A forward freight agreement (FFA) is a financial instrument used in the shipping industry to hedge against future price fluctuations in vessel charter rates. In a FFA, two parties agree to fix the rate at which a particular vessel will be chartered at a future date. The agreed-upon rate is then used to offset any fluctuations in the market.
Let us consider an example to understand how a FFA works. Suppose a shipping company, ABC Shipping, wants to charter a vessel on a particular route in six months` time. The charter rate for this route is currently $10,000 per day. However, ABC Shipping is concerned that the charter rate may increase in the future, leading to higher costs.
To mitigate this risk, ABC Shipping enters into a FFA with a counterparty, XYZ Trading. They agree to fix the charter rate at $10,000 per day for the agreed-upon route on the future date. This means that ABC Shipping is protected against any increases in the charter rate beyond $10,000 per day.
If at the future date the charter rate for the route has increased to $12,000 per day, ABC Shipping can purchase the charter at the previously agreed-upon rate of $10,000 per day, and XYZ Trading will pay the difference of $2,000 per day. Conversely, if the charter rate has decreased to $8,000 per day, ABC Shipping will pay the previously agreed-upon rate of $10,000 per day to XYZ Trading, but will benefit from the difference of $2,000 per day.
FFAs can be settled in various ways, including cash settlement, physical delivery of the vessel, or a combination of both. They are commonly used by shipping companies, charterers, and traders to manage their risk exposure and ensure a predictable cash flow.
In conclusion, a forward freight agreement is a useful tool for managing risk in the shipping industry. By fixing the charter rate at a future date, parties can protect themselves from future price fluctuations and ensure predictable cash flows. Examples of FFAs can be found in various shipping publications and industry reports.