Hedging Freight
International trade is a complex business, and traders are presented with many more problems than those doing business in a domestic environment are. The costs involved in trading globally such as Transaction Costs that are many and varied. There are risks involved in arranging international payments, and those posed by adverse currency movements.
Transport costs may also fluctuate according to the state of the market, the costs of bunker fuel, and other factors beyond the control of either buyer or seller.
Forward Freight Agreements (FFAs)
To a limited extent some traders may be able to protect themselves against unforeseen movements in the freight market by trading in freight futures, sometimes known as Forward Freight Agreements (FFAs). Trading in ’futures’ of any type – and if you read the financial press you will see that there are futures markets in most commodities, from crude oil to orange juice involves a form of ’betting’ on what the market prices are likely to be at some point in the future.
As long as there are two opposite sides who stand to gain or lose by future price movements usually the buyer on one hand and the seller on the other) then the conditions exist for a futures market. If I am running a business making instant coffee in Europe, then I have an interest in what the price of the coffee beans I need to buy will be in the future. My main fear will be that for some reason beyond my control such as a world shortage of beans owing to bad weather at harvest time, a disease affecting the plantations, political disruptions, etc the price will increase substantially and affect my business. If, on the other hand, I am a grower of coffee beans in Kenya, my worst fear is that the price when my crop is ready for sale will be so low that I cannot cover my costs and will face financial ruin. If, as a buyer of coffee, I can find a seller prepared to bet that the price of coffee beans in six months’ time is going to be no more than 5% above today’s price, I can stake money now on that being the case. This being on the basis that if he is wrong and the price is substantially higher on the agreed date, he will pay me in proportion to the difference between the price named in our ‘bet’ and the actual market price. If the price on the day turns out to be much lower than our ‘bet’ then I will pay him on a similar basis. The logic behind this is that we are both traders in the coffee business with a lot to lose if the market goes against us. If the price of coffee in six months time is higher than the level agreed in our ‘bet’, then I win. Depending on how much higher the price turns out to be, and how much money I staked, I stand to gain financially from the deal.
On the other hand, I am faced with buying my coffee beans at a higher price, so my gain in the futures deal is offset by having to pay a higher price in the real-physical market. On the same basis, a market in freight futures was established, as a result of perceived demand from traders, during the 1980s.
In 1985 the Baltic Exchange inaugurated the Baltic Freight Index, which was designed to reflect as closely as possible the level of freights in the most important sectors of international dry cargo shipping. Shipping routes have been revised over the years to reflect changing trends, and can be weighted according to their importance in the market at any given time in the real-physical freight market.
BIFFEX (Baltic International Freight Futures and Options Exchange)
A glance at Lloyds List will show how a number of these indices are made up at the present time, each reflecting movements in a particular sector of the freight market. Clearly on any given day it is highly unlikely that there will have been actual fixtures reflecting all or any of the voyages making up the index. Therefore a panel of ten of the world’s leading international shipbroking firms submit their informed estimated rates for that day on each of the voyages to the Committee. The Committee then discards the highest and lowest figures and averages the remaining figures in order to compute the level of the Index for that day. As well as computing the Index on a daily basis, the Baltic Exchange hosted a market for traders dealing in freight futures, known as BIFFEX (Baltic International Freight Futures and Options Exchange) to allow players to trade in futures contracts in a formal way. Although the market moved from the Baltic Exchange to the London Commodity Exchange in 1991 and then to the London International Financial Futures Exchange the Index was still used as the basis for trading.
Charterers, who have sold a commodity to be shipped at some future date, are naturally concerned that freight rates might rise, reducing or eroding their trading profits. To protect themselves against this eventuality they can “buy” freight futures contracts. Therefore if their worst fears are realized, and freight rates rise sharply at the time when they have to fix a ship, the loss they will incur on the physical market will be offset to some extent by the profit they will make on their futures position.
Shipowners face the exact opposite risk to Charterers that is to say that they stand to lose if freight markets plunge. They can protect themselves against falling freight rates by “selling” futures contracts in the same market. If, contrary to their expectation, freight rates actually rise, then they will benefit from higher earnings in the physical market though they will lose money in their futures trading. With an index-based futures contract, it is not possible to deliver an actual cargo or a ship in settlement of a position, so all the contracts traded in freight futures are settled in cash, based on the actual level of the index on the date that the position matures. Such markets depend on the willingness of shipowners on one hand and charterers on the other to “buy” and “sell” contracts. If both parties are involved in the physical markets that are reflected in the index (for example the charterers may be grain traders active in the US Gulf to Northern Europe trade and the shipowners may be operating bulkers of Panamax size in the Atlantic). This being the case then they can expect that the index will reflect the actual trading conditions that they will be involved in. To this extent, their activity in the futures market can be seen as “hedging” their prospects in the physical market – if they gain in one, they will lose in the other, thus reducing their exposure to wild fluctuations which could be disastrous for them.
There is nothing to stop players who are not actually shipowners or charterers from buying or selling contracts in the freight futures markets, in fact such trading takes place in virtually all the futures markets and lends liquidity to the market. However, as they have no vested interest in the physical market, they are not involved in hedging operations, but are investing on a purely speculative basis, hoping to make a profit on their dealings at the end of the day. It will be clear by now that this is a very specialized form of hedging which requires considerable expertise and knowledge of the market, and is not to be undertaken without careful consideration and advice from experts in the field.