Disclaimer: FreightWaves, in collaboration with Nodal Exchange and DAT, launched the world’s first Trucking Freight Futures contracts in March 2019. The author is not presently an investor in FreightWaves, or any other startups developing derivatives products for the freight trucking industry.
A financial derivative is an instrument that derives its value from the behavior of an underlying asset. Freight derivatives are financial instruments whose value is derived from the behavior of freight rates. With the exception of a few proprietary operations, the trucking industry has not made widespread use of financial derivatives in the past. That is changing, and the conditions now exist for freight trucking derivatives to become more commonplace among carriers, shippers, third-party logistics service providers (3PLs), and financial speculators. This article argues that freight derivatives are here to stay in the trucking industry.
This article will not discuss the technical aspects of valuing financial derivatives, nor will we spend time on quantitative data about derivatives markets, or freight markets for that matter – that data is easily available from FreightWaves and elsewhere. A technical discussion of the valuation of derivatives instruments falls outside the scope of this column. Rather, the only goal is to help readers of FreightWaves develop a brief, qualitative, yet adequately sophisticated understanding about why the trucking industry is ready for freight derivatives – without going into all the intricate details. While freight derivatives can be utilized in other markets, this article is written with a particular focus on the United States.
I touched briefly on the topic of derivatives in the trucking industry in; Industry Study: Freight Trucking (#Startups) (2016) and Updates – Industry Study: Freight Trucking (#Startups) (2016).
Types Of Derivatives
In this section we will briefly define forwards, futures, and options, while ignoring swaps, credit derivatives, and other types of derivative instruments. This approach makes sense because swaps and other types of derivatives are unlikely to be used until the market for forwards, futures, and options has matured considerably.
A forward contract is a bespoke, private contract between two parties that creates an obligation to buy and sell the underlying contract at a specified price at a specified date in the future. If the future freight rate is higher than the rate specified in the contract, the buyer experiences a gain while the seller experiences a loss.
Futures contracts are standardized versions of forward contracts. Because futures contracts are standardized, they are traded on a futures exchange with a clearinghouse acting as an intermediary between buyers and sellers. The futures are backed by the clearinghouse, and require daily settlement of gains and losses.
An option is a contract between a buyer and a seller that confers the right, not the obligation, to buy or sell the underlying contract at a specified price at a specified date in the future. A call option confers the right to buy the underlying contract to the buyer of the option. A put option confers the right to sell the underlying contract to the buyer of the option. An obligation is created only if an option is exercised. The seller of a call option has an obligation to sell the underlying contract, while the seller of a put option has an obligation to buy the underlying contract.
A single counterparty, a carrier or shipper, could use forwards, futures, and options for different parts of its trucking operations. The use of one type of derivative instrument does not preclude the use of another.
Why Use Derivatives?
Volatility in spot or cash freight rates adversely affects shippers and carriers. Rate volatility makes it difficult to forecast expenses and revenues. Moreover, the underlying causes of freight rate volatility are beyond the control of shippers and carriers.
Financial derivatives enable carriers, shippers, and 3PLs to engage in;
- Risk Management – By locking in known, agreed, and contractually guaranteed freight rates, and
- Price Discovery – By getting a sense of what other market participants believe about future spot or cash freight rates.
Financial speculators use derivatives to speculate on the future movement of freight rates in an attempt to make a profit. Financial speculators are unlikely to have any relationship to the freight markets – for example, quantitative hedge funds with no interest in the trucking industry could trade freight futures as a means of earning a financial profit.
The 3 Factors Leading To the Creation and Adoption of Freight Trucking Derivatives
As has already been stated, market volatility creates risk and uncertainty for shippers and carriers. As time progresses and technological innovations mature, these carriers and shippers may wish to hedge such risks and minimize the uncertainty associated with their business operations.
Three primary factors specific to the trucking industry have encouraged the development of derivatives markets and instruments for freight trucking.
- First, recent advancements in information technology, and the application of such innovations to trucking, has encouraged the development of freight derivatives. Over the past half-decade it has become easier to gather and analyze relevant data about the state of the freight trucking markets. This makes it easier for different market participants to develop opinions about the current and future state of the underlying market for freight trucking rates, and then make decisions about how much risk they are willing to bear and how to price that risk in order to transfer some or all of it to other market participants.
- Second, as a direct result of the application of information technology in freight trucking, the market has experienced an influx of participants with significantly more familiarity and sophistication as it relates to information technology, financial markets and instruments and their use as a risk management mechanism in other industries that share similarities with the freight trucking industry, as well as a deep knowledge of freight trucking itself. These market participants understand how the use of derivatives in other markets have helped to make those markets more efficient, and they have set out to accomplish the same effect in the trucking market, arguing that a market with the size, breath, and economic impact of freight trucking deserves, and is ready to adopt more sophisticated risk management products.
- Third, freight trucking markets around the world are more susceptible to increasing volatility, uncertainty, complexity, and ambiguity (See: Commentary: Key supply chain innovation issues to consider in a world with VUCA). This is creating a need for risk management tools that did not exist in the past.
In Why digital freight brokers might fail to disrupt the freight brokerage industry, we discussed the functions of a digital freight marketplace. The functions of an emerging freight derivatives exchange reflect those identically. However, the most important task for startups developing freight trucking derivatives is the development of a large audience of shippers, carriers, speculators, 3PLs, and other parties interested in using freight trucking derivatives – increased awareness of the applicabilitions of freight trucking derivatives is the most critical first step in the evolution of the trucking industry’s adoption of these instruments.
Freight trucking derivatives are here to stay because the three factors that led to their creation will continue to become more accommodating to their implementation and adoption. This will happen at a faster rate than we expect or can predict.