Goods which have to be transported from A to B can be arranged through physical transactions between two parties. For instance, a hypothetical power plant in Dubai, let’s call it Dubai Power, needs to get coal delivered from a coal producer in China. The Chinese producer has to deliver this commodity to the power plant. The electricity producer can arrange this directly at the market place with brokers or ship owners but also Dubai Power has the option to trade an FFA.
Which market participants are trading these FFAs? Ship owners, traders and shippers of bulk commodities and crude oil/petroleum products are able to exchange a floating freight rate exposure (e.g. the index or spot rate) with a fixed price of the future freight index. This is called a financial swap agreement.
Cash settlement or physical delivery?
All contracts are cash settled at the end of the month, with settlement determined as the simple average of the month’s daily prices. The net effect of a forward freight agreement is that market participants receive a fixed price guarantee in the future, which will make or lose money depending upon the price of the index, hence the swap price. Thus, no physical delivery will take place.
Dubai Power in our example might protect itself against rising freight prices by buying an FFA. Simply put, the power plant will earn money on the long FFA-position if the price rises. On a daily basis, mark-to-market adjustments will take place. The other way around is also true: the power plant will lose money in this long position in FFA, when the index falls below the price at which the FFA is bought. Is this is a big deal in case the power plant loses money on this long FFA-position? No, because that means that the ‘spot’ (freight index) price has fallen. Dubai Power is able to arrange its coal delivery at a lower market price than the future price.
The future for forward freight agreements
If for instance, Dubai Power has to rent a capesize vessel, it might trade dry bulk forward freight agreements. These FFAs trade as an average time charter basket based upon vessel size with prices quoted in US$/day. There are several types of capesize vessels which typically haul 60,000 – 70,000 tonne cargoes such as iron ore and coal. This implies that Dubai Power also competes with steel producers which need iron ore. If steel producers like Arcelor Mittal need more steel, this might put pressure on freight tariffs for shipping coal (and vice versa).
As more screen-based trading takes place in freight derivatives, more exchanges start to list these products, and last but not least the volatility of freight rates is enormous and therefore hedging with respect to freight can be very significant.