What is Freight Risk?

Shipping is a business activity which is exposed to a wide variety of risks. One particular form of such shipping risk is the freight market riskwhich the risk of loss arising from unexpected changes in the freight rates. Freight risk usually refers to the risk a ship owner (long) or a shipper(short) faces when buying freight services on the spot market. The rate is not the only specification of the freight contract. Different from asset like equities or even commodities like electricity, freight comes in a lot of different flavors: the owners have different requirements, e.g. on the vessel in terms of safety, reliability and special capability. The agreed speed of the ship is also important to determine a price. Thus a shipper might accept a higher quality bid from a ship owner, without it being the lowest achievable price. The other important assumption used is deep liquidity. As all stocks or bonds of one type traded are basically equal, a fully liquid market is reached at a lower trade volume. There are currently about 6000 active vessels of the size the Baltic Indices covers. Assuming the VLCC size ship only does 6-8 round trips a year this specific vessel is available only few times a year in the market. The owner has only at these intervals the chance to bargain for a rate and has to execute the agreed rate at all other times. For example he might be stuck in a 3Y time charter without recourse when suddenly the demand picks up and the notorious spot rate spikes appear. And at last many of the freight contracts are not traded on an exchange but are OTC agreements. Even they add to the overall liquidity of the market , it is hard to put them in the frame of fixed quotes, like the model contract.

Justification for Risk Management in Shipping

The fluctuation of shipping freight rates (freight rate risk) is an important source of market risk for all participants in the freight markets including hedge funds, commodity and energy producers. With roughly 90% of the world s traded goods by volume transported by sea, the ability for ship owners, operators, and charterers to control the cost and risk of transporting freight including freight rate volatility is a key to managing supply chainmargins and

enterprise risk. Whether one runs a trading desk, are a risk manager, trade FFAs, or invest in the shippingmarkets, the level of complexity grows each day. Having advanced systems to identify, measure, and manage freight rate risk is increasingly important, especially when measuring the impact of freight rate variability on cash flow performance. As the freight derivatives market grows in sophistication, so does the range of strategies used. Freight rates have historically been volatile. The impact of unforeseen geo-political events and the slow speed of adjusting supply to demand have often resulted in dramatic fluctuations in the level of freight rates.

Definition
The Baltic Dry Index is a daily average of prices to ship raw materials. It represents the cost paid by an end customer to have a shipping company transport raw materials across seas on the Baltic Exchange, the global marketplace for brokering shipping contracts. The index is quoted every working day at 1300 London time. This index can be used as an overall economic indicator as it shows where end prices are heading for items that use the raw materials that are shipped in dry bulk.

Importance
As the BDI increases, so effectively does the cost of raw materials. This cost associated with procuring the materials must be passed along the value chain by producers and refiners. In the end, consumers will see higher dry bulk rates in the higher prices they pay for goods derived from these raw materials. For example, when Folgers pays an extra $10/ton to import coffee beans, they will pass along this increased procurement cost to consumers to maintain margins. Additionally, imported goods may often carry a BDI factor in the prices. An example of this would be the average Chinese imported good. As China transformed from coal exporter to importer, they began buying coal from nations such as Russia, Brazil, and Australia. The coal from the latter two must be shipped using dry bulk carriers. As the rates for the BDI went up in 07, so did the cost of coal to China. Since coal is used for 70-80% of China's energy generation,overhead costs for factories increased with the price of coal. As the overhead costs increase, so must the price of the end good to maintain the margin of profit. As this end price increased, an American paid more for a t-shirt or toy at Wal-Mart.

Example of fluctuation in Baltic Dry Freight Index

Freight Risk Management

A freight Risk Management solution analyses position, including vessels, Freight Forward Agreements (FFAs), Contract of Affreightments(COAs), cargo bookings, cargo relets, and options. The advanced solution graphically displays a consolidated view of total physical and paper freight risk exposure, mark-to-marketanalysis, and long/short position. Additionally, the solution should provide a monthly breakdown of total days and value exposure, coupled with yearly and grand totals for the entire exposure period selected. The system also manages bunker exposure by combining the exposure from physical contracts and bunker swaps. Customers can calculate option premiums specifically aimed at the Shipping Industry and perform mark to market based on the next open port.

Freight derivatives, including FFAs, bunker swaps, and options, are primarily used by ship owners and operators, oil and trading companies, and grain houses as tools for managing freight rate volatility. Good freight risk management will give the following benefits.
 Enabling freight providers to minimize risk reduce overhead costs and ensure that 

   

operational compliance requirements are delivered. Enabling freight providers to reduce communications risks, such as the information and data that narrows the gap between regulatory expectations and infrastructure capabilities. Enabling freight providers to accurate import data that traces the importation process back to the origin of the goods. Enabling freight providers to accurately assess the true landed cost of an import shipment. Enabling freight providers to provide more details about shipments and shipment data while offering a higher level of customer service. Enabling freight providers to handle more complex processes, taking less time, and without that intensive software interaction from the operators.

Freight Derivatives Mechanism for Freight Rate Risk hedging.

Freight Derivatives, which includes Forward Freight Agreement (FFA), container freight swap agreements and options based on these, are financial instruments for trading in future levels of freight rates, for dry bulk carriers, tankers and containerships. These instruments are 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, BraemarSeascope LTD, Ifchor, FIS Freight Investor Services, BGC Partners, GFI Group Inc, ACM Shipping Ltd, BRS, Tradition-Platou, ICAPHYDE and IMAREX); but screen-based trading is becoming more popular, through various screens. Trades can be given up for clearing by the broker to one of the clearing houses that support such trades. There are four clearing houses for freight: NOS Clearing, LCH.Clearnet, NYMEX (NY Mercantile Exchange) and Singapore Stock Exchange (Singapore). Freight derivatives are primarily used by ship owners and operators, oil companies, trading companies and grain houses as tools for managing freight rate risk. Recently with Commodities now standing at the forefront of international economics; the large financial trading houses, including banks and hedge funds have entered the market.

What are FFAs and how do they work?

An FFA is a forward freight agreement. It allows ship owners, charterers as well as speculators to buy and sell the price of freight for future dates. In the shipping industry, the underlying asset is the freight rate for a specific physical trade route which receives a daily assessment on one of the Baltic ExchangeIndices. While not all routes receive such an assessment, as demand for FFAs increases, the Baltic Exchange continually evaluates additional trade routes for inclusion in the indices. Freight derivatives serve as a means of hedging exposure to freight market risk by providing for the purchase and sale of a freight rate (the contract rate ) along a named voyage route (the contract route ) over a specified period of time (the contract period ). Contracts are cash settled, and there is no physical delivery. On settlement, if the contract rate is less than the average of the rates for the contract route over the contract period (the settlement rate ), as determined by reference to the relevant index, the seller of the FFA is required to pay the buyer an amount equal to the difference between the contract rate and the settlement rate multiplied by the number of days specified in the contract (the settlement sum ). Conversely, if the contract rate is greater than the settlement rate the buyer is required to pay the seller the settlement sum. The freight derivatives market began with the trading of voyage rates for certain dry cargo routes in the early 1990 s and later was expanded to include wet tanker routes. Until recently FFAs were used almost exclusively by participants in the shipping industry, such as shipowners and charterers, to hedge against fluctuations in freight rates. As the basic forms and means of trading FFAs have evolved, new participants such as investment banks and financial institutions have entered the market for the purpose of speculation. The conventional wisdom is that the paper market for FFAs will soon come to surpass the underlying physical market in terms of dollar value.

The International Maritime Exchange or Imarex is an Oslo-based exchange for trading forward freight agreements (FFAs). It started trading tankerfreight futures contracts in 2001, followed by dry cargo freight futures contracts in 2002. All futures contracts are cleared by the Norwegian Futures and Options Clearing House (NOS). Imarex is owned by Imarex ASA (formerly known as Imarex NOS) and has subsidiaries in Oslo, Singapore, Genova and Houston (USA). The International Maritime Exchange ( Imarex ) in Norway is the principal exchange dedicated to FFAs and uses the Norwegian Futures and Options Clearinghouse ( NOS ) to clear its transactions. Until recently, Imarex/NOS was the exclusive forum for clearing freight futures trades. However, in 2005, due to increasing demand from FFA traders, the New York Mercantile Exchange (NYMEX) and LCH.Clearnet also began clearing trades. Later in 2006, Forward Freight Agreement Brokers Association ( FFABA ) members Clarksons,

Ifchorand Freight Investor Services plan to launch a multi-user screen based trading system which they have jointly developed as part of an effort to generate more FFA futures trading.

Freight rates volatility affecting sourcing of grains

In early 2008 , Ocean freight rates for grain and oilseeds have moved steadily higher over the last 12 months after having moved erratically lower over a period of about three years. This rise has become quite steep in recent months and the peak rates of March 2004 have been surpassed.

For many years prior to 2003, the dry bulk cargo sector of the ocean freight market had been plagued by apparent excess capacity. The grain trade was therefore benefiting from very competitive transportation rates. Typical costs were about four times lower than current costs on trans-Atlantic grain routes. However, growth in trade, particularly iron ore and coal, as well as some port congestion, mainly in China, led to higher levels of vessel utilization in 2003 and 2004. A rise in freight rates resulted in incentive returns for ship owners and additions were made to the dry bulk fleet. Net additions to the ocean fleet have averaged over 20Mt over the last four years, more than twice the growth rate of the four prior years.

Until 2006, freight rates were generally trending down, albeit erratically. The dry bulk fleet was increasing over 5% a year and seemed to keep pace with growth in demand. But this downward trend has been reversed over the last 12 months. Freight rates on the US Gulf - European ports route have increased from about US$24.00/t a year ago to US$52.00/t in late July, rising very steeply in recent weeks. Rates on this route reached US$42.00/t in March 2004. Dry bulk sector: grain and oilseed freight rates influenced by vessel shortage for other industries Grain and oilseed trade represents only 10% of the total bulk ocean freight market and is declining. The volume of grain trade is relatively stable between years, although it can be quite seasonal on certain routes. Relatively small vessels up to Panamax size (60,000t to 70,000t) tend to be used as cargoes starting places and destinations are dispersed, more than for other sectors of the freight market. The ocean freight market is driven by the iron ore, coking coal and steel sectors which are largely complementary to each other and represent about half of bulk cargoes. Those sectors have shown most of the growth in trade but are also raising most concern over future prospects for continued growth. The major contributor to the ocean freight market is China, mainly thanks to its expanding steel production which has risen from under 25% of world output to over a third in the last three years. This major portion of the market has starting places and destinations more centralized than others. Thus, larger vessels (Cape size, 120,000130,000t) and more specialized onshore facilities are used. Freight rates on Cape-sized vessels have been more volatile than on Panamax and smaller vessels in recent years. The former also appear to have led the latter.

The capacity of both floating and onshore facilities of the Cape market has been frequently under pressure. In particular, in relation to the growth in the Chinese steel trade, onshore facilities have proved to be manifestly inadequate to manage congestion at ports. Port congestion appears to be most serious at Australian coal and iron ore loading facilities. Although the situation has improved slightly, typically about 140 vessels have been laying at anchor waiting to load coal at east coast Australian ports during 2007. This is about twice the number waiting in years prior to 2007. Reducing these queues would increase the effectiveness of the existing fleet. But such a solution is probably not quicker than building more vessels. The tight supply situation in the Cape-sized/steel trade related sector, affected mostly by those port congestions, was soon reflected in the more general Panamax and smaller-sized vessel sector of the market. Indeed, coal and iron ore shippers sought alternatives to Cape-sized vessels opting for smaller ones. Hence, costs to the grain and oilseed trade have increased and any immediate relief of freight rates is not anticipated. In the longer term, more vessels, and/or improved inland facilities, and/or a slow down in the growth in Chinese steel production would resolve the situation. The tight cereal situation have driven freight rates upward further In recent weeks before June 2007, the grain sector had evolved independently from the rest of the dry bulk market. A surge in purchases by key importers has resulted in increased freight booking from North American ports in July. Even when supplies from the EU and the Black Sea regions are much less abundant this year compared to last season and virtually no Australian wheat is available. Indeed, North African and Middle Eastern wheat importers could not rely on their usual European and Former Soviet Union suppliers due to this year s grain shortage. The

volumes may not be large relative to iron ore and coal but they may well have had a significant impact on prices as the ocean freight supply situation was so tight. In this season, grain exports do involve longer distances and add to overall demand for ocean transport. However, the surge in business is not expected to be sustained and may simply be the forward movement of ongoing business. Therefore, there may be a relative lull in the booking of grain cargoes later. Ultimately, it will be the larger iron ore/coal/steel sector of the dry bulk cargoes market which will determine the future of ocean freight rates which at the moment is very uncertain.

Freight Rates outlook in 2011

Freight rate volatility on the Asia-north Europe route has increased since the European Commission banned the Far Eastern Freight Conference (FEFC) by repealing its block anti-trust exemption in October 2008, according to new Alphaliner research. Freight rate volatility on the Asia-north Europe route has increased since the European Commission banned the Far Eastern Freight Conference (FEFC) by repealing its block anti-trust exemption in October 2008, according to new Alphaliner research. Subsequently, Asia-north Europe trades have experienced rate volatility in a 20% range every year compared to a pre-ban annual average 14% fluctuation over the previous 10 years, its report concludes. Rates on the non-European trades tracked by the CCFI (China Containerised Freight Index), trades which retained conference immunity, showed less volatility during the October 2008-2011 period, researchers note. This evidence suggests that the absence of the Far Eastern Freight Conference has resulted in an increased rate volatility compared to trades which continued to enjoy anti-trust immunity.