Freight Derivative

Moving iron ore from Brazil to China costs money, and that cost moves violently — freight rates have historically risen and fallen by factors of ten within a year. A forward freight agreement lets both sides of that exposure fix it in advance.

The contract settles against a published index rather than an actual voyage:

• The shipowner earns freight rates and fears they fall. Selling an FFA locks in today's rate.
• The charterer — a miner, a grain trader, a steel mill — pays freight and fears it rises. Buying an FFA locks in their cost.
• At settlement the two exchange the difference between the agreed rate and the index average over the period. No ship changes hands.

The indices themselves are assessments: a panel of shipbrokers reports what specific routes are being fixed at, and the Baltic Exchange publishes daily averages by vessel class — Capesize, Panamax, Supramax for dry bulk, plus tanker routes.

Why freight is so volatile

• Supply is fixed for years. A new ship takes two to three years to build. When demand rises, the fleet cannot respond, and rates go vertical.
• Demand is inelastic in the short run. The cargo must move; freight is a small fraction of the cargo's value, so charterers pay almost anything rather than not ship.
• Small imbalances produce enormous price moves. A few percent of surplus tonnage collapses the market; a few percent of shortage triples it. Annualised volatility of 70–100% is ordinary.
• Port congestion and canal disruption remove effective capacity overnight without any change in the fleet — a recurring source of spikes.

The four risks a hedger keeps

The 2008 lesson

Freight rates fell roughly 95% in a few months in 2008. Bilateral, uncleared FFAs were the norm, and counterparties who owed money simply did not pay — defaults on freight derivatives were widespread and the market seized. Clearing was adopted rapidly afterwards and now dominates. It is one of the clearest natural experiments in the value of a central counterparty.

Pricing: a curve with no cost of carry

Freight cannot be stored. There is no inventory to arbitrage, so the standard cost-of-carry relationship that links spot and forward in metals or oil does not apply. The forward curve is a pure expectation plus a risk premium:

• This means the curve can and does invert violently, and neither shape implies mispricing. Contango and backwardation carry information about expected fleet supply, not about storage.
• The orderbook is the fundamental. Shipbuilding orders placed today determine supply in two to three years, and that data is public. Freight curves are one of the few markets where the medium-term supply schedule is genuinely knowable.
• Scrapping is the release valve on the other side, and it responds to rates with a lag — producing the classic multi-year boom-bust cycle the sector is known for.

Relationship to the commodity itself

Freight is a component of delivered commodity cost, which links this market to commodity futures in a specific way: the spread between a CIF (delivered) and FOB (loaded) price is the freight rate. Traders arbitrage the three legs together, and a dislocated FFA curve shows up as a distorted regional commodity spread before it shows up anywhere else.

Practical structure of the market

• Contracts trade by route (specific voyages) or by timecharter average (a basket of routes), monthly, quarterly and calendar-year.
• Options on FFAs exist and are priced with standard machinery — but freight's fat tails make lognormal assumptions unusually poor. Desks apply large smile adjustments; the volatility page explains why the correction is needed.
• Liquidity concentrates in Capesize and Panamax dry bulk and the main tanker routes. Anything else is a negotiation, not a market.

The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.