A freight derivative is a financial contract between two parties, which sets an agreed future price for carrying commodities at sea. The contract does not involve any actual freight or any actual ships. It is purely a financial agreement - much like that found in other commodity futures markets. At Marex Spectron you can trade Freight Futures, Freight Options and OTC Freight Forwards (FFAs).
Shipping markets are large commodity markets and all characteristics for financial derivatives are present. Tanker and Dry bulk chartering both have a significant underlying market size. Both markets experience very high volatility in spot and long term prices. Exceptionally high volatility in the price of freight, means that in the physical underlying markets - which are the world shipping markets, natural buyers (refiners, importers, traders etc) have to take into account a high risk of price movements in freight when calculating the cost of transport. At Marex Spectron, Principals (those trading directly for their own account) trade freight derivatives electronically on screen in real time, or via an Marex Spectron Exchange Broker. All principals trade anonymously, and with the security of "Straight through Clearing".
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.
The same reason that people book airline flights months in advance. Sometimes they might want to ensure that they are guaranteed a seat on the plane. Sometimes they spot what they consider to be a cheap fare, so they lock in the rate. In addition to this – speculators also participate in the freight derivatives market (FFA market). They might see a rate that they consider to be either too high or too low. They will then buy or sell at that forward price accordingly.
Many times they do, but as more owners become familiar with the freight derivatives market – they realise they can hedge their position with a much more seamless transaction.
With a freight forward agreement, you only pay commission of about .4% per trade. There are no delivery or redelivery issues. There are no bunker clauses. There is no off-hire. You don’t have to worry about cargo contaminations, drunk crew members or collisions. In other words, you can keep your ship under your own control – but effectively charter out its “equivalent” in the paper market.
The way you would lose money on the paper trade would be if you sold on a forward (the equivalent of putting your ship out on time-charter) – and the spot market went up. When you went to buy back your position in the future, it would cost you more than you sold it for. You have basically sold low and bought high. The goal of course when selling forward is to sell high and buy low. But – you need to remember that had you put out your ship on time-charter, you would be locked into a revenue stream – and not enjoying the rising market.
You need to view it a different way. Let’s go back to the paper trade. You sold forward – and rates went up. When you go to buy back this contract at higher price – you lose money. But – and this is the key – you still have your ship trading in the spot market. So your physical position is making more money. The increased revenue from your spot ship can be used to offset the losses you incurred on the freight forward agreement (FFA) trade.
Effectively – yes. There is always some “slippage” in any market – but you have been able to lock in an estimable revenue stream. This is the point of the hedge. Let’s go back to the time charter issue for a second. You had commented that if you put your ship out on time-charter, that you don’t actually lose money in a rising market. This is not true. You have lost the opportunity cost of having your vessel earning higher spot returns. You have effectively locked in at a given rate level – which brings us back to the paper trade you made when you sold the freight forward agreement (FFA). The paper trade and putting the ship out on time-charter amount to the same results.
Well – first, keep in mind the results are not exactly the same. But more important – freight forward agreements provide for a cleaner transaction. While ship owners and charterers are quite adept at working the time-charter market, there will always be issues with one person owning the ship and another person operating the ship. Shelltime 4 is 16 pages with appendices. Every potential contingency for the time-charter must be negotiated in advance – and is subject to differing interpretations down the road. The FFA offers you a flexible hedge, in that you can unwind your trade at any time. You can even add to your trade if you like. With a time-charter, you are effectively committed to that position until it expires.
No, we are not saying that. Even with a fully transparent and liquid paper market – there will always be a need for a physical time-charter market. Ships still need to move cargo and the ships should be owned, operated and controlled by those parties best suited to control shipping risk management as well as the rewards of shipping. The freight derivatives market is another tool for owners and charterers to use.
The freight derivatives market started with the players that had natural exposure in the shipping market – owners and charterers. They saw the need for this market to develop and some of them worked hard to ensure that it succeeded. From there, institutional money came on board, i.e. hedge funds and investment banks. Some of their trading might be speculative, where they buy or sell because they might forecast the market moving in a given direction. Other times they might have some sort of quantitative trade on, where one of their mathematical models tells them that they should buy or sell a certain contract. You never really know why a hedge fund or bank puts on a certain trade.
Again – we don’t know why people put their trades on. We might see an owner buying forward space – which is the opposite of hedging. This is also called a Texas Hedge. The owner, in addition to already owning ships, is taking an additional long position. But with this said – we don’t know why. He might be covering a short position he took earlier (i.e. unwinding his hedge).
We get that comment on occasion, but – when used properly, forward freight agreements are actually the opposite of gambling. Owning 20 ships in the spot market could be considered gambling. If the market goes up, you win. If it goes down, you lose. With FFAs you can reduce your exposure to the spot market if you feel it is too great. From the charterer’s perspective, having 50 cargos to move in a year could be considered gambling. If rates go up, you lose. If they go down, you win. By using a freight forward agreement, the charterer can reduce the full exposure that 50 spot cargos represent.
We wouldn’t say that. They can be very risky. It all depends on how you use them. When used properly, they are a good tool for shipping risk management. If you have a significant long, or short, position – they allow you to “take some chips off the table”.
It’s the same answer we gave above for owners and charterers – we have no way of knowing exactly what they are trying to accomplish on a given trade. Speculators do put on directional trades. But they also might have a trade that involves multiple positions – and the FFA trade is just one component of a much larger trade. They might also be trading forward freight agreements in conjunction with the commodities market – oil, coal, ore. You really don’t know why they are doing it.
Within Marex Spectron – your trade is matched with a counterparty that is willing to sell you that tanker FFA at that price. It is similar to buying stocks, either online or through your broker. Two willing parties have come together to transact at a mutually agreeable price. But keep in mind, freight futures and freight options are different from stocks.
With respect to the above, the buying and selling of stocks is based on the spot market. You buy the stock. It is yours. You pay the seller. He takes your money – and each party goes about their way. With freight futures – you are buying something which will be delivered at a forward date. Therefore, someone must be obligated to sell it to you at that forward date. So – the seller doesn’t necessarily “walk away” once the deal is concluded. The seller must in fact stick around – in order to deliver the contract he promised to sell.
The outcome here depends on how the trade was executed. If the deal was done “over-the-counter”, then there could be some risk that you might not get paid. It would depend on how the deal was structured and if a clearing house was involved. When dealing with Marex Spectron, you are dealing with regulated exchanges and their clearing houses. The clearing house therefore takes on the role of counterparty to your trade (FFA clearing). Your trade is therefore guaranteed.
The clearing house serves many purposes. First, it ensures that all trading members have the proper asset levels, credit history and liquidity to trade. Once this due diligence has been done, the clearing house is able to take on the counter-party risk mentioned above, meaning once you execute your trade, they become your counterparty. They have vetted all their members – and feel comfortable that there will not be any defaults. With that in mind, they are willing to guarantee their members that in the rare case that someone does default, the clearing house will make good on any trades that the defaulting member is responsible for.
During the GFC there were some defaults in the over-the-counter markets. It is rare - but it can happen. The clearing house guarantees settlement and effectively eliminates default risk.
They are responsible for ensuring that all accounts have proper margin levels in them. Margin requirements change as the price of any contract changes. So the clearing house ensures that proper margin levels are in place.
Margin is the amount of money you have to put up to make a trade. If you want to put on a trade with a notional value of $1,000,000 – you don’t really have to put the full $1,000,000. Depending on the FFA contract you have traded, and depending on how far out the settlement date of the contract is – your margin requirement may only be 10 to 15% of the notional value.
Most futures markets work this way, but even so – it’s not as simple as that. Recall that in order to trade you need to have a qualified credit history as well as certain asset and liquidity levels. One of the first things you do is put up collateral – maybe $250,000, which can be done through a letter of credit if needed. On top of this is the margin requirement. If your trade starts moving against you – you are required to put up more margin. This protects the clearing house. If you are unable to put up more margin, the clearing house still has the collateral you put up.
It’s called “mark-to-market” – and it works the same as it does in other futures markets. Each day the FFA contract is revalued to ensure it reflects the true market value – not just some outdated number. Even on days where the FFA contract may not trade, it is revalued to reflect the state of the freight derivatives market. The margin requirement is therefore reset based on the mark-to-market price.
Correct. This also ensures that accounts that continue to lose money are “paying as they go”.
You execute either way. Marex Spectron offers a trading screen – which is similar to what you would see if you purchase your stocks through an online broker. We also have brokers you can call that will execute the trade for you. Many trades are done via a combination of the two. We might get a call from an owner looking to trade, but wants to make sure he is not missing anything. He will then execute the trade himself via the trading screen.
On the tanker side, you have many contracts – but the most liquid are TD3, TD5, TD7 and TC2. This provides a range of different ship sizes and regions, and also allows for people to trade in both the crude oil and clean products segments. TD3 is the VLCC contract for the Middle East to Japan route. TD5 is the Suezmax contract for the West Africa to the US East Coast. TD7 is the Aframax contract for the North Sea region. TC2 is the contract for the gasoline trade from Europe to the US East Coast. The contracts are quoted in "Worldscale", which is the standardized rate structure for the tanker business.
Simply put – it is a standardized rate mechanism that allows you to compare apples to oranges. The concept goes back to World War II, when the US and British governments requisitioned merchant ships and needed a simplified rate scale. The details have changed since then, but the concept is the same.
You may have one ship that will transport cargo from Point "A" to Point "B". Another ship may carry a slightly different amount of cargo from Points "A" and "C" to Point "B". The Worldscale mechanism allows you to evaluate the profitability of the two voyages even though they are different, as it provides a simple comparison for net daily revenue for the ship. It can be more complicated than that – but it doesn’t have to be for sake of this conversation. The Worldscale website has a very good explanation (www.worldscale.co.uk).
Yes. The overall freight derivatives market is growing and Marex Spectron is growing. There are many players who require a certain level of liquidity in a market in order to trade. They want to be able to get in and out of a trade without too much slippage (the difference between the bid and ask). What we are seeing is that liquidity begets liquidity. What this means is that as more people trade, liquidity increases. As liquidity increases, more people trade. You could call this the opposite of a "Catch-22".
Yes. The freight derivatives market can be volatile. A futures market can help direct risk towards those best positioned to shoulder it. In volatile markets, people might need protection against wild price swings. The risk can be transferred to some entity that is better suited to take it. It is the same concept outlined above for shipping. People can use the FFA market to limit (or increase) their shipping risk. The goal is to create a market where risk is placed upon the party that can handle that risk for the lowest price. This means a more efficient market for everyone. We have created that market.
It can be viewed that way. You might have 20 ships in the spot market. In order to protect yourself from a declining market, you can hedge some of those positions. Then your exposure might only be to 10 ships or so. You can view it in the same light as insurance, although the more appropriate insurance analogy would be a comparison to freight options.
It’s only as complicated as you need to make it. If you want to trade freight options, then yes – it can be complicated. But understanding options is not too difficult a task. The simpler explanation is that buying an option is similar to buying insurance. You pay a premium. With that premium, you are entitled to receive some form of compensation in case the event you are insuring against occurs. If the event occurs – you receive the compensation. If the event doesn’t occur, the seller of the FFA option keeps your premium – and both parties walk away. With this – you have protection against a given event – but your downside is limited to the premium.
In theoretical terms, yes. You know your downside is limited to the premium, but you also know that you are protected if certain events occur. At the practical level, however, I wouldn’t say that it’s so easy “even a cavemen can do it”. There is some higher math involved in terms of pricing these FFA options.
No. In fact, their position is the opposite of yours. Their upside is limited to the premium, but downside is unlimited. Remember they are on the hook to compensate you on your upside. Simply put, their upside is your downside and your upside is their downside.
First you would get cleared by the clearinghouse, which takes 3 to 7 days, all going well. Then, after posting collateral, you would be looking to buy a futures contract similar to the shipment you will need to make. If you are hedging a shipment from the Middle East to Japan, then the TD3 contract would cover you quite well. If you wanted to hedge a VLCC contract from West Africa to the US Gulf, you could choose between the same TD3 contract above, or you could consider the TD5 contract, which is the Suezmax contract for the West Africa to US East Coast route.
Correct. You therefore have to decide whether you feel hedging the same ship size on a different route is better than hedging with a different ship size on the same route. You would look for a combination of the highest correlation with the most liquidity.
That depends on how the buyer interprets the correlation and liquidity combination. For sake of the example, let’s assume you chose the hedge with TD3.
You can, but you don’t have to. You can buy in 5,000 ton segments if you like. But from there, the process is the same. You have some price ideas – and you are looking to buy the forward contract at or below your ideas. This is where the freight derivatives market comes in. If you want to buy on a day when most want to sell, you will likely get your price. If you end up buying on a day when others also want to buy – you may have to outbid them – and pay more then what you had planned.
No. You can – but you don’t have to. You can buy a few thousand tons at a time. This is called scaling in. It is quite common in the trading world. If you come in with a big buy order all at once, the market might interpret this as a bullish sign – causing the sellers to raise their prices. Sometimes it is better to scale in. It helps prevent the market from thinking a big move is underway.
You will get a trade confirmation – and each day your trade will be marked-to-market.
Yes – you can turn around and sell it immediately after you buy it if that is in your best interest. The buying process is then reversed – and you sell at the highest price you can get.
That is called holding until settlement. Let’s say in the example above you were hedging a VLCC lifting that you thought would occur in early February. You could buy either the January or the February.
If you have an early February lifting to do, you will likely be concluding your charter party in January – so that is the month you are concerned with, as it will reflect the status of the spot market you will be dealing with. Another issue to understand is that the current month contract loses liquidity towards the end of the month. You need to put thought into which contract suits your needs.
It is also important to understand that as soon as you conclude your charter party to lift your cargo, you need to unwind your trade. If you don’t, you are effectively long twice – as you own the FFA trade – and you have purchased the services of the VLCC for the February lifting.
Let’s say you bought the January contract – and didn’t want to unwind it. You hold it all the way through January. What happens is that the January settlement price is the average of the Baltic Index for TD3 for all the trading days in January. The difference between this average and the price you paid for it would be your profit/loss.
No – it’s the average of the daily Baltic rates for the month.
No. All contracts are paper settled.