A commodity is any item that can be bought, sold, exchanged, or traded. The term can be used to refer to a wide range of items, from agricultural products (e.g. wheat and corn) and natural resources (e.g. oil and gold), to metals (e.g. aluminium and copper) and other raw materials.
Commodity derivatives are financial tools that allow an investor to invest in a commodity and make a profit without actually owning it. A commodity derivative gets its value from ‘the underlying asset’, meaning its value is based on the physical commodity (e.g. wheat or gold) it represents. They can be traded on the market or used as exchange-traded derivatives (i.e. bought and sold on organised exchanges). There are a number of different types of commodity derivative contracts, such as:
- Forwards
- Options
- Futures
- Swaps
What are freight derivatives?
Freight derivatives are financial tools whose value is based on the expected future price of freight rates (i.e. the cost for carrying dry bulk goods on ships or for transporting oil on tankers). Types of freight derivatives include:
- Forward Freight Agreements (FFAs)
- Container freight swap agreements
- Exchange-traded futures
- Swap futures
Freight derivatives are used by suppliers (e.g. oil companies and trading corporations) and end-users (e.g. ship owners and grain-houses) to reduce risk and protect against sudden price changes along the supply chain. An oil company, for example, might expect shipping rates to go up over the next few months and so buy freight derivatives to lock in transportation for their product at a lower price, therefore guarding against potential losses. However, it’s not just those directly involved in the industry who use freight derivatives. Investors who want to speculate on future freight prices (e.g. hedge funds and traders) also buy and sell freight contracts. This helps to create a more active and liquid marketplace where different participants can take part in trading.
How do derivatives work?
In essence, a derivative is a contract between a buyer and a seller, where they both agree to buy/sell the underlying asset at a specific price on a specific date in the future. The value of the contract changes depending on how the underlying asset performs.
Their purpose
A financial derivative serves two main purposes:
1. Risk management/hedging
Derivatives are used to manage (or hedge) risk, allowing a party to lock in a price in advance to protect against price changes.
2. Speculation
Investors use derivatives to speculate on future price movements of the underlying asset with the aim of making a profit from these price fluctuations.
How they’re traded
Derivatives are traded in one of two ways:
1. Over-the-counter (OTC)
The derivatives are traded privately, in an unregulated environment.
2. Exchange-traded
The derivatives are traded on a public exchange, following standard rules.
Types of derivative
There are a number of different derivative structures, each enabling investors to take a slightly different position or manage specific risk in a different way. Some common derivative structures include:
- Futures and forwards
These are contracts to buy/sell the underlying asset at a predetermined price on a specific date in the future. Futures are traded on exchanges, whereas forwards are traded privately. - Swaps
These involve two parties exchanging cash flows based on the underlying asset’s performance.
What are freight forwarding agreements?
Let’s start by looking at what freight forwarding means. Freight forwarding is when a third party helps you ship your goods from one location to another. A freight forwarder acts as a link between the shipper and the carrier, taking care of every step of the shipping process, including:
- Finding the best shipping options
- Advising on import/export rules
- Choosing the right vessel
- Handling all necessary paperwork
Introduced in the 1990s, Forward Freight Agreements (FFAs) are the most common type of freight derivative used in the shipping industry. How do they work? In short, on the contract settlement date, the difference between the agreed price and settlement price is calculated based on the cargo size or duration of the voyage. If the agreed price is higher than the settlement price, the seller pays the buyer the difference. On the other hand, if the agreed price is lower, the buyer pays the seller the difference.
FFAs are usually traded OTC, meaning they are not publicly disclosed and rely on trust. However, they do usually follow standard terms and conditions as set by the Forward Freight Agreement Broker Association (FFABA).
Types of clauses in freight forwarding agreements
FFAs contain various clauses that set out the rights, obligations and responsibilities of all involved parties. Although there’s no standard template for FFAs, there are important terms and key details which should always be agreed upon and included, such as:
- Scope of services
An outline of the services the freight forwarder will provide, such as transportation, customs clearance, documentation etc. - Charges and payment
Details of the rates, fees and charges for the freight forwarding services, including payment terms and any surcharges. - Liability and insurance
A clear outline of liability limits and the freight forwarder’s responsibilities in case the goods are lost, damaged, or delayed during transit. Plus details of insurance coverage. - Dispute resolution
A clause to establish how any disputes will be resolved, for example via mediation, arbitration, or litigation. - Termination of services
An outline of how the agreement can be terminated, including details of notice period, grounds for termination, and any applicable penalties.