DREWRY, the London maritime research consultancy, and the World Container Index (WCI), have published a guide on how index-linked contracts work, given that they have become widely adopted in the container shipping industry over the past two years.

The study, which can be downloaded from Drewry's website, examines the causes of recent container freight rate volatility and how index-linked contracts can mitigate impacts of instability. It explains how these new contracting arrangements work with reference to current models in use and summarises the extent of industry adoption thus far, a jointly issued statement said.

According to Drewry's freight rate research manager Martin Dixon, its paper on index-linked contracts "lifts the veil on a much misunderstood subject that has the potential to transform the way in which container shipping is contracted".

Persistent freight rate volatility is said to be forcing the container shipping industry to consider alternative forms of shipper-carrier contracting arrangements that enable the contract rate to vary relative to an external index. Index-linked contracts are a response to the failure of traditional fixed-rate forms of contracting to provide the necessary space, volume and price protections.

"Freight rate volatility will continue to be a feature of container shipping for some time to come," Mr Dixon warned.

Drewry researchers maintain that enabling the contract rate to vary relative to an external index serves to reduce any possible divergence between contract and spot rates. Meanwhile, the resultant exposure to wider market volatility can be mitigated through the application of dampeners, floor and ceiling limits or hedging.

The paper goes on to explain that index-linked contracts bring other benefits, such as reduced shipper tender costs and carrier cost of sale.

Adoption is growing rapidly. In May, the Federal Maritime Commission (FMC) confirmed that 61 index-linked contracts covering US trades had been filed with the organisation in 2012. Drewry estimates that 50 index-linked contracts have been signed on the Asia-Europe trade so far this year.

"It is quite conceivable that by 2020 the vast majority of containerised ocean freight will be transacted on the basis of index-linked contracts," added Richard Heath, director of the World Container Index. "Contracts will be negotiated on the basis of discounts or premiums to benchmark indices, relative to service level needs."

The WCI is a 50-50 joint venture between Drewry and Cleartrade Exchange, an electronic marketplace for OTC freight and commodity swaps. The WCI is a global index, which can be used by physical and derivative market participants to manage freight risk.