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  Derivatives Explained  

A - Freight Derivatives Explained

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

Given the current volatility of the freight markets, managing freight market risk is a significant issue for the shipping industry. One method of managing this risk is through the purchase and sale of forward freight agreements (“FFAs”).

What are FFAs and how do they work?

FFAs are derivatives. Derivatives are risk management tools, the value of which is derived from the value of an underlying asset. 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 Exchange[1] Indices.[2] 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.

Types of FFAs: Swaps v. Futures

There are two categories of freight derivatives. One is privately-negotiated derivatives known as “over the counter” (“OTC”) derivatives or “swaps”. The other is standardized, exchange-traded derivatives known as “futures” or cleared contracts. One of the major differences between swaps and futures is the assumption of counterparty risk; that is, with OTC derivatives the risk of default by either party to the FFA is assumed by the other party to the agreement (the “counterparty”), whereas with exchange-traded derivatives the risk of default by either of the parties is assumed by a clearing house, and the parties to the agreement only assume exposure to default by the clearing house.
[3] The assumption of counterparty risk by a clearing house makes it almost certain that the holder of an in-the-money futures contract will be able to collect and has the potential to make this type of derivative more liquid than the OTC variety. This liquidity, combined with the ability to mask the true identities of the counterparties when trading on an exchange (as opposed to the transparency that comes with negotiating FFAs at arms-length, as is the case with swaps) generally makes futures more appealing to speculators. The liquidity of freight futures has been further enhanced by the entry of new clearing facilities to the marketplace. The International Maritime Exchange (“Imarex”) in 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, Ifchor and 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.

While swaps may lack the liquidity of their exchange-traded counterparts, the fact that they can be individually negotiated makes them a useful hedging tool for participants in the physical marketplace who are seeking to offset specific risks to which they find themselves exposed through contracts of affreightment and/or time charters. Parties to swap agreements generally use either the FFABA form contract or the International Swaps and Derivatives Association (“ISDA”) Master Agreement and Schedule. ISDA is a trade organization whose primary purpose is to encourage the prudent and efficient development of the privately-negotiated derivatives business. The ISDA prescribed form agreement for swap transactions includes a Master Agreement which sets forth the terms of the ongoing legal and credit relationships between the parties. Any amendments to the Master Agreement are set forth in an attached schedule. One of the major issues agreed to in the schedule is the choice of law provision, which typically provides that either New York law or English law govern the contract. From a legal perspective, the advantage of the ISDA form is that it has been used as the standard form of derivative contract for the great majority of traded commodities and, as such, it has been subject to judicial review and found to be enforceable in a number of international jurisdictions. As a result, the legal risk of uncertainty surrounding the interpretation of the terms of the ISDA Master Agreement is greatly reduced.
[4] This has not always been the case with the FFABA form agreement.

Before the 2005 amendments to the FFABA form, provisions setting forth events of default, termination and close-out netting rights were noticeably absent, and an aggrieved party litigating any such matter would have been forced to rely on English common law, which governs both the original and the revised FFABA contract, to show that its counterparty had violated the agreement. The FFABA has sought to bridge the gap between its form and the ISDA form by incorporating ISDA’s approach in listing specific and detailed events of default and in providing express termination and close-out netting provisions. While there is still no universally accepted form of OTC contract, the harmonization of the two most widely used forms and the movement towards a standard OTC contract with clearly definable rights and obligations should have the effect of enhancing the liquidity of swaps and bringing more participants into this segment of the marketplace.

Conclusion

The FFA market is still very much a work in progress. While there have undoubtedly been significant advancements in both the swaps and futures components of the market in terms of enhancing liquidity and reducing participants’ exposure to uncertainty and credit risk, these measures have as yet largely gone untested.
by Donald J. Kennedy and Richard T. Califano

Endnotes

[1] The Baltic Exchange is an independent, London- based association of shipbrokers, shipowners, charterers, financial institutions, maritime lawyers, educators, insurers and related associations involved in the shipping industry.
[2] The Baltic Tanker Indices consist of the Baltic Clean Tanker Index and the Baltic Dirty Tanker Index. The Baltic Dry Bulk Indices are the Baltic Dry Index, the Baltic Capesize Index, the Baltic Panamax Index and the Baltic Supramax Index.
[3] While an FFA clearing house has yet to default, it is worth noting that such a default is not beyond the realm of possibility. In 2004, a member of the NOS in Oslo defaulted against the NOS by not being able to fulfill its obligations to pay the daily market settlement, i.e., the variation margin caused by the sharp increase in the market rates. The NOS, acting as a clearing house for the international market for FFAs, guaranteed the settlement of all member transactions delivered to NOS for clearing. In this case, the NOS closed the defaulting members position with the NOS and covered with their own funds the outstanding cash calls due to other members.
[4] See, for example, Finance One Public Company Ltd. v., 414 F.3d F. 3d 325 (S.D.N.Y.) (2nd Cir. 2005) and The First National Bank of Chicago v. Ackerley Communications, Inc., 2001 U.S. Dist. Lexis 20895 (S.D.N.Y. 2001). 
 

 B - Forward Freight Agreements (FFA) – The standard contracts FFABA 2005.

Introduction

The role of freight derivatives as a financial tool is on the increase. Their emergence is a symptom of both the growing sophistication of freight and commodities markets and the appetite of financial institutions for increasing diversification of their investment portfolios. Freight derivatives in the form of Forward Freight Agreements or FFAs have bee around for more than twenty years. FFAs are bespoke swap contracts traded “over the counter” (OTC) between counterparties on a principal to principal basis as a means of hedging exposure to freight market risk. They used to be the preserve of the biggest players in the industry and attracted little external interest due to a lack of liquidity and obscure pricing. Now, however, a number of factors mean that barriers to entry are getting lower, there is an improved level of liquidity and as a consequence interest in freight derivatives is increasing rapidly.

This note explains what freight derivatives are and how they can be used to manage risk and examines the issues thrown up by the recently introduced FFABA 2005 standard contract.

The Basics     

A straightforward swap freight derivative is essentially a “bet” on whether the market freight for a certain type of voyage or a certain period of time over a designated route or combination of routes will be higher or lower than the price struck as the basis of the “bet”. The winning party receives the difference between these two prices, multiplied by the agreed contract quantity. Managing Freight Price Buying the fixed price side of the bet means that the other party takes the risk of the market rising. Conversely, the risk of buying the fixed price is that the market might fall. The opportunity to lock in a fixed price for freight over a particular route is obviously attractive to commodities traders who wish to mitigate the risk of an increase in their chartering costs which can impact heavily on price and profit margins.

The ability to hedge the cost of freight permits traders to price their business with a greater degree of certainty and long term stability. Why have Freight Derivatives become more Popular?  While the volatility  of the freight market is something that commodity traders wish to hedge against, it is a can also be a selling point for those wishing to speculate. Large movements in price within short periods also mean the potential for large profits.

Recent developments in OTC and exchange traded freight derivatives are both adapting to and driving the development of the market. In response to the increasing sophistication of the freight derivatives market and a demand for uniformity, the Freight Forward Agreement Brokers Association (FFABA) has produced a new 2005 contract that brings the terms on which freight derivatives are traded more in line with other derivative products.

Exchange Trading

As an alternative to the traditional FFAs outlined above, exchange trading and clearing have increased liquidity in the market, which in turn has increased interest. Smaller units of freight can be bought and sold thus providing greater flexibility for larger users and greater access to companies previously priced out of the market.

Freight futures and options traded exchanges such as IMAREX provide a relatively simple method of participating in the market. The contracts traded through IMAREX are cleared by the Norwegian Futures and Options clearing house (NOS). The advent of clearing provides advantages for markets participants. First and most importantly, the risk of default by a counterparty is virtually eliminated. The clearing house effectively acts as counterparty to both buyer and the seller of the contract. Second, this process can be completed instantly at the click of a mouse. Cleared contracts are settled on a daily basis and traders pay or obtain the difference between the price of their contract and the market index.

All of the signs are that screen market derivative trading is increasing and it will be interesting to see whether the traditional FFA market decreases as a result.

The New FFABA 2005 Form – Important Changes and Potential Pitfalls As outlined above, FFAs are OTC products which are generally traded on a standard form and agreed between principals with a broker acting as intermediary. The new 2005 FFABA form was created with the objective of introducing an improved contract acceptable to the industry but which would eliminate the risk related deficiencies of the old form. 

Overview

The key to the operation of the 2005 document is its incorporation of the 1992 ISDA Master Agreement 1992 (Multi currency cross-border) without schedule. The ISDA Master Agreement is the most widely used contract that exists for derivatives transactions. Although there is a 2002 version, the 1992 version is still widely used and it is this version which forms part of the new FFABA form.

Generally, the ISDA Master Agreement is agreed between counterparties through the negotiation of a customised schedule that produces a bespoke umbrella agreement under which all derivatives deals between the two parties are executed. The 2005 FFABA contract incorporates by reference the ISDA Master Agreement with a set of standard elections and with no separate schedule. The objective is to create a standard form document that ensures market conformity and maintains liquidity.

In addition to the incorporation of the ISDA Master Agreement in relation to individual trades, the 2005 FFABA contract also puts in place a master agreement structure for existing and future transactions.

We highlight below some of the important changes in the new form.

Default/Termination

The default provisions of the old version of the FFABA contract were rather vague and it was a matter of judgement as to when a party was entitled to terminate a particular contract. This uncertainty is removed by the incorporation of the Events of the Default clause of the ISDA master agreement.

Netting

The netting provisions are an improvement on the old FFABA contract as it means that a single balancing payment can be made between parties to cover all contracts made in the same currency in respect of which payment must be made on the same day. This has the added effect of avoiding difficulties in jurisdictions where insolvency law does not already provide for setting off of debts owed to an insolvent company, so long as the relevant jurisdiction recognises netting provisions.

Exclusive jurisdiction is conferred on the English High Court

The new jurisdiction clause is a potential concern for anyone who trades with overseas counterparties. Any dispute must be settled in the English courts and in some countries it can be difficult to enforce such a judgment. Although this change brings the form in line with ISDA 1992, the possibility of refusal to honour a judgment introduces an important new factor in determining counterparty risk.

Invoice based payment terms

The new invoice based payment terms are designed to eliminate problems caused by counterparties who fail to issue invoices. A party who does not produce an invoice has no right to demand payment by a particular date.

Warranties

Under the new form, the warranties set out in clause 11 only need to be correct as at the date of the contract whereas under the corresponding clause in the 2000 form warranties were continuing. They were, however, limited to good standing, capacity and consents. By ISDA section 3 there are separate continuing representations and warranties covering acceptance of binding obligations, absence of conflicts, as well as absence of any event of default termination. Taken together, the warranties provided by the 2005 form are wider.

Other issues

We understand that uptake of the new FFABA form is excellent and that it is being used without amendment by traders. Yet the new form does raise some issues of potential concern, particularly for traders who, unlike banks or financial institutions, will probably not be negotiating full ISDA Master Agreements with counterparties. In the 2005 FFABA contract, the ISDA Master Agreement is incorporated without schedule and accordingly there are certain provisions (such as the cross default clause or the provisions relating to events of automatic early termination or additional termination events) that will not apply unless amendments are made. In addition, clauses 20 and 21 aim to apply the ISDA Master Agreement to all existing and future trades. However, the wording of the clauses is not clear regarding incorporation of the other new provisions of the FFABA into future and past dealings. An amendment to the terms could remove this uncertainty.

Conclusion

Exchange trading and clearing offer a reduction in counterparty risk and a boost to liquidity. However, FFAs still provide flexibility in terms of contract routes, quantities and pricing structure.

Whilst it is obviously necessary in terms of liquidity to maintain a standard form across the industry, it is also a good idea for traders to review the effect of new documentation particularly if they are unfamiliar with the 1992 ISDA Master Agreement and the way it is intended to work. The 2005 FFABA contract is in effect a hybrid document the nature of which remains untested. It is therefore particularly important for banks and traders to understand the potential issues that could arise even if it might not be possible or desirable to amend the contract.

C – USEFUL LINKS:

If you want to read interesting presentations and have more information about the Freight Derivatives Market, please click on the below links:

1 – The Baltic Code

The Baltic Code contains guidance for shipbrokers and is based on the distilled experience of Baltic Exchange members over many years.

http://www.balticexchange.com/default.asp?action=article&ID=3385

2 – Intertanko Association Presentations page

By clicking on the link below you will be able to view some if the most recent presentations given by Intertanko staff or invited speakers at meetings and conferences around the world:

http://www.intertanko.com/templates/DocumentList.aspx?id=20528

3 – BIMCO free maritime documentation (including agreements).

We noticed that some other website dedicated to the maritime industry are selling BIMCO agreements online despite these being offered freely on the BIMCO website. So below is the link where you can browse their documentation section, we hope you will find what your are looking for:

https://www.bimco.org/Chartering/Clauses_and_Documents/Documents.aspx

http://www.bimco.org/Corporate%20Area/Documents/Document_samples.aspx



 


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