfillment
- revenue collected through margin paid by buyer & seller
Number of dry bulk FFAs traded via IMAREX & cleared by NOS; nominal trade value in USD mln
2009: IMAREX registered 900 trades - nominal value USD 669 mln
2003: 26 trades - nominal value USD 177 mln
FFA Trading Volume Dry Bulk Market
1 lot = 1 day of time-charter or 1,000 metric tons of cargo;

e.g. FFA contract for 60 days hire is considered as 60 lots;
FFA contract for transportation of 150,000 metric tons of cargo is considered 150 lots
FFA Trading Volume by Vessel Type
June 2007August 2011
- following 2008 market decline, trading volume in FFA contracts also declined in all dry bulk sectors
- most notable drop: Panamax FFA trading
FFA Cleared vs. OTC Trading Volume
- following credit market squeeze in mid-2008,

FFA market went through a transformation
- participants switched from trading OTC contracts

to cleared contracts
- due to increased sensitivity to credit risk exposure

of OTC FFA contracts
- participants tried to avoid using clearing facilities

offered by clearing houses
(such as London Clearing House (LHC.Clearnet),
- change in pattern of trading FFA contracts Imarex NOS (Norwegian Option Clearing House),
from mainly OTC prior to 2008 to cleared contracts after 2008, Singapore Exchange (SGX))
for Capesize, Panamax, Supramax markets
FFA players
Ship Owners
mitigate risks from possible changes in demand for transportation
(protect break-even cash flow)
trade on market opinion
Cargo Owners
mitigate risks from possible changes in transportation costs
(protect sales margin, protect cif-fob spread, ...)
Operators
mitigate risks from cargo / vessel commitments
Brokers
bringing buyers & sellers together
using freight derivatives as source of information
Financial Institutions
assisting their customers in managing their risks
trading for their own account
- to make a trading profit
- to hedge risks resulting from vessel financing and/or risk management services
providing their customers with clearing accounts
Clearing Houses
facilitate smooth execution of trades
102
mitigate default risk
FFA Buyers - Sellers - Speculators
Buyers (Long) Sellers (Short)
Oil companies, mining companies, Ship-owners,

power plants, short cargo operators long cargo operators
Speculators / Market Makers
Investment banks, institutional investors, hedge funds
103
Source: Baltic Exchange
FFA uses
Hedging
cargo owners (oil companies, commodity houses, power utilities) FFA buyers
Speculation
possibility of profits from falling /rising freight markets
(based on market view different from others)
Speculation: business trading targeting profits form price rises/decreases
(rather than from actual business earnings)
Enhanced trading opportunities

arbitrage trade (e.g. AP12 vs AP 14)
spread trades (TD3 vs TD5, Capesize vs Panamax)
Arbitrage: process of attaining non-risky profits (price differences/inefficiencies)

by buying an underlying asset in one market cheaper
+ selling it in another market higher
Market information
Forward curves
Collateral in ship finance transactions
104
FFA practices
OTC FFAs traded through network of specialist FFA brokers *

members of Forward Freight Agreement Brokers Association (FFABA)
Contract form used: FFBA contracts or

ISDA contract
Counterparties can be anonymous until just before trade terms are concluded
Hedges can be offset prior to expiry
FFA broker (intermediary only) not responsible for contract performance
Typical broker commission 0.25% from each party

on fixed (or expected) freight rate
(it may differ between contracts)
Clearing through LCH.Clearnet, NOS, SGX, CME
* Clarkson's Securities, SSY - Simpson, Spence & Young, Ifchor, FIS - Freight Investor Services, BGC Partners,
GFI Group Inc, ACM Shipping Ltd, BRS, Tradition-Platou, ICAPHYDE 105
FFA practices (cont.)
Standard practices in FFA trading

Usual practice Possible deviations
Commission 0.25% (dry) discount for very large volumes

0.50% (wet)
Settlement (cash) 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, vessel mortgage
market convention:
volume of FFA trades measured in terms of lots
1 lot represents 1000 MT of cargo carried
1-day unit of trip-charter hire
contract size depends on vessel type & route

(around 54,000 tons for a Panamax;150,000 tons for a Capesize)
106
FFA trading steps
Step 1:
Broker establishes trading interest & obtains a firm Bid + Offer
Step 2:
Full trade confirmation agreed verbally with both counterparties
Step 3:
Recap of trade issue detailing main terms
Full contract issued for signing (original kept by broker)
Step 4:
On settlement day, settlement price is calculated & a settlement statement is issued
Step 5:
Settlement funds (cash) paid no later than 5 London banking days
after each settlement day
107
Principle-to-Principle FFA Contract
FFA
Desk / Broker
C8 Avg T/C
Buyer Seller
USD 35,000
FFA contract directly between Buyer & Seller
108
Cleared FFA Contract
LCH / NOS / SGX

Clearing House
FFA
Desk / Broker
FFA contract between FFA contract between
Clearing House & Buyer Clearing House & Seller
C8 Avg T/C
Buyer Seller
USD 35,000
Freight derivatives trades can be given up for clearing to one of the clearing houses that support such freight
derivatives trades. Clearing services are provided by IMAREX/ NOS, CME-NYMEX/LCH.Clearnet, Clarkson
Investor Services, Singapore Stock Exchange.
Why Central Clearing is important ?
Counterparty risk increases... Using a Central Clearing counterparty...
...as traders open numerous FFAs ...simplifies this risk !...
110
Source: SSY
How do FFAs work ?
(1) Settlement vs. Agreed price:

when agreed time has expired...
if final settlement price > HIGHER than agreed rate
FFA seller pays FFA buyer
difference between (settlement price - agreed price)
if final settlement price < LOWER than agreed rate

FFA buyer pays FFA seller
difference between (agreed price - settlement price)
(2) Standard final settlement price:

individual route trades:
average of last 7 Baltic Exchange published Index days of relevant month
period trades:
average of all Index days (calendar month)
(3) Payment settlement:

party owing money at settlement produces an invoice with all bank details included ;
payment is made by telegraphic transfer in USD,
within 5 London business days following settlement date 111
FFA Dry market volume: 2007-2011
FFA traded volumes were more volatile & higher prior to the financial crisis, 112
but have stabilized more recently
FFA Tanker market volume: 2007-2011
113
Recent market evidence
Shipping market crash from Sept 2008 propelled FFA market from 50% cleared to 100% cleared in a matter of weeks
No more bilateral credit risks are taken !
Clear shift from OTC trading to cleared trading; LCH - dominant clearing house 114
Dry FFA Volume Trends
115
Source: SSY
FFA Contract Description: LCH.Clearnet
116
FFA Forward Curves
Forward curve snapshot of current market forward price expectations
an implied market forecast based on all market participants
a method of comparing FFA opportunities against physical options
used for position & portfolio valuations
a key toll for freight market users
117
Forward Curves: Dry market
Spot prices vs forward curve
50000 Cape T/C

Cape FFA curve
45000 Pmx T/C
Pmx FFA curve
40000
Supra T/C Avg
Supra FFA curve
35000
$ / day
30000
25000
20000
15000
10000
Mar-06
Mar-06
Mar-06
Mar-06
May-06
May-06
May-06
Jun-06
q3 06
q3 06
q3 06
q4 06
q4 06
q12 07
q12 07
q12 07
q34 07
q34 07
2008
2008
2008
2008
2008
2008
Apr-06
Apr-06
Source: FIS 118

Forward Curves: Tankers market
Spot Prices vs Forward Curve

350
TD3: AG -East
300 TD7: North Sea to Continent
TD3 - FFA
TD7 - FFA
250
200
150
100
50
0
M 3
3
M 4
4
M 5
5
M 6
6
03
03
04
04
05
05
06
06
-0
-0
l -0
-0
-0
-0
l -0
-0
-0
-0
l -0
-0
-0
-0
l -0
n-
p-
n-
p-
n-
p-
n-
p-
ar
ay
ov
ar
ay
ov
ar
ay
ov
ar
ay
Ju
Ju
Ju
Ju
Ja
Se
Ja
Se
Ja
Se
Ja
Se
M
M
N
N
Source: IMAREX 119
Forward Curve Pricing of Shipping
FFA market provides a unique method for pricing shipping equity,

as forward curve presents market consensus of revenue stream moments
Use forward curve to evaluate market expected future T/C earnings 120
FFA Benefits vs. Risks
Benefits Risks
risk management (stabilize cash-flow) credit risk
guarantees freight rates (up to 3 years forward)

volatility of market
buy/sell positions prior to expiry (flexibility)
limited forward period (usually up to 2-4 years)
easy to fix & close out positions
hedging & speculation different approaches
price discovery
basis risk
no restrictions to physical operation
(retain control of vessels & of specific types of cargos)
liquidity risk
easily understood & quickly traded
less risky than physical market
no re-negotiations from parties as in physical
121
FFA Credit Risk
Credit risk particularly relevant for shipping derivatives market,

since most of paper trades are done on a principal-to-principal basis
Trading cleared contracts

- IMAREX with NOS in Oslo offer cleared FFAs & Options
- London Clearing House(LCH), CME, Singapore Exchange
Cleared FFAs provide protection against counterparty default, however:

- margin requirement & initial deposits tie-up a lot of capital
- margining & marking-to-market may create a cash-flow mismatch
between paper & physical markets
122
FFA Future Trends
Freight as a new commodity

investors constantly search for attractive asset classes
FFA market grown sharply

(following deregulation & liberalization in European energy market,
as energy & other traders seek to manage freight risk)
High shipping market volatility; attracted interest from investors outside shipping
(such as hedge funds)
Credit risk & Clearing

(clearing will also attract new players; facilitates & speeds-up negotiations)
Electronic Trading
123
FFA Future Trends
Emergence of Freight Options

- Asian options on freight rates
- create opportunities for asset owners
- pricing & risk management issues
Growth of paper market on shipping freight

- more extensive use of risk management techniques & instruments
- concerns of credit risk
Entrance of new players in shipping markets

- trading houses, energy companies, investment banks & hedge funds
124
Shipping Information
specialized organizations collect disseminate information on fixtures, prices,

cargos, vessels available
market participants can make informed - rational decisions

Baltic Exchange
International Maritime Exchange (IMAREX)
Lloyds Marine Information Services (LMIS)
Lloyds Register of Shipping (LRS)
Clarkson Brokers
Platts
Lloyds Shipping Economist
Lloyds List
Bloomberg etc.
http://www.clarksonsecurities.com/drycargo.aspx
http://www.freightinvestorservices.com/freight/ffas 125
http://www.freightinvestorservices.com/market-information/glossary
http://www.bfl.co.uk/products/freight-futures.html
More participants in FFAs
126
Practical Cases
on Freight Derivatives Uses
127
1. FFA Hedging example 1
Dry Market Hedging
Today:
steel trader, based on China - may believe spot freight rate likely to rise
agrees fixed price of $30 p. ton for 150,000 tons of Australian iron ore,
to be shipped in 1-month freight budget: $30 p. ton $4.5 mln.
128
Dry Market Hedging
To lock in freight budget

(W. Australia /
/ Beilun-Baoshan)
buys FFA through a broker at $30 p. ton (contract rate),
for 1-month (contract period), for Capesize Route C5 (contract route)
129
Dry Market Hedging
Counterparty (= FFA seller)
shipping firm, active on same C5 route - may believe spot freight rate likely to fall
wish to lock-in min. freight price of $30 p. ton
130
1. FFA Hedging example 1 (cont.)
Dry Market Hedging (cont.)
In 1-month (contract-end):
under FFA terms, at month-end (settlement date),

Chinese steel-trader pays / receives cash from c/party,
depending on actual level of Index for this route on settlement date
Assume:
actual C5 spot rate = $32 p. ton +$2 p. ton on contract rate
Physical market: freight cost= $32 p. ton x 150,000 tons = $4.8 mln.
(+$300,000 over budget of $4.5 mln.)
Final outcome: Chinese trader receives $300,000 payment from c/party

(on spot rate FFA rate difference)
($300,000 = $2 p. ton x 150,000 tons)
Implication: actual freight cost

protects freight budget (keeps it at $30 p. ton) !
131
2. FFA Hedging example 2 spot voyage
Today 4-Dec-12:
shipment to take place 31-Mar-13

54,000 tonnes grains shipped from US Gulf to Japan
spot freight rate = 23.76 $/tonne

spot freight cost = $1,283,040 (= 54,000 * 23.76)
charterer considers an FFA hedge:

i.e. buy a route 2 FFA for settlement in Mar-13 grains from US Gulf
to Japan
route 2 FFA = 23.90 $/tonne
FFA-contract premium = + 0.59% vs. spot (23.76 $/tonne)
expected total freight = $1,290,600 (= 54,000 * 23.90)
charterer locks rates at FFA level by buying route 2 FFAMar13
market view: route 2 freight rates will increase between Dec to Mar
132
2. FFA Hedging example 2 spot voyage (cont.)
31-Mar-13
spot freight rates up = 25.20 $/tonne
(new) spot freight cost = $1,360,800 (= 54,000 * 25.20)
route 2 FFAMar13 settlement price up = 25.14 $/tonne

(calculated as avrg rates of route 2 over last 7 March trading days)
expected freight : $1,357,560 (=54,000 * 25.14)
Physical market LOSS: $ 70,200 (= 1,360,800 1,290,600)
FFA market PROFIT: $66,960 (= 1,357,560 1,290,600)
Final result Loss - $3,240
FFAs for hedging reduced substantially adverse impact of freight rates increase
133
3-Month Hedge for period: 4-Dec-12 to 31-Mar-13
Physical (Spot) market FFA (Forward) market
4-December-2012
route 2 freight rate:23.76 $/tonne FFAMar13 route 2 : 23.90 $/tonne

spot freight cost: $1,283,040 (= $54,000 * $23.76) expected freight: $1,290,600 (= $54,000 * $23.90)
Charterer buys FFAMar13 route 2 contract
31-March-2013
route 2 freight rate: 25.20 $/tonne FFAMar13 route 2: 25.14 $/tonne

spot freight cost: $1,360,800 (= 54,000 * $25.20) expected freight: $1,357,560 (= $54,000 * $25.14)
Loss in the physical market: Profit from FFA transaction:

- $ 70,200 (= $1,360,800 - $1,290,600) + $66,960 (= 1,357,560 - $1,290,600)
Net result from hedging = - $3,240 134

3. Freight Options: Call
CALL option example:

(Ras Tanura to Chiba)
You buy a TD3 Call Option, Spot WS100
Q4 13, WS120 Call Cost: WS10
why WS130 ???

Q4 13 - Result:
If the market goes above WS130

you have all the profit
why WS10 ???
If the market falls
you only lose WS10 points
135
4. Freight Options: Put
PUT option example:

(Ras Tanura to Chiba)
You buy a TD3 Put Option, Spot WS100
Q4 13, WS80 Put Cost: WS10
why WS70 ???

Q4 13 - Result:
If the market falls below WS70

you have all the profit
why WS10 ???
If the market rises
you only lose WS10 points
136
Appendix
More Case Study Examples on FFAs
137
Tanker Hedging
April 2013 (80,000 mt North Sea

to Continent)
TD7 contract trades at WS 125 for June
Energy trading company worries freight rates to increase over following 12 weeks;
decides to use FFAs to cover this risk
Charterer buys 80 TD7 June 2013 contracts @ WS 125

(each contract being for 1,000 tons)
Worldscale: used as basis for calculation of tanker spot rates; worldscale points show cost of transporting a tonne of cargo using a standard vessel on a round voyage,
also known as Worldscale 100.
Worldscale (WS) = a unified system of establishing payment of freight rate for a given oil tankers cargo. WS was established in Nov. 1952, by London Tanker Brokers
Panel, as an average total cost of shipping oil from one port to another by ship (a large table was created). The same scale is used today but merged with American Tanker
Rate Schedule (ATRS) in 1969. By 2002, the table included average cost of 320,000 voyages in permutations of from one load and one discharge port to five loads & ten
discharge ports. The freight for a given ship & voyage is normally expressed in a (%) of published rate & is supposed to reflect freight market demand at time of fixing. In
negotiating a price to pay, the table is referred to as WS100 or 100% of Worldscale. The actual price negotiated between ship-owner and charterer can range from 1% to
1000% and is referred to respectively as WS1 to WS1000, depending on how much loss the first is willing to take on that voyage and how much the latter is willing138 to pay.
Tanker Hedging (cont.)
June 2013
TD7 Settlement Price: at WS 156.15

(calculated as average of TD7 freight rate assessments over June)
Physical market: charterer incurs a loss

(due to higher freight rates)
FFA market: charter makes a profit in FFA market

(bought contract at lower rates)
Net WS = 156.15 125 = WS 31.15
Settlement = Contracts x Lot Size x Flat Rate x net WS

= 80 x 1,000mt x $4.30/mt x 31.15% = $107,156
139
ship-owner has vessels coming open early next year;

worried about securing employment at attractive rates
(especially over Christmas & early new year period)
decides to hedge this exposure from Jan to Mar 2013

by selling the T/C average for this period
FFA type: Time / Charter Contract

Buyer: TUV Operator
Seller: XYZ Shipping Corporation
Price: $11,750
Duration: Jan / Feb / March 2013; 00- 91 days
Settlement: Average of all Index days with monthly settlement
140
Results of Hedges
January:
January Average: $11,000
Trade Price: $11,750
Difference: $750 x 31 days = $23,250
February:
February Average: $11,500
Difference: $250 x 29 days = $7,250
March:
March Average: $12,250
Difference: $500 x 31 days = ($15,500)
Net Hedge Result = $23,250 + $7,250 - $15,500 =

= $15,000 profit
141
Charterer: needs to ship 10,000 metric tons (mt)

from Europe to US Atlantic Coast for October 2013
June 25
Physical market vs. FFA market
TC2 tanker route spot freight rate $30.5457/mt
TC2 FFAOctober contract price $25.2241/mt
To lock freight rate at $25.2241/mt buy 10 x FFAOctober contracts

(i.e. 1 FFA contract = 1,000 mt)
Settlement (Closing) Price for

October TC2 Rotterdam to USAC 37K ($/mt)
Physical market vs. FFA market Contract June 25 June 22 June 21
June 2013 30.5457 29.3466 31.1746
TC2 tanker route spot freight rate $26.5973/mt.
July 2013 24.4265 24.6259 24.6259
TC2 FFAOctober Settlement Price $26.5328/mt
(= average of rates for each business day within October) August 2013 25.7226 25.5232 25.5232
September 2013 25.5232 25.1152 25.5140
October 2013 25.2241 25.2241 25.2241
Source: CME
Results
Physical market COSTS - $265,973 = (26.5973 * 10,000)

FFA market GAINS + $13,087 = ((26.5328- 25.2241) * 10,000)
Final Realized Outcome (COST)Shipping Cost - $252,886 or $25.2886/mt (= lower than spot rate !) 142
(= slightly higher than expected rate, $25.2241/mt, because FFA settlement = average of rates instead of spot rate)
Situation
May 1
Ship-owner charters out 75K dwt Panamax in spot market
on a 60-day contract - at $15,000 per day
assumes freight rates will drop in near future
wants to lock in rate that (s)he can charter out the vessel, after current contract expires
May 1
Ship-owner sells a Q3 Panamax 4TC contract (20 days per month) for $12,250
Aug 1
Ship-owner receives his ship back + fixes it out on another 60-day contract
at prevailing rate of $11,000 per day
Aug 1
Closes out his FFA position by buying back a Q3 Panamax 4TC contract for $10,000 per day
143
8. FFA Hedging example 8(cont.)
Calculations
Revenue from chartering out ship on 60 day contract:
$11,000 x 60 days = $660,000 (1)
Profit from closing out FFA position: ($12,250 - $10,000) x 60 days = $135,000 (2)
Total Profit (1+2): $795,000 or $13,250 per day
Conclusions
ship-owner manages to secure his fixing
on a 60 day contract at $13,250 per day (in real terms)
(a rate which is $2,250 better than current market rate due to FFA use)
ship-owner can then continue to pursue such a policy further on

by buying/selling FFAs, should he finds rates attractive + wants to lock them in again
144
9. FFA Trading example 9
Situation
May 1
trader thinks that current freight rates are too depressed

is bullish about freight rates rising towards year-end
has option to either buy a ship to take advantage of that

or buy an FFA to avoid having to pay cash up front
trader decides to buy an FFA
May 1
trader buys a Q4 Capesize 4TC full contract (30 days per month) for $21,500
keeps the position open - settles the position in Oct, Nov & Dec respectively based on settlement
price of $28,500, $26,750 & $31,000 respectively
145
9. FFA Trading example 9 (cont.)
Calculations
Oct settlement: ($28,500 - $21,500) x 30 days = $210,000

Nov settlement: ($26,750 - $21,500) x 30 days = $157,500
Dec settlement: ($31,000 - $21,500) x 30 days = $285,000
Total profits from FFA: $652,500
146
10. FFA Hedging example individual trip-charter route
2 month-hedge - 2 July 2013 to 31 August 2013
PHYSICAL MARKET FFA MARKET
2 July 2013: route C2 freight rate: $11,158 / day FFA Route C2 Aug. 2013: $10,050 / day
Spot freight income: $ 669,480 (= $ 11,158 x 60 days) FFA income: $ 603,000 (= $10,050 x 60 days)
FFA trades at 9.93% discount (10,050/11,158 - 1) compared to physical rate market indication of falling freight rates between July end August.
Shipowner sells FFAAug2013 contract (to lock expected income)
31 Aug. 2013: route C2 freight rate: $ 7,483 / day FFA Aug.2013 settlement price: $ 7,545 / day
Spot freight income: $ 448,980 (= $ 7,483 x 60 days) Settlement freight result: $ 452,700 (= $ 7,545 x 60 days)
Result in physical market (1) Result in FFA market (close-out position) (2)
Loss = - $154,020 (= $448,980 - $603,000) Gain = $150,300 (= $ 603,000 $ 452,700)
Net result from Hedging (1+2) = - $3,720 * (better than -$154,020)
* Loss does not refer to actual monetary loss but rather to notional loss from fixing a rate below anticipated rate in July;
it reflects the opportunity cost for (not) hedging.
Shipowner to pay also brokers commission typically 0.25% of total freight rate (= 0.25% * $ 603,000 = $ 1,507.50)
C2 160,000 dwt Iron ore Tubarao (Brazil) to Rotterdam (Netherlands) (BCI: 10%)
147
11. Freight Option Hedging on FFAs
Freight options traded at IMAREX allow option holder right to buy (call) / sell (put) an FFA at a predetermined price;
traded OTC or cleared at Clearing House (NOS) (by paying fee = 1.25% of option premium)
Today
Option TC2October2013 strike (exercise) price $25.2241/mt
Option premium $0.8/mt
To hedge freight rate

charterer buys TC2October2013 option pays $8,000
(option for shipping 10,000 mt)
148
11. Freight Option Hedging on FFAs (cont.)
October
SCENARIO 1 rising prices
Physical market actual freight rate $26.5973/mt
Settlement Price of TC2October2013 option $26.5328/mt

(= average of rates for each business day within October)
Spot price > Strike price $26.5973 > $25.2241

charterer exercises option !

Freight Option market GAINS + $13,087 = ((26.5328 - 25.2241) * 10,000)
Final Realized Outcome (COST) (- $252,886) + (- $8,000)= -$260,886 or $26.89/mt
149
11. Freight Option Hedging on FFAs (cont.)
October
SCENARIO 2 falling prices
Physical market actual freight rate $23.5973/mt
Settlement Price of TC2October2013 option $23.5328/mt

(= average of rates for each business day within October)
Spot price < Strike price $23.5973 < $25.2241

charterer DOES NOT exercises option !

Freight Option market COSTS - $8,000
Final Realized Outcome (COST) (- $235,973) + (- $8,000)= -$243,973 or $24.3973/mt
150
12. Hedging Freight Rates with Freight Option
2 Apr 2013
trading house sales 70,000 tons of thermal coal from Richards Bay, South Africa to Europe
shipment to take place on 31-Oct-13 - market view: freight rates may increase
spot freight rate on BPI route A1 = 7.26 $/ton (= 70,000 tons of Coal from Richards Bay to N. Europe)
spot vessel chartering freight expenses $508,200 (= 7.26 $/ton * 70,000 tons)
charterer could use FFA to lock in a specific freight cost
BUT inflexibilities in FFAs not advantage of potential freight rate decline
alternative freight risk hedging approach:
buy CallOct13 option for BPI route A1

(broker finds a counterparty willing to write such an option)
strike price = 7.5 $/ton
premium = 0.60 $/ton Total Premium = $42,000 (= $0.60 * 70,000)
151
12. Hedging Freight Rates with Freight Option (cont.)
31 Oct 2013
Scenario 1: Falling market
spot freight rates down to 4.86 $/ton
charterer prefers to fix tonnage at that rate
total freight expenses at $340,200 (= 4.86 * 70,000)
lower freight expenses vs. Apr-13 by: $168,000 (=$508,200-$340,200)
strike price > spot price (7.50 > 4.86)
option NOT exercised let it expire !
Final result = - $382,200 (= -$340,200 - $42,000)
152
12. Hedging Freight Rates with Freight Option (cont.)
31 Oct 2013
Scenario 2: Rising market
spot freight rates up to 9.50 $/ton
total freight expenses = $665,000 (= 9.50 * 70,000)
higher freight expenses vs. Apr-13 by: $156,800 (=$665,000-508,200)
strike price < spot price (4.86 < 9.50)
option WILL BE exercised !
Final result = - $567,000 (= (-$7.5 * 70,000 = $525,000) - $42,000) vv
Better outcome than spot (- $567,000 vs. $665,000)
Implicit Gain = $ 98,000 (= -$567,000 + $665,000)
153

1 MS&T-NCL U-Mar8043 - Part1 NCL

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

1 MS&T-NCL U-Mar8043 - Part1 NCL

Uploaded by

Copyright:

Available Formats

NEWCASTLE UNIVERSITY

School of Marine Science and Technology

Financial Risk Management

Financial Risk Management in Shipping

Concept of Risk & Risk Management

Shipping Markets & Risk

Shipping Risk Management Basics

Forward Freight Agreements (FFAs)

Practical Cases on Freight Derivatives

Appendix: Recent Trends in the FFA Market

Options Contracts: Basic Positions

to build a theoretical & practical understanding on a set of sophisticated techniques

Forward Freight Rate Agreements (FFAs)

hedging freight risk in shipping with FFAs

By the end of this module, students should be able to:

comprehend critical role, properties, operations of financial derivatives markets

familiarize with function of key derivatives instruments (futures & options),

implement modern risk management techniques, predominantly hedging, to control for

Alizadeh, A. & Nomikos, N. (2009):

Kavussanos, M. & Visvikis, I. (2006):

Grammenos, C. (2010, 2nd ed.):

Stopford, M. (2009, 3rd ed.):

Hull, J. (2014, 9th ed.):

Chapter 28 - Syriopoulos, T. (pp. 568-603):

Chapter 29 Thanopoulou, H. (pp. 605-630):

Chapter 30 - Kavussanos, M. (pp. 661-692):

chance (probability) that a decisions (investment) actual outcome (return)

measurement: standard deviation of historical (or average) returns of a specific investment

standard deviation = high risk level = high (investments volatility)

fundamental relationship: risk return

key components: risk assessment & evaluation

a chance of bad consequences

2 critical components to define risk:

probability (chance) of occurrence

Some risks cannot be quantified

Risk is evolving permanently

Models are only models

Some risks can be quantified:

- consequence of occurrence: variation of P&L

- consequence of occurrence: loss given default

Not a single measurement can capture all aspects of risk !

What RISK.. .. for what RETURN ?

Risk Management : set of approaches, techniques, instruments to

Identify + Quantify + Manage Risks

identification of all significant

monitoring + evaluation of performance & suitability of risk assessment + analysis of potential

- across vessel sizes - types

Risk management = imperative !

not 1 but sub-divided in 4 interrelated core market segments !

Demolition (Scrap) Market

Source: M. Stopford (2009) ton-miles

Freight Income primary ship-owners revenue

BUT.. sea-transport freight rates = extremely volatile

freight rates fluctuate

Fundamental factors driving freight rates

Market cyclicality: well known phenomenon in various industries worldwide;

critical in shipping industry:

Shipping cycles: irregular, with no firm rules about length or timing;

Distinction between: long-term trend vs. short-term cycle

Freight market volatility Baltic Dry Indices

Freight market volatility Baltic Tanker Indices

5 main risks in shipping:

- importance for ship-owners