Commentary: Betting on Derivatives

Q: I’ve been reading about something called freight derivatives lately, and I have no idea what the term means. We’re a fairly large exporter, and I think I should know something about it, but this is beyond my experience. Can you help?

A: Sounds like calculus, doesn’t it? But really it’s simply a kind of gamble on what the future may or may not bring by way of rate changes.

Right now transportation-based derivatives are used only in the international maritime trade. They take the form of something called a “Forward Freight Agreement,” and they work like this:

You foresee a need for certain capacity at some reasonably specific time in the future, say a year or 18 months from now. But you’re concerned rates may rise substantially between now and then, and don’t want to be caught by the hike.

So you scout out somebody else who’s willing to bet that, instead of rising, rates will drop in that time. You execute an FFA with that person at current rates (or perhaps a bit more or less; the FFA is pretty elastic that way) for the capacity you anticipate needing at that future time.

No, this doesn’t reserve you space aboard an actual vessel. In fact, the other party to the FFA doesn’t even have to be a carrier, and usually isn’t. Except for the financial end, it’s a wholly fictitious transaction, and it is, I might add, entirely free from regulation or any other form of government oversight.

Time passes, and you now need to book your space. If rates have increased, as you feared, you’re going to pay them just as you would if you hadn’t planned ahead. But (and here’s the point), your FFA partner owes you the difference between the agreed rate and the rate you’re actually paying the carrier hauling your freight.

Ah, but what if rates have fallen, as your partner wagered? In that case, you pay the carrier only the smaller sum it now demands, but you pony up the difference — the amount of decline — to whoever’s on the other side of your FFA. So either way your net outlay will be the rate you chose for your FFA some months earlier. In effect, you’ve locked yourself in at that rate.

It isn’t a perfect wash. The actual rate you pay isn’t the measure; FFAs go on the basis of rate indices (mostly those of the Baltic Exchange, a London-based association that compiles them for the dry bulk trades, or, on the container side, from Drewry Shipping Consultants in London or the Shanghai Shipping Exchange, the latter two of which can be found in the JOC’s By the Numbers section). But the indices are route- and type-specific, so you’ll likely come close to actual rates.

The simplest type of FFA is a private agreement, called a “swap”; only the two parties are involved. There’s obviously an element of risk here; if the other party comes out on the losing end but doesn’t or can’t pay up, you have no recourse to anybody else. (It’s especially risky because FFAs can be bought, sold and traded.)

But there are established exchanges that mediate these transactions (for a “house cut,” of course; nothing’s free). If you go through them, the transaction becomes a “future,” and is guaranteed by the exchange; if your FFA partner doesn’t pay, the exchange makes good.

Shippers and carriers have equal access to freight derivatives, depending on the direction of the wager; shippers hedge against rate increases, carriers against rate declines. Not all use them, but enough do that there’s a burgeoning market.

Why would you want to use freight derivatives? Mostly, it’s pure speculation; maritime rates yo-yo so unpredictably that anybody with an even slightly flawed crystal ball can’t forecast what they’ll be at any given future moment.

But say you’re a shipper locked into a major fixed-price contract that calls for delivery many months down the road. A big jump in rates could really hurt you, and perhaps you’re willing to sacrifice some of your profit for assurance of what you’ll pay for shipping.

Or say you’re a carrier whose finances are a trifle unsteady. If rates fall precipitously, it could put you on the rocks, so you take out insurance against that possible calamity. In other words, there can be sound reasons to copper your bets this way.

But say you’re a riverboat gambler with a penchant for making blind bets. Move over, Las Vegas and Monte Carlo, there’s a new game in town.

If you’re thinking of investing, I’d suggest you consult your company accountant first, of course.

Consultant, author and educator Colin Barrett is president of Barrett Transportation Consultants. Send your questions to him at 5201 Whippoorwill Lane, Johns Island, S.C. 29455; phone, 843-559-1277; e-mail, BarrettTrn@aol.com. Contact him to order the most recent 351-page compiled edition of past Q&A columns, published in 2010.
 

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