DEFINITION of Freight Derivatives

Freight derivatives are financial instruments whose value is derived from the future levels of freight rates, like "dry bulk" carrying rates and oil tanker rates. Freight derivatives are often used by end users (ship owners and grain-houses) and by suppliers (integrated oil companies and international trading corporations) to mitigate risk and hedge against price volatility in the supply chain.

As with any derivative, market speculators, like hedge funds and retail traders, partake in both the buying and selling of freight contracts providing for a new, more liquid, marketplace.

BREAKING DOWN Freight Derivatives

Freight derivatives include exchange-traded futures, swap futures, and the older "forward freight agreements," container freight swap agreement, container freight derivatives and physical deliverable freight derivatives. The instruments are settled against various freight rate indexes published by the Baltic Exchange and the Shanghai Shipping Exchange. Cleared contracts, in contrast, are margined on a daily basis through the designated clearing house. At the end of each day, investors receive or owe the difference between the price of the paper contracts and market index. Clearing services are provided by leading exchanges, including the NASDAQ OMX Commodities, European Energy Exchange and Chicago Mercantile Exchange, to name a few.

With shipping markets bearing more risk, freight derivatives have become a viable method for shipowners and operators, oil companies, trading companies, and grain houses to manage freight rate risk. Forward Freight Agreements (FFA), the most common freight derivative, are traded over the counter on the terms and conditions of the Forward Freight Agreement Broker Association (FFABA) standard contracts. The main terms of an agreement cover the agreed upon route, time of settlement, contract size, and the rate at which differences are settled.

Baltic Dry Index 

The London based Baltic Exchange issues a daily the Baltic Dry Index as a market barometer and leading indicator of the shipping industry. It provides investors with insight into the price of moving major raw materials by sea but also helps price freight derivatives. The index accounts for 23 shipping routes measured by a timechart basis and covers various sized dry bulk carriers, including Handysize, Supramax, Panamax, and Capesize.

A ship owner, who is traditionally long of tonnage, use the index to monitor and protect against a drop in freight rates. Charters, on the hand, use it to mitigate the risks of rising freight rates. The Baltic Dry Index is considered a leading indicator for economic activity because a rise in dry bulk shipping signals a surge in raw production materials that stimulate growth.