Air cargo hedging for a paper market
03 / 05 / 2018
In many industries index-linked block space agreements (BSA) and derivatives markets, also known as forward freight agreements (FFA) and paper markets, are normal.
In shipping, for example, many bulk sectors have a paper market that offers the option to hedge against the volatility of prices in the physical market.
Now, one company is looking to create a paper market for air cargo. Freight Investor Services (FIS), which specialises in shipping derivatives, says that index-linked BSAs and FFAs should be suitable for the air cargo industry because of the high levels of price volatility, limited price visibility and the abundance of fixed-price BSAs with limited flexibility to react to market changes.
FIS believes that the fact that there are now established rate indices and demand from e-commerce companies for a derivatives option are other reasons that now is the right time to launch FFAs and index-linked BSAs.
FIS, which was founded in 2002, offers brokerage services, trade execution and market intelligence to help customers make informed decisions about their derivatives strategies.
Out in front
Leading the charge are head of strategy Michael Gaylard and air cargo business development manager Nicola Hughes, who will be engaging with potential users and educating the air cargo sector on how the paper market can work to its benefit.
Gaylard says that FIS began considering an airfreight derivatives product after it was approached by customers that were using some of its shipping services.
One prerequisite of a derivatives market and index-linked BSAs is a trusted price index that can be used to base rates on. With this in mind, FIS began working with the TACIndex.
FIS says it selected TAC because its data is fully verifiable and accountable, all activities are carried out in full compliance with applicable laws and transaction data is cleaned to remove erroneous and anomalous data using statistical filtering and data validation.
Says Gaylard: “We have probably now been talking and working with TAC for about 18 months to understand a bit more about how they put the index together, how the data is received, how it is compiled and using them as a bit of a backdrop and sounding board to understand the market.
“We felt there really was something interesting for us to look at and something that we could get our teeth into.
“It didn’t fall outside of the scope of what we do ourselves. We talked to a couple of users of our other products, so some of the financials that are involved in air industry financing and leasing.
“It was an interesting tool that they had thought about — if they are financing a new build for five or 10 years they could manage some of that risk in the forward market. It’s a great way for them to be able to mitigate their exposure along the way.”
Gaylard says that one of the first steps to launching a derivatives market is the development of index-linked BSAs.
This is where customers and suppliers agree that the rates paid will be fixed against a pricing index that will fluctuate along with the market.
As a result, participants will not pay a set price for the full year and then end up winning or losing depending on how the market goes, but instead know they will end up paying the going market rate.
A similar outcome can be achieved by playing the spot market, but this can involve a lot of people hours as staff need to check prices and negotiate with various carriers to ensure they are getting the best deal.
They also risk having cargo turned away if there is an upturn in the market and spare capacity becomes scarce.
Another benefit for carriers of offering index-linked BSAs is that it could help them win extra business if customers are interested in the concept as it is an extra product to sell.
FIS says index-linked BSAs will also free up carrier staff to spend more time developing new business and focusing on customer service, rather than negotiating based on price.
Gaylard says he expects the first index-linked BSA in air cargo to happen within the next three to six months.
“On all of the other products we have done, everything has taken that first step with the move away from either annual or six monthly pricing onto index-linked pricing. That is the first step on the road, so to speak,” he says.
“I think at this stage it is a new concept and is something that a good number of users are intrigued by. It might be a case of starting with a small amount on a particular route to see how it works, and understand how it will be settled, how that looks on the balance sheet and the profit and loss sheet and once they understand it and if they like it they can introduce some more.”
To help improve liquidity for the indices, TAC and FIS will put routes from various destinations into overarching baskets, covering, for example, Hong Kong to Europe or the US, rather than airport to airport. These baskets will still fluctuate with overall market conditions.
Index-linked BSAs, however, do not help remove risk as the companies are still susceptible to the peaks and troughs of the market.
Reducing risk can be achieved through a derivatives market, which allows buyers and sellers to hedge exposure in the physical world.
For example, forwarder A would offer to trade on the paper market at $6 per kg on a particular route basket and carrier B would offer to trade at $4 per kg, the two parties would agree to a settlement price in between the two — $5 per kg.
Usually, the positions these parties take in the paper market are the inverse of their position on the physical market. In this way, no matter which way the market goes, the two parties have mitigated some of that risk and helped smooth out some of the market volatility.
One downside to hedging is that a particular party would not gain to the same extent when a market swings to their benefit.
“The primary benefits are always going to be managing price risk,” explains Gaylard. “At this point nobody has an idea through this next year where the market is going to be, whether you are going to beat the market or whether you are going to be a substantial loser.
“If we are looking at an index-linked product then we know that, worst-case scenario, we are going to match the market.
“If we are looking at forward contracts, it allows us to manage a forward book without having to act here and now. So whatever happens to the pricing in the meantime, we are going to have our price risk smoothed out.”
The concept of removing pricing volatility is fairly straightforward, but the wider derivatives concept is more complex and can be hard to understand.
Gaylard, however, points out that most airlines already hedge so should have some understanding of the concept.
“A lot of the airlines will enter this from a fuel perspective,” he says. “It generally comes through the treasury side of the business to hedge their fuel risk so it is something that the airlines will be doing anyway.
“[Cargo] is a different side to the business but [hedging] is an expertise that is within the business so it is not going to be completely new to the market and if they want to look internally there will be an expertise there that will be able to educate.”
Another challenge faced when launching an index is market acceptance. In order for the market to work there needs to be various counter parties taking different positions.
This is one reason the container shipping industry has been very slow in taking up the concept — the shipping lines for various reasons did not buy into the concept.
Overall, Gaylard is not anticipating a lack of counter parties to be a problem in the air cargo sector because there is a drive from end users, particularly e-commerce companies, that want pricing visibility and clarity.
He explains that e-commerce companies work differently to other areas of the market, they are data driven, digital and are open to tools that help them improve margins and drive efficiency and transparency.
“E-commerce and end-user companies are very interested,” he says. “In their first call to us they want to know if [FFAs] are something we cover and if we have pricing, then they want to understand more about us and whether pricing and hedging is available.
“Then we will then put them in touch with TAC so that they can understand more from the index and then become an index subscriber, so that they get some index linked pricing to take that first step.
“Similarly, TAC pass onto us any of its subscribers and other contacts that come to them and ask if they offer a forward market.”
However, there is interest from the more traditional areas of aviation as well.
“[Interest] also comes from the financial side of the market, from those people that have a physical interest in airlines, whether that is from financial or actual ownership perspective.
“Even if it just comes down to managing the market and exposure they have on a day-to-day basis. Currently that is not available to them — there is no pricing colour that they can understand.”
Another complaint often levelled at FFAs and index-linked contracts is that they reduce the market to a commodity, where service levels and different levels of product offering are not taken into account.
However, Gaylard says other FFA markets do take this into account. For example, the iron ore market trades on different grades. The indices take this into account by offering differentials for the various grades.
The air cargo FFA market could take similar measures, adding a premium for certain services.
He adds that overall market conditions tend to affect all different product offerings.
For example, it may cost more to transport a sensitive pharma product than a TV, but when demand outstrips supply in the market overall, the price of transporting both products will increase.
So, should the air cargo industry be ready for the FFA market to sweep the business over the next 12 months?
Gaylard admits that the market will take time to develop: “We are not under any illusion that tomorrow there will be a million tonne forward market trading.
“It is going to take two to five years. It is an education. It is a time spent in the market. It is a trust relationship that you build. It is something we have done with all the other markets and something that we are happy to do.
“It is something that we will take our time to develop with the market and if it works, which we hope it will, then we will want to be there to help our customers into that market.”