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What Does Forward Freight Agreement Mean

At this point, we look at an example of how this works: in February 2016, a trader buys three shipments of NOPAC grain in Japan, which will be transported when the grain season begins: one shipment in August, one in September and one in October. The distributor is concerned that the shipping market will rise in August and wants to secure its freight against such a potential increase. On the other hand, a Panamax shipowner, who fixed his ship when the charter opened in mid-July in the Far East, fears that the market will loosen again, and that is why he wants to sell an FFA. The owner and charterer negotiate and set in August 8,000 USD/day for a duration of 50 days (estimated duration of the trip) and the billing price based on BPI-Route 3a (the Trans-Pacific route for Panamax-Bulker s) as an average of the last 7 indices published in August 2016. As we know very well, shipping is a very risky and volatile sector. In the past, both dry matter and oil and oil markets have fallen sharply or increased in a few days, and forecasts are very difficult (short-term), if not impossible (in the long run). To cope with their market risks, market participants can use different instruments. Fixing a temporary charter ship/naked hull is a traditional solution used to block your income (owners) or your transport costs (charterer) for a certain period of time. However, this measure is not flexible at all, as the vessel is bound for a long period of time and the exit of a contract can be costly.

Fleet diversification is another traditional instrument used by shipowners. By diversifying the fleet, a shipowner participates in several markets where market risks are shared. To overcome the disadvantages of traditional market risk management strategies, a more advanced instrument has recently been developed: Freight derivatives. Let`s look at freight derivatives, their history and use in the marine industry, and how they work. FFAs, the most common freight derivative, are traded under the terms and conditions of the Forward Freight Agreement Broker Association (FFABA). The main terms of an agreement include the agreed itinerary, the date of the billing, the size of the contract and the rate at which the differences are compensated. A shipowner uses the index to monitor freight rates and protect them from lower freight rates. Charters use them to reduce the risk of higher freight rates.

The Baltic Dry Index is considered a leading indicator of economic activity, as an increase in dry basic shipping indicates an increase in raw material production that stimulates growth. The settlement price (7 days average) was finally USD 8,500/day, which is why the FFA seller (owner) pays the difference to the FFA buyer (charterer) for 50 days ($500 per day – $50-$25,000). Indeed, no party loses money, since the charterer takes back the $500 paid to the owner in the physical market, while the owner pays nothing out of his own pocket, since the $25,000 is part of the total freight he earned (since he earned 8,500/day on the physical market). Freight derivatives are financial instruments whose value derives from future freight rates, such as freight and tank car rates. Freight derivatives are often used by end-users (shipowners and grain farmers) and suppliers (integrated oil companies and international trading companies) to reduce risk and guard against price fluctuations in the supply chain. However, as with all derivatives, market speculators – such as hedge funds and retailers – are involved in both the purchase and sale of freight contracts that allow for a new, more liquid market.

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