Ilija Murisic - News for banks - Blue Sea Thinking

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The sea may be calm but the freight rates are volatile

Blue Sea thinking A new index on sea-freight derivatives helps investors tap into the China story In the same week that UBS launched its Blue Sea index on freight derivatives, the 203,512-tonne bulk carrier China Steel Team was booked to carry iron ore from Brazil to China. At a record-breaking $303,000 per day, the freight rate was more than three times higher than the ship’s last fixture, just one month previously. China Steel Team is one of fewer than 600 Capesize bulk carriers in the world. And as the name of this particular one suggests, China’s prodigious appetite for raw materials is keeping all of them busy. That’s not surprising, when you consider that Baosteel, China’s leading steel producer, needs 150 ship-loads of ore every year to feed its blast furnaces. Statistics like these explain why sea freight rates are rocketing, particularly for dry bulk cargoes such as iron ore or coal. According to Simpson Spence & Young, a consultancy, average dry bulk freight rates reached almost $220,000 per day in May, up from $80,000 or below in January and a previous long-term average of $15,000 – $20,000. Capacity shortage is responsible for part of this squeeze but a lack of tonnage is not the whole story. Even if the 185 or so Capesizers on order could be delivered tomorrow, ports and cargo terminals are too choked with shipping to allow them to load and unload

on time. The upshot is a rising trend in freight rates, coupled with spectacular volatility; the benchmark Baltic Exchange sea freight index for dry commodities sagged by more than a third between November last year and mid-January 2008 on fears of a US recession, although it has since bounced back. That volatility, of course, has already attracted banks, hedge funds, and other financial institutions. So far, would-be investors have looked to the existing markets for sea-freight derivatives, which are based mainly on futures and forwards on the principal reference indices. What was lacking, however, was a packaged instrument that offered a balanced exposure to a representative spectrum of the dry-bulk freight market. It was this gap that UBS sought to fill when it launched its Blue Sea Index on May 22. Congestion factor UBS Blue Sea is the first fully integrated index to be benchmarked on the most actively traded dry-bulk forward freight agreements. FFAs are non-standardized over-the-counter forward contracts based on one of several underlying freight indices. They are agreed between two parties for a specific route, for a specific delivery rate and a specific vessel type. The index

also incorporates a “Port Congestion Factor” that takes into account the effect on freight derivative prices of loading or unloading delays in more than 60 iron ore and coal ports worldwide. The index is aimed primarily at investors who are interested in freight as a generic asset class. In addition, shipowners and charterers could use the index to hedge their total exposure to freight rates. For this purpose, sub-indices are also available. These are based on the three categories of bulk carriers that comprise the main index, namely the Capesize giants and the handier-sized Panamax and Supramax types. It’s too early to say which types of investor will make the most intensive use of the new index. But Blue Sea has certainly captured the attention of industry experts. Lloyds List, the longest-standing daily newspaper for the maritime industry, commented as follows: “This new UBS initiative deserves to be watched as it may introduce a new level of sophistication to the freight derivatives market by opening it up to investors who are not necessarily freight professionals. The Blue Sea Index is indeed blue sky thinking.” Ilija Murisic UBS Investment Bank, Hybrid Derivatives Trading ilija.murisic@ubs.com UBS News for Banks / Autumn 2008

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