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Volatility spurs rush to hedging option

After rates in the bulk sector take a roller-coaster ride, freight forward agreements fill a gap for the industry

The number of forward freight agreements (FFA) contracted in the bulk shipping sector have more than doubled this year as shipowners and charterers seek cover from an increasingly volatile market swayed by China's demand for raw materials, industry experts say.

Some 6,000 FFAs were contracted in the first eight months of this year, against 3,000 for all of last year, in deals which the Baltic Exchange estimated were worth up to US$30 billion.

'It is not a coincidence that the emerging interest in FFAs has coincided with the increased volatility of the bulk market. All derivative traders will tell you that volatility is the lifeblood of their markets,' Baltic Exchange chief executive Jeremy Penn told the South China Morning Post yesterday.

'I think the market was ready for lift-off anyway. But there is no doubt it has been a fortuitous combination of events.'

The exchange's benchmark index, the Baltic Dry Index (BDI), has had a tumultuous ride this year, largely due to Beijing's economic austerity measures targeted at slowing the import of raw materials such as iron ore.

The BDI, an average of several indices that monitor the cost of transporting raw commodities on different trade lanes with varying sizes of vessels, lost 54 per cent of its 5,681-point value in just under four months after China announced import restrictions in March.

It reached a nadir of 2,622 on June 22 before rebounding to above the 4,000-point mark just three weeks later on signs that China's economy was headed for a soft landing.

According to Mr Penn, the market's unprecedented volatility sent executives scurrying for cover options outside long-term charter agreements and freight contracts.

'There wasn't a lot of choice and the traditional mechanisms all had their disadvantages,' he said. 'So the market needed another hedging mechanism.'

Fundamentally, FFAs are paper deals between two participants who fix a price for settlement against a projected rate on a future date.

The position is usually settled by referencing one of the indices in the BDI and is usually bought or sold on a specific trade lane where the principals wish to mitigate their risk; they would typically feature an agreement on a rate per tonne for the commodity carried or a daily time-charter rate for the vessel.

As such, they can be used by a commodity buyer or shipowner to hedge their exposures to freight costs and demand for vessels.

FFAs also may be used for trading purposes - or taking a punt. In one of the more spectacular examples of how that can backfire, Hong Kong-listed Jinhui Holdings, a dry bulk shipping specialist, was forced to post a profit warning in July after losing as much US$70 million on FFAs in the second quarter.

But Mr Penn said FFAs were no more risky than the traditional physical alternatives.

'[FFAs] are an effective mechanism for hedging market risk provided you are trading something which correlates effectively with physical market risk,' he said.

However, the principals in 'over the counter deals' take on the credit risk of their partners unless it is done through the industry's only clearing house in Norway.

About 20 per cent of the world's FFA contracts are undertaken in Asia, according to Andy Lucey, chairman of the FFA Brokers Association.

Mr Lucey told Lloyds List at a conference in Hong Kong on Monday that the derivative method of fixing bulk cargo would probably overtake physical fixtures in volume terms next year.

He estimated the derivative market would fix 1.7 billion tonnes of cargo next year, against 1.68 billion tonnes for its physical counterpart.

About 1.3 billion tonnes would have been fixed under FFAs this year, he said.

'Some people will always hold off until they see all their friends in the market. Others have a more pioneering style,' said Mr Penn. 'But I would not say you have to be pioneer to join this market now. It has considerable depth.'

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