It is the beginning of February, an oil trader spots a good price to purchase oil with delivery October. He calculates the sale price for 260,000 mts crude oil which he is going to purchase in the Middle East Gulf (MEG) and intends to sell to Japan. The cargo has to be loaded beginning of October when he needs to ship the oil. Foreign exchange fluctuations and freight rates are some variables the owner is keen to fix today in order to secure enough profit in reference to his selling price. He fears increasing charter rates and thinks to take advantage of the current costs of shipment to secure his targeted profit margin.
Today, beginning of February, the dealer buys a September TD3 (BDTI) MEG/Japan FFA expiring by the end of September. The FFA contract price is WS 107. The settlement price, used by the end of the period, results from the average of all published index days in September.
It is end September and the charter rates have risen marginally. The oil trader has to fix his cargo of 260,000mts oil at WS110. This represents a difference of WS 3 points or $ 75.00 per ton (WS 1 point = $25.00) to the bought FFA, thus is 260,000 x 1,950,000.
As the indices refer to the development of the physical charter market the settlement of the FFA (basis risk excluded) is at end September WS 115 points. The oil trader bought for WS 107 and receives therefore WS 8 points or $ 200 per ton from the seller. Speaking of a agreed amount of 260,000mts crude oil he makes a $ 520,000 profit from his paper hedge.
WS115 – WS107= WS8 points = $200 (8x$25) x 260,000 mts = $ 520,000
The result: the physical freight is WS 110 and the paper generates a profit of WS8 points, which represents freight expenses of WS 102 points. The oil trader successfully secures his calculated profit by buying the FFA in Febrauray at WS 107 per ton. Due to fortunate timing the oil trader is even able to reduce the freight to WS 102 through the combination of FFA and physical freight.
In the case of a decreasing market the situation is vice versa. The oil trader loses on the paper side, wins however on the falling freight rates for his ship.The final results remains unchanged – he has to pay about WS 107 for the ship as originally the FFA he bought in February.
It is mid November. A shipowner knows that by the end of the first quarter of the upcoming year one of his VLCC tankers, trading spot, will be open in the market. Normally he fixes his ships for three to six months and would like to do same for the second and third Quarter of next year.
As a shipowner he is the seller of freight, therefore he is the seller of the FFA contract as well. He is afraid of a falling market and therefore wants to secure the current Forward rates for the upcoming year on the paper market. He sells a Q2&3 FFA contract at $120,000 per day.
In case the shipowner made a correct forecast (the charter market dropped by the end of the first quarter) the price for Q2&3 FFA (basis risk excluded) is reduced to the same value. By fixing a period charter for his vessel he simultaniously buys back the same FFA at the cheaper price and secures therefore the difference to his selling price times the period.
Basically he fixes his his ship at $ 100,000 per day for six months. In comparison to his FFA Position this means a different of $20,000 daily, during a period of six months its $ 20,000 x 183 days = $ 3,660,000.
At the same time his paper position for Q2&3 dropped also to $ 100,000. The owner purchases the FFA back at this level. Q2&3 FFA, being $ 20,000 less than he sold last year, he nets his smaller charter rate with a identical gain on the paper position for 183 days.
In case the charter rates are higher at the moment of the physical fixture, compared to last year, the above situation is vice versa. The final result remains $ 120,000 per day that is locked in. The shipowner would have the possibility facing an increasing market to purchase back his positions sooner and to accept a reduced loss on the paper side but to fully profiting from the rising rates on the physical you have to keep in mind that a protection via a hedge would be annulated being dependent on the market movements.