Freight Derivative Sensitivity: Test Both Price Moves

Key takeaways

• Define the combined physical and financial cost before applying price changes.
• Test different movements in the physical price and financial reference.
• Keep quantity assumptions visible: matching a price movement does not compensate for a different represented amount.
• Treat the sensitivity grid as a map of consequences, not a forecast or a position-size recommendation.

The model below is an original educational exercise with invented inputs. It does not reproduce an exchange contract, establish an appropriate hedge amount or describe current freight prices. A real assessment needs the exact instrument terms, physical exposure and qualified risk review.

State the formula and its boundary

The teaching model concerns a cargo buyer with an uncertain physical freight cost. It combines that physical cost with a simplified financial receipt tied to a reference. The financial receipt can be negative, in which case it adds to the combined cost.

The model deliberately excludes fees, funding, tax, accounting effects and other voyage costs. These exclusions make the relationship between the selected price inputs easier to see. They also limit the conclusions: a lower result in this grid does not establish a lower complete cost or a feasible funding plan.

The relevant sensitivity is the change in the combined result, not the movement in the financial component alone. Reporting only a financial gain can overlook a larger increase in the physical payment. Reporting only a financial loss can overlook a lower physical cost.

Before using a similar model, identify which real price exposure remains open. A fixed physical payment should not be treated as variable simply because a reference continues to move.

Illustrative grid with independent price changes

ILLUSTRATIVE — invented quantities, prices and simplified financial formula. Assume physical quantity Q of 40,000 tonnes and financial quantity H of 30,000 tonnes. Initial physical price and financial entry reference are both USD 20 per tonne. The baseline combined freight cost is USD 800,000.

Define financial receipt as H × (final reference − entry reference). Combined cost equals Q × physical price minus that receipt. With quantity fixed, the change in combined cost is therefore Q × physical price change − H × reference change.

The grid shows changes in combined cost, in USD. Positive amounts mean a higher cost than the fictional baseline; negative amounts mean a lower cost.

If both prices rise by USD 2 per tonne, the physical invoice increases by USD 80,000 and the financial receipt is USD 60,000. Combined cost rises by USD 20,000 to USD 820,000. The represented financial quantity is smaller than the physical quantity, so identical price movements do not produce a complete offset in this model.

If the physical price rises by USD 4 per tonne while the reference rises by USD 2, combined cost rises by USD 100,000 to USD 900,000. The physical and reference changes no longer match, leaving an additional residual effect.

Read across the grid before choosing a central case

The diagonal illustrates matching price movements under the model's fixed quantities. The other cells test divergence. A desk that shows only the diagonal has assumed away an important part of the question.

The grid does not say which cell is likely. It gives no probability for a reference moving while the physical price is unchanged, or for the physical price moving more sharply. Those cases are analytical tests. Any claim about their likelihood would require separate evidence.

Some cells produce a favourable combined result. That does not establish that the assumed relationship is desirable or stable. An outcome favourable to the buyer in one direction can reveal exposure to a different outcome when the relationship changes.

Use the grid to identify the mechanism that matters. If the decision depends on the physical and reference prices moving closely together, the evidence supporting that relationship deserves attention. If the residual is driven mainly by the quantity difference, the exposure description and represented amount need review.

Illustrative quantity comparison

ILLUSTRATIVE continuation — alternative financial quantities are teaching inputs, not recommended positions. Retain physical quantity of 40,000 tonnes and compare financial quantities of 20,000, 30,000 and 40,000 tonnes.

Matching the financial quantity to 40,000 physical tonnes removes the residual in the identical-movement case within this formula. It does not remove the USD 80,000 effect in the divergent-price case. Quantity alignment and price alignment are separate assumptions.

Do not turn the table into an automatic sizing rule

The quantity comparison explains mechanics. It does not establish what amount an organisation should transact. Actual quantity may be conditional, the relationship between prices may be uncertain and the selected instrument may have terms omitted from the model.

An anticipated cargo reduction is particularly important. A financial amount chosen against a larger programme can remain unchanged when the physical exposure shrinks. The appropriate response requires the actual mandate and qualified review; it should not be inferred from whichever row currently has the most favourable result.

Similarly, a model that fits historical movements does not establish that the same relationship will hold in the future. Sensitivity testing should challenge that assumption rather than make it invisible.

Add the timing and funding review separately

The grid compares defined final economic amounts. It does not describe when the physical payment and financial cash flows occur. Obtain the applicable contract and account terms before evaluating that cash path.

A treasury review should identify resources available at the times they may be required. An eventual economic offset is not itself cash on hand. Conversely, a cash deposit should not automatically be treated as a final economic loss without understanding its actual treatment.

Timing also affects the price comparison. If the physical pricing period changes while the financial reference period remains the same, a grid built around contemporaneous price moves may no longer represent the question. Update the exposure statement before extending the model.

Turn the result into evidence requests

The most useful conclusion identifies the assumption that drives the residual. Ask for confirmation of the physical amount, evidence supporting the proposed price relationship or clarification of the pricing period, as appropriate.

Report the model's boundaries beside the result. The reader should understand that the exercise tests defined variables while leaving other commercial matters for separate review. This is more informative than presenting a single attractive outcome with its limitations hidden elsewhere.

The decision may be to improve the analysis rather than to enter a transaction. Sensitivity has succeeded when it reveals the question that must be resolved before an authorised choice can be made.

Common mistakes

Moving both prices together in every case. Include independent changes so the model tests the assumed relationship.

Calling a sensitivity cell a prediction. Separate consequences from likelihood and do not invent probabilities.

Assuming quantity alignment removes every mismatch. The physical price and reference can still behave differently in the model.

Using the final result as a funding plan. Review actual cash timing and resources separately.

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