What is a Forward Freight Agreement (FFA)?

The Strait of Hormuz crisis has sent some freight rates to extraordinary levels that have impacted not just energy markets. But did you know that freight rates can be hedged?

A Forward Freight Agreement or FFA, is a financial derivative that allows a company to hedge the future cost of freight.

Imagine you’re a trader who has agreed to buy 20,000 tonnes of metal for delivery in three months.

You’ve hedged the metal price, the FX exposure, but your freight rate is only booked at the time of shipment.

When you agreed the trade, you expected freight to cost $50/mt. But by the time you actually ship the material, freight has increased to $80/mt.

That’s $600,000 that has just disappeared from your profits.

This is exactly the type of risk an FFA can help manage.

FFAs allow participants to buy or sell freight for a future period, with the contract financially settling against a specific freight index.

There is no physical delivery, you don’t take delivery of a ship. You simply receive or pay the difference between your fixed FFA price and the floating settlement price.

For those paying vessel costs worried about freight rates rising, you can buy freight forward.

If you’re a ship owner worried about freight rates falling, you can sell freight forward.

However, unlike traditional commodity hedging where the derivative often exactly matches the physical, there might not be a liquid FFA contract for the exact journey you’re making.

Perhaps your physical cargo is moving from A to B, but the liquid FFA market represents freight from C to D.

If the two freight routes are sufficiently correlated, the FFA may still provide a useful hedge.

Suppose freight on your physical route increases by $30/mt while the FFA you’re using increases by $25/mt.

That hedge wouldnt be perfect, but instead of absorbing the whole $30/mt increase, the effective exposure was only $5/mt. The risk was changed from outright to basis risk.

Of course, correlation can change and needs constant monitoring if using FFAs. The relationship between your physical freight and the index you’re hedging against can widen, narrow or even temporarily break down.

The events in the Strait of Hormuz have provided an extreme real-world example of exactly how complicated that relationship can become.

When physical markets become severely disrupted, even establishing what the “correct” freight rate should be can become difficult.

That’s why understanding the difference between what you physically buy or sell and the derivative you use to hedge it is every bit as important in freight as it is in commodities.

Hedging isn’t about eliminating every possible risk. It’s about identifying the risks you have, understanding the tools available to manage them, and deciding which risks you’re comfortable continuing to hold.