Risk Management and Applications

With the growing size of container vessels, more and more cargo has been containerised. By the end of the twentieth century, a larger portion of high-valued goods had been transported in boxes. For several years now, an increasing amount of low-value, high-volume cargo like soya beans, scrap metal, woodchips and waste paper is being containerised.

Commoditisation takes place when goods or services lose differentiation across their supply base. We have seen this occur in the container market with standard 20-ft. and 40-ft. dry containers on the major trade lanes being described as commodities, with carriers hardly able to differentiate their product offerings. Some carriers use the proposal of service quality—i.e. on time deliveries—as a method to differentiate their product. With cargo now being quoted on a FAK (freight all kind) basis, the underlying product—i.e. the container—is identical regardless of the provider.

The industry has seen huge losses, as well as profits over the years, as market volatility has led to large swings in container freight rates and t/c rates. It is still common practice during times of heavy losses for governments to keep companies afloat due to political or nationalistic interests. Moreover, many container divisions have been subsidised through group activities, profits, or by virtue of being state-backed businesses.

Freight indices have been in existence since the beginning of the twenty-first century. A freight index is a snapshot of the actual market environment and can be used as an indicator in the physical market. It can also be used as a neutral benchmark for future settlements in the securities market.

The Shanghai Shipping Exchange (SSE) launched several container-related indices focusing on ex-Asia cargo. Other currently available indices include the WCI (World Container Index), the CCFI (China Container Freight Index), the CTS (Container Trade Statistics) and the TSA Index (Transpacific Stabilisation Agreement). Each index has a slightly different methodology, as is outlined below (see Table 17.1). This suggests that the core number may differ individually. However, there is a high correlation between the rate movements reported in each. Market players have been familiar with indexation in the stock, energy, and commodities markets for decades. Users must deem the indices to be trustworthy. This can happen only if the index reflects the market accurately and is transparent in its methodology. Participants are unlikely to use it if they do not believe that it reflects the market or if they do not understand or trust how it is calculated.

In the container industry, the Hamburg ConTex has already been used as a charter benchmark. However, this index reflects only the t/c market. The approach to index the relatively small t/c market is difficult. Although standards are clearly defined, too many differentiating factors separate individual vessels. Successful indexation of the commodity itself seems to hold more promise.

It appears that a derivatives market can be established in a much easier way in the underlying freight market. Risk can be successfully transferred to more potential risk takers.

Many believe that the first record of a modern futures exchange originated in seventeenth century Japan with rice futures commonly hailed as the first. Gluts and shortages of the product led to price fluctuations. Participants were able to trade in forward (future) contracts, which insulated them from adverse movements in price. This is now more commonly known as a hedge and is commonplace in other markets, such as those dealing in interest rate swaps, foreign exchange (FX), and oil, to name a few. A derivative is a financial product whose value is derived from an underlying variable. This variable may be a freight index such as the Shanghai Containerized Freight Index (SCFI). Swaps, options and forward freight agreements (FFAs) are forms of derivatives.

In particular, a forward contract is an agreement made on a specific date (X) between two parties to exchange at a fixed future date (Y) a specific quantity of an underlying asset for an amount of money that was agreed upon at the start of the contract (X). Future contracts are closely linked to forward contracts but are instead normally traded on an exchange. To make trading on an exchange possible, contracts have specific standardised features (see Table 17.2).

The correlation of the two existing markets in the container industry-i.e. charter market vs. freight market-has been controversialy discussed for many years. It seems logical that also container vessels are ultimately earning money through the cargo they transport. Due to technological (e.g. rapid development of vessel size) and several artificial influences (e.g. tax exemptions, government support of the shipbuilding industry, cartels, substations, etc.) the two markets can appear to have an extensive time delay, although in the end, the markets have been following one another. Ultimately, the demand for vessels and, thus, for the t/c rate in the market is influenced by demand from operators for vessel employment. The operators, in turn, are affected by the growing demand for containerised cargo. Therefore, it is logical to suggest that when demand for cargo is high (freight rates increase), there is a greater demand for vessels (t/c rates increase) and vice versa (see Fig. 17.2). As discussed earlier, other influencing factors can affect each market individually, but due to market fundamentals over the long term, the two markets are closely correlated.

It has been common practice for many years in the wet and dry shipping markets to link charter contracts to indices. The Baltic Freight Index (for bulkers) and the Worldscale (for tankers) are commonly accepted industry standards.

To make long-term projects happen, owners and carriers must discuss how a flexible agreement can be reached. If both parties earn more in good markets and less in weak markets, both sides should be satisfied.

The current t/c model creates an artificial separation of the cargo from the tonnage market. Hence, the underlying market conditions are not connected to the asset being deployed. In reality, revenue earned through the freight market goes towards paying for the t/c of the vessel. From an owner’s point of view, an upside in the freight market should be reflected in his charter income, as presumably in a bullish economic environment his financing, crewing, and other expenses will rise.

The distortion of costs or revenues can be solved by reuniting the two markets using a freight index as a basis to calculate the charter income/costs.

A certain factor is connected to each index point; the charter rate payable is calculated by multiplying both of these factors. Besides, on creating a charter rate that always conforms to market conditions, counter-parties can benefit from the container FFA market to lock in their cash flows, as these financial tools are settled against the same index.

Procedure:

To implement an index-linked contract, a number of parameters need to be negotiated to allow owners, charterers, and brokers to continue playing the market.

Certain quality criteria of individual tonnage evolve around by what factor to apply as well as any possible base rate. Simple calculation tools can help both parties establish the possible effect on the overall t/c.

Floating element: This would be linked to a suitable index such as the Shanghai Containerized Freight Index (SCFI) and would indicate the factor with which to multiply the index. This would establish the floating t/c element, which would fluctuate as the index increased or decreased.

Basis rate: A base t/c that is fixed for a given period may be added (see Fig. 17.3). This could be a figure that would allow the owner to cover OPEX costs.

Once these negotiations between the two parties (owner and charterer) are completed, the owner or charterer may wish to enter into an FFA position to secure their income (owner) or costs (charterer). Because FFAs are future contracts, they can be bought or sold before the actual vessel delivery.

Because Forward Freight Agreements (FFAs) are linked to the same index as the one where the floating t/c is based, they can be used to lock in future cash flows. They also remain fungible, allowing either party to reverse their fixed cash flow and participate in the spot market. Another important factor is that FFAs remain flexible as they can be traded for a chosen period. This can provide parties with long-term cash flow security, which should attract lenders and investors (see Fig. 17.4).

An embedded derivative is formed when a derivative instrument, such as a container FFA, is combined with a non-derivative contract, such as a vessel employment contract (t/c), to create a single hybrid contract (see Fig. 17.5). An embedded derivative causes some or all of the cash flows generated from the host contract to be adjusted based on a specified variable, such as a freight index. The use of such derivatives enables participants to secure cash flows that would otherwise fluctuate due to changes in the host contract. The use of derivatives in this manner is commonplace in the oil markets, with companies that participate in crude derivatives being able to cover exploration costs. In the meanwhile, index-linked contracts are regularly used in the bulk and tanker markets with settlements against the BDI and BCI.