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Freight Options

Ola Strand Andersen, managing director, Imarex Asia on the freight option: a useful tool in a complex world

Recent events have forever changed the face of the shipping industry. Principles of trust and good faith have been overshadowed by defaults and lawsuits. World recession and the collapse in freight rates in 2008 created serious challenges as many counterparties were not honouring their contracts. Consequently, it is more important than ever to find ways that eliminate contractual disputes and mitigate risks. Freight options are ideal for this purpose because they are flexible, easy to unwind and carry no counterparty risk if traded via a clearing house. As liquidity increases, freight options will get more attention from the shipping community due to their dynamic nature and practical application in hedging strategies.

It is essential for companies exposed to deep-sea shipping to analyse the inherent optionality attached to any contract. In the freight market, this can be divided into physical and synthetic. Physical optionality is manifested by contractual fine-tuning, such as duration of a timecharter, redelivery window, counterparty vetting and percentage fleet coverage. Synthetic optionality on the other hand can be represented by freight options and can be used to support the strategy and manage the risk profile of a company.

Options – the basics

An option is the right but not the obligation to buy or sell something in the future at a predefined level called the strike price or exercise price. Freight options can simply be regarded as insurance on freight rates, whereupon one pays an agreed price to be insured against adverse rate movements. For example, a trader that knows that their profit margin will be significantly reduced or even negative if the cost of shipping rises, could consider buying a protection against higher rates, or what is named a call option. On the contrary, a shipowner will be a natural buyer of a put option, a protection from rates collapsing, and at the very least ensure rates are covering break-even cost of operating a vessel. To be in possession of this right, an options premium or “insurance premium” has to be paid. This premium is determined by the market and reflects the perceived probability of rate fluctuations at a point in time. Freight options are what we define as Asian or Average options, because they are settled against the average of a future period, eg a month, quarter or year. Whilst options can be concluded bilaterally between two counterparties, the majority are now traded cleared.

Profit sharing

To illustrate the benefits of freight options, imagine an owner interested in timechartering out a vessel for one year, being approached by two charterers with the following alternatives: one charterer with a good reputation in the market offers a flat daily hire rate for the year, whilst the smaller and less-known charterer offers a seemingly attractive profit-sharing agreement where the owner will receive a lower minimum rate but will be able to participate with a profit split up to a certain threshold level. The owner intuitively prefers the latter alternative, but has to consider the relative value between the two alternatives.

Let’s assume the reliable charterer offers a rate of $20,000 per day whilst the other proposed profit-sharing agreement guarantees the owner a minimum of $18,000, but a split that is dependent on the spot shipping rates. If the spot turns out to be between $18,000 and $30,000 the profit is split 50% between the owner and the charterer. The owner reaches his maximum threshold at $30,000, hence will not be gaining any additional profit if the market turns out to be stronger. Since the owner will only gain 50% of the upside, they have the potential to gain another $6,000 in addition to the floor of $18,000. This is equivalent to $24,000 per day. The chart above illustrates the two alternatives. Net payout received (vertical axis) versus the spot market (horizontal axis).

The black line shows alternative one for the owner, a flat payout of $20,000 regardless of spot market movements. The red line illustrates the second alternative, a profit-sharing agreement between the owner and the charterer. An owner, naturally interested in the best deal possible, should look at freight options to value any profit-sharing strategy. The seemingly good profit-sharing alternative turns out to be less attractive, because it is undervalued relative to what could be obtained using freight options. In the example below, it is assumed the owner charters out their vessel at the flat rate of $20,000 and replicates the profit-sharing payoff by buying a “call spread” (simultaneous purchase and sale of two call options with different strikes).

At approximately $750 extra per day, the owner is able to receive an additional $3,250 per day if the market turns out to be stronger. This is clearly a viable alternative to the initial strategy. Firstly, the owner will incur less counterparty risk by timechartering out the vessel to a more reputable charterer. Secondly, a cleared option will completely remove the risk of default and thirdly, if any unforeseen circumstances do occur and the physical exposure for the owner changes, the option strategy can be easily unwound in the market. The blue line shows payoff if a vessel is timechartered out at $20,000 and profit sharing is replicated with options. For an additional $750 per day invested, the owner will have a significantly higher payout if the spot market is strong.

It is important to remember that the example above is only one of many possible strategies that the owner can choose from. Adjusting for volumes would, for instance, reduce the additional cost but at the same time decrease the payoff if physical rates remain strong. In other words, it would bring the strategy more in tune with the charterer proposing the profit sharing, but still with a preferential payoff.

Extending a timecharter contract

A charterer might take a ship for one year at a given rate, and at the same time offer the owner a lump sum of money for the option to extend the timecharter for another year. Both the owner and the charterer agree to a date where the charterer must decide whether he will declare the option, and thereby keep the ship. This is in effect an owner selling a “call option” since the potential to participate in a stronger market is exchanged with the benefit of collecting a premium. There is little doubt that the charterer will extend the contract if the market is strong. Similarly, the ship will be redelivered if rates subside.

Whether this is a prudent strategy is a separate discussion to the relative value of entering into such agreement on the physical side as opposed to what value can be realised from selling a cleared freight option. By doing the latter, the trade rightfully demands a margin to be posted with the clearing house. Nevertheless, it is an attractive alternative as the additional premium received could easily outweigh the cost of margin financing.

It is important to realise that all physical optionalities have a value and are often directly linked to shipping rates. Freight options can be used as a supplement, a valuation tool or as a substitute for many types of contract arrangements in the physical market. Although not applicable to all circumstances, any company related to ocean freight should explore how freight options can assist in improving decision-making and overall risk management.

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