Recently, Swiss investment bank UBS joined a host of others banks in the shipping business. Not by purchasing ships, but by creating a freight index to track the variation in shipping costs. Yawn, right? Just another index. Not so fast.

Gold Standard

The gold standard for shipping rates is the Baltic Dry Index (BDI). The BDI is a weighted composite index of the daily rate of three different sizes of ships on four main shipping routes. Not only does it tell you what a ship would cost on a given day, it also has information value on the state of the global economy: things like supply and demand in certain commodities such as coal, iron and grains. The axiom for shipping wonks is that "people don't book freighters unless they have cargo to move." And when they do have cargo, they have to have the ships to get their products from point A to point B or they might as well become salmon fishermen.

But you can't invest in the BDI. If you were a private investor, the closest you could get was to invest in a shipping company - but that's a little like buying a cow when all you're interested in is the milk. Sure you get the milk, but you also get a whole lotta other things to worry about.

And if you're one of the hundreds of ship owners, operators, charters and traders, there was no way to hedge against the volatility of freight costs. Hedging would be invaluable in this case, because shipping costs are volatile with a capital V.

Many things can contribute to the rough seas of freight costs - supply and demand of the commodities transported is No. 1. In 2007, the average freight rate almost doubled from 2006. To get under the hood, there's no better source than the ingeniously named shipping trade magazine - theBaltic. In March 2008, they discuss the factors contributing to the rise of freight costs, and its subsequent fall in January of 2008 is discussed in an article called "Dry bulk markets damaged, but not sunk, by ‘perfect storm.'" Here's a brief breakdown.

Prices went UP because:

• Dry bulk shipping activity rose by 7%
• Iron ore transportation rose by 70 million tonnes - that's up 10% compared with 2006
• China alone imported over 390 million tonnes of iron ore in 2007
• China imported over 51 million tonnes of coal - a 34% increase. It was estimated that this demand created a need for an additional 40-bulk vessel in 2007.
• Cargos such as nickel, manganese ores and alumina rose around 10%
• Grains volumes transported rose 3%

And DOWN:

• In Brazil, Vale had to cancel around 5 million tonnes of iron ore shipments to China because of port congestion and maintenance problems
• Recession worries due to the U.S. Federal Reserve's interest rate cut

And UP again:

• Chinese iron and coal imports continue to increase
• Demand for grains around the world increasing

This will be on the final exam, and be prepared for a quiz on Friday.

Industry Hedging

With all of this volatility, industry participants needed a way to hedge against wild price swings. Freight forward agreements (FFAs) are pretty much the only way that industry participants can protect themselves from the extremes. FFAs are pure, principal-to-principal agreements between a buyer and a seller to pay the difference between the cost of shipping something today, versus the cost of shipping something at a future date. It's the nonexchange-traded equivalent of the listed futures commodities investors are familiar with. There's a small industry of intermediaries who help manage FFAs: folks like Freight Investor Services (FIS) and GFI.

FFAs can be structured in a number of ways: based on a specific route; an average of the several routes a particular ship size would sail; by the day; or by the tonne from port to port. It's a growing market, and has become a highly flexible and sophisticated way to both speculate and manage risk. Freight forward contracts grew 150% in a year as of February 2008, and may grow another 20% as more banks and hedge funds get into the act.

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