Final Freight Derivatives - Grp 4 5obq

Freight derivative Presented by: Ankush Sinha 31 AnoopSharma 32 Archit Khare 33 Arti Sood 34 Arun Dalal 35 Baishali Sen 36 Chinamaya Dash 37

Roap 1. Current Developments in Shipping Markets 2. Fundamentals of Shipping Markets 3. Highly cyclical shipping industry 4. Forward Freight Agreements (FFAs) 5. Underlying asset 6. Quotes Duration 7. Trading 8. Market Participants 9. Role of the Baltic Exchange 10.Indices 11.Baltic Capesize Index (BCI) • • •

12.FFA Settlement 13.Freight Rate Formation in the Market 14.World scale 15.TD3 -Example Trades 16.TD3 Options 17.Uses of FFAs 18.Uses of FFAs: Forward Curves 19.Uses of FFAs: Trading Opportunities 20.Risks 21.Dealing with Credit Risk 22.FFAs – Future Trends 23.Freight Derivatives in INDIA

Current Developments in Shipping Markets • • Freight as a new commodity • High volatility in the shipping markets – Sharp fluctuations and sudden changes in the market

• Entrance of new players in the shipping markets – trading houses and energy companies as well as investment banks and hedge funds

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Fundamentals of Shipping Markets • Freight rates reflect the cost of transporting bulk commodities by sea across different parts of the world • Market Segmentation – Across Type of Commodity • Wet Market: Transportation of Crude Oil and Oil products • Dry Market: Dry Bulk Commodities – Grains and agricultural, Coal, Iron Ore etc.

– Across Sizes • Commodities are transported in different sizes according to their Parcel Size Distribution Function

Highly cyclical shipping industry

Forward Freight Agreements (FFAs) 

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An FFA is a Swap – Principal to Principal contract with a buyer and a seller – An agreement today to buy or sell a freight rate at a – Certain level for a defined period in the future. – To settle at a future date at a price based on freight

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• Cash settled • Flexible periods (12 to 36 months horizon can go to 10 years) • Tradable on different routes and vessels

Underlying Asset • Freight

rate

o Prices in the freight market are termed freight rates o Are expressed in of $/day (“timecharter”) or $/tonne (“voyage charter”)

o • The freight market is highly segmented and freight rates are specific to: – Vessel type – Route – Duration of charter agreement

Quotes Duration • Prices are listed monthly for the first six months • Quarterly for six more quarters then • Calendar quotes are posted for two years out. •  Accordingly 2-4 year quotes are provided

Trading • Exchange traded 

Settled against various freight rate indices published by the – Baltic Exchange (for Dry and most Wet contracts) & – Platt's (Asian Wet contracts).

• • FFAs are often traded over-the-counter – Through broker of the Forward Freight Agreement Brokers Association FFABA – Example :Clarkson's Securities, SSY -

Market Participants • • • •

Ship owners Charterers Banks Brokers – GFI, Prebon and TFS

• Investment Banks – Morgan Stanley, Barclays Bank

• Oil companies – BP, ConocoPhillips, Shell and Total

• Hedge Funds • Clearing Houses – NOS,LCH

Role Of Baltic Exchange • Responsible for standardizing a set of routes • Sets the rules and oversees the process of collecting and processing the brokers’ assessments of freight rates in more than 40 cargo routes  • Settlement Rates :Average of the rates for the contract route over the contract period

Indices • Dry Market – Baltic Capesize Index (BCI) (150,000+ dwt) – Baltic Panamax Index (BPI) (70,000+ dwt) – Baltic Supramax Index (BSI) (52,000+dwt)

• Wet Market – Baltic Tanker Index (Dirty and Clean) – Baltic LPG Index (44,000cbm) – Platts Assessments

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Baltic Capesize Index (BCI) FFAs can be traded against any of these

individual routes or against the averages of Routes 8 to 11

Most trades concentrate on C4, C7 and the average of

C8-C11

Route

Descr

FFA Settlement On settlement, • if the contract rate <settlement rate, • Seller of the FFA is required to pay the buyer settlement sum • (SR-CR ) X number of days specified in the contract • • Conversely, if the contract rate is greater than the settlement rate the buyer is required to pay the seller the settlement sum. • 

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Freight Rate Formation in the Market Spot freight rates are determined through the interaction of supply and demand for shipping services at any point in time

Demand

The demand for sea transportation is a derived demand, which depends on world economic activity and international trade •Political events •The world economic activity •Seaborne commodity trade•Transportation cost •Average haul

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Supply

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•T h e su p p ly o f sh ip p in g se rvice s is th e a m o u n t ( to n m ile s) o f tra n sp o rta tio n se rvice o ffe re d b y sh ip o w n e rs'fle e t b a se d o n th e o p tim iza tio n o f th e ir re ve n u e •

•Fleet productivity •Freight rates •Stock of the fleet •Shipbuilding production •Scrapping and losses

W o rld sca le   •New Worldwide Tanker Nominal Freight Scale (World scale) = annual publication listing $/MT for voyage between 2 ports.   •WS rate -% applied to flat rate to calculate the $/MT rate for specific voyage between 2 ports.   Flat Rate x WS Rate = $/tonne rate eg 5.40 x W150/100 = $8.10/MT

TD3 -Example Trade • • • • • • • • •

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•Buyer /Seller-We Buy •Route-TD3 •Period-Q4 07 •Quantity-20kt •Contract price-WS88 •WS Flat Rate-17.72 •Contract-FFABA / ISDA / Cleared •Counterparty-OTC -Counterparty Risk

TD3 Example Trade • •Q4 07 has three monthly settlements. •October: WS57, November: WS91, December: WS240 •P/L Calculation for October = Settlement Price -Contract Price x Flat Rate x Size of Trade 

• (57%-88%)x17.72x 20,000 =(31%)x354,400 October Loss = ($110,000) 

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• Similarly November Profit = $10,000 December Profit = $540,000

TD3 Trade Example 

Conclusion • Our Trade has generated a profit of roughly $440,000. • If we were using the trade to cover physical exposure then this would be available to offset our increased freight costs in Q4. 

– A full 260,000mt trade would have generated $5,720,000

• By hedging we are able to fix our future costs according to known FFA pricing . • The decision not to hedge leaves unknown risk exposure.

• FFAs can effectively manage freight risk.

TD3 Options • • You buy a Call Option (The right to buy) • Q4 ‘08 W120 Call -Cost W10 • Result. • If the market goes above W120 in Q4 ‘08 you have all the profit, once your cost of W10 is covered. • If the market falls you only lose 10 Worldscale points.

Uses of FFAs H e d g in g

Cargo owners (power utilities, oil companies) are buyers of FFAs

Market information Forward curves

Speculation

FFAs give the possibility to profit from falling freight markets

Enhanced trading opportunities

Arbitrage trades (e.g. API2 vs API4) Spread trades (TD3 vs TD5, Cape vs Panamax)

Collateral in ship finance transactions

Uses of FFAs: Forward Curves 

• Forward curve is a ’snapshot’ of current

market  forward price expectations. • An implied market forecast – based on all market  participants • A method of comparing FFA opportunities against  physical options. • Used for position and portfolio valuations.

Uses of FFAs: Trading Opportunities • Good liquidity in FFAs – position tradability‘buy’ and ‘sell’ • High volatility – position taking opportunities • More trading players than physical – Investment banks, trading houses, hedge funds

• Spread Trades – Inter route spread, e.g. C4 v C7, TD3 v TD5 – Inter month spread, e.g. 3rd Q06 v 4th Q06 – Inter-size spread, e.g. P-4TC v C-4TC 

Risks  Credit Risk (Netting Facility by exchange)  Volatility of market  Unpredictability due to time horizon  Hedging and speculation  Basis risk  Liquidity risk - Overall, less risky than physical market

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Dealing with Credit Risk • Trading cleared contracts – IMAREX with NOS in Oslo offer cleared FFAs and Options – London Clearing House, NYMEX and Singapore Exchange also provide clearing services

• Cleared FFAs provide protection against counterparty default, however – Margin requirement and initial deposits tieup a lot of capital – Margining and marking to market may create a cash-flow mismatch between the paper and physical markets

FFAs – Future Trends • The market has grown sharply following deregulation and liberalisation in the European Energy market as energy and other traders seek to manage freight risk 

• Recent high volatility in the market has also attracted interest from investors outside shipping such as hedge funds 

• Credit Risk and Clearing – Clearing will also attract new players in the markets as it also facilitates and speeds up negotiations

– • Electronic Trading 

• Emergence of Freight Options

Freight Derivatives in INDIA • MCX in strategic collaboration with the Baltic Exchange proposed to introduce freight futures contract in year 2004

• • Cargoes at Indian ports are expected to top 1 billion tonne in 2011 compared to about 845 million tonne last year. So huge potential for freight derivative market.

• • MCX would create India-specific freight contracts keeping into consideration India's large coastline consisting of ndia's large coastline of 11 major and 139 minor ports

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Thank you