Freight Derivatives and Risk Management in Shipping


IntroductionMarket segmentation of the shipping industryGeneral cargo and bulk cargo movementsBulk-cargo segmentationGeneral (dry) cargo segmentationMarket conditions in shipping freight marketsEquilibrium freight rates in tramp freight marketsFreight rates for different duration contractsTerm structure of freight rate contractsSeasonality in freight rate marketsCase 1: Seasonality patterns in dry-bulk marketsSpot market seasonalityOne-year T/C seasonalityThree-year T/C seasonalitySeasonality comparisons between vessel types and contract durationsSeasonality patterns under different market conditionsCase 2: Seasonality patterns in tanker marketsCase 3: Seasonality strategiesVessel prices and vessel price risksVessels as capital assetsMarket efficiency in the markets for vesselsSummaryNotesBusiness risks analysis in shipping and traditional risk management strategiesIntroductionThe sources of risk in the shipping industryBusiness decisions faced by the international investorThe cash-flow position of the shipownerVolatilities of spot and time-charter rates in shippingTime-varying freight rate volatilities for different sub-sectorsTime-varying freight rate volatilities for contracts of different durationVolatilities (risks) in different vessel marketsTime-varying volatilities of different vessel sizesVolatility spillovers across shipping segmentsCorrelations amongst shipping sub-sectors and portfolio diversificationSummary of traditional risk management strategiesRisk management and the use of derivatives in the shipping industrySummaryNotesIntroductionThe economic functions and benefits of financial derivativesThe risks associated with financial derivativesTypes of participants in derivatives marketsForward and futures contractsMarket positions (long and short)Mark-to-market and clearingBasis and basis riskOptimal hedge ratio determinationPricing and the cost-of-carry modelExample 1: Contango market: Futures/forward price higher than the spot priceExample 2: Normal backwardation: Futures/forward price lower than the spot pricePricing examples for different underlying assetsCase 1: Forward price of asset with no incomeCase 2: Forward price of asset with incomeCase 3: Forward price of assets with known yield and stock indicesCase 4: Forward price of currency contractsCase 5: Forward price of assets that are held for investment purposesCase 6: Forward price of assets that are held for consumptionCase It Forward price of non-storable assetsSwap contractsPricing of swap contractsCase 1: Pricing interest rate swapsCase 2: Pricing currency swapsOption contractsPayoffs of option contractsHedging with option contractsOptions versus futures/forwardsIntrinsic and time value of optionsFactors influencing option prices and the “Greeks”Price of underlying asset (S)Strike or exercise price (X)Time to expiration (T)Price volatility of the underlying asset (σ)Risk-free interest rate (r)Case: Utilising the Greeks – a Delta hedge strategyOption pricingModel 1: The binomial modelModel 2: The Black–Scholes modelPrice limits of optionsPut–call parity relationshipAsian optionsModel 1: The Kemma and Vorst modelModel 2: The Turnbull and Wakeman modelModel 3: The Levy arithmetic rate approximationModel 4: The Curran approximationOther exotic optionsAccounting treatment of derivative transactionsSummaryAppendix: Cumulative standard normal distribution tableNotesFreight market information and freight rate indicesIntroductionDry-bulk market information and freight rate indicesTanker market information and freight rate indicesBaltic Exchange freight rate indicesPlatts freight rates assessmentsLiquefied Petroleum Gas (LPG) and Liquefied Natural Gas (LNG) indicesContainership freight rate indicesChina (Export) Containerized Freight Index (CCFI)Shanghai Containerized Freight Index (SCFI)World Container Index (WCI)Ningbo Containerized Freight Index (NCFI)The Freightos Baltic Index (FBX)SummaryNotesFreight rate derivativesIntroductionFreight futures markets: early efforts and currently non-active exchanges in freight derivatives – a historical perspectiveThe Baltic International Freight Futures Exchange (BIFFEX) contractClearing BIFFEX trades: the LCH.Clearnet (LCH)The International Maritime Exchange (IMAREX)Clearing IMAREX trades: the Norwegian Futures and Options Clearing House (NOS)The Nasdaq Energy Futures Exchange (NFX)Active exchanges trading freight futures and associated clearing-housesThe European Energy Exchange (EEX) and the European Commodity Clearing (ECC) HouseClearing EEX trades: the European Commodity Clearing (ECC) HouseA Clearing example at the European Commodity Clearing (ECC) houseThe Chicago Mercantile Exchange (CME) GroupThe Intercontinental Exchange (ICE)The Singapore Exchange Limited (SGX) and the Singapore Exchange Derivatives Clearing SGX-DCOver-The-Counter (OTC) freight derivativesTrading volumes of freight derivativesTrading volumes of freight derivatives: OTC versus clearedCredit risk in freight derivative contractsClearing OTC freight derivativesKey properties of FFA contractsTailor made versus liquidityBasis and off-hire risksMarket information on FFAs and freight options contractsNegotiating and writing FFA contractsThe Forward Freight Agreement Brokers Association (FFABA)The Baltic Forward Assessments (BFAs)The Baltic Options Assessments (BOAs)Freight futures prices from market-makers and shipbrokersFreight options prices from organised stock exchanges (market-makers)Trading screens for freight derivatives and other developmentsHistorical evolution of shipping derivativesSummaryAppendix I: Clarksons dry-bulk FFA daily report (29 May 2019)Appendix II: Clarksons dry-bulk freight options daily report (23 June 2017)Appendix III: Forward Freight Agreement Brokers Association (FFABA) Forward Freight AgreementAppendix IV: Forward Freight Agreement Brokers Association (FFABA) Freight Options ContractNotesApplications of FFAs, pricing and risk management of FFA positionsIntroductionPractical applications of freight futures and FFAsDry-bulk voyage FFA, non-clearedDry-bulk voyage “hybrid” FFA, clearedDry-bulk voyage non-cleared versus cleared FFADry-bulk T/C non-cleared versus cleared FFADry-bulk 12-month T/C non-cleared versus cleared FFADry-bulk voyage trend FFA, clearedThe hedger’s point of viewThe speculator’s/investor’s point of viewTanker voyage FFA, non-clearedTanker voyage freight futures, clearedTanker T/C “hybrid” FFA (cleared)FFAs in newbuilding ship financeSecuring favorable shipping loan terms through FFAsApplication of the optimal hedge ratio in the FFA marketSpread tradesFreight derivatives strategies for banksFreight derivatives versus other risk management strategiesThe role of brokers in freight derivativesEconomics and empirical evidence on FFAs and freight futuresPricing, price discovery and unbiasednessHedging effectivenessForecasting performanceImpact on market volatilityMicrostructure effectsForward rate dynamicsMarket risk measurementSurveys on the use of shipping derivativesSummaryNotesApplications of freight optionsIntroductionThe characteristics of freight optionsOption strategies for freight hedging purposesDry-bulk freight option hedgeCase 1: The shipowner’s hedge – buying a protective put (floorlet)Case 2: The charterer’s hedge – buying a protective call (caplet)Case 3: The shipowner’s hedge – writing a covered callCase 4: The charterer’s hedge – writing a covered putOptions versus futures/forwardsCase 1: Options versus FFAs in a voyage hedgeCase 2: Options versus FFAs in a time-charter hedgeTanker freight option hedgesCalendar option hedgesCase 1: Charterer’s calendar hedgeCase 2: Shipowner’s calendar hedgeFreight option strategies for finance purposesExample 1: Price volatility (business cycle) tradingExample 2: Forward curve shape tradingFreight option strategies for investment purposesOption spread strategiesCase 1: Bull call spreads (or supercaps)Case 2: Bear call spreads (or superfloors)Case 3: Butterfly spreadsCase 4: Calendar spreadsOption combination strategiesCase 1: Bottom (or long) straddles (or straddle purchases)Case 2: Top (or short) straddles (or straddle writes)Case 3: Bottom (or long) stripsCase 4: Top (or short) stripsCase 5: Bottom (or long) strapsCase 6: Top (or short) strapsCase 7: Bottom (or long) strangles (or bottom vertical combination)Case 8: Top (or short) strangles (or top vertical combination)Freight option strategies for arbitrage purposesCase 1: ConversionsCase 2: ReversalsCase 3: BoxesExample 1: Short box strategyExample 2: Long box strategySummary of freight option strategiesEconomics and empirical evidence on freight optionsOption pricingFreight option dynamics and information transmission across physical and derivative freight marketsSummaryNotesMarket risk measurement and management in shipping marketsIntroductionWhat is Value-at-Risk (VaR)?Various types of Value-at-Risk modelsNon-parametric modelsHistorical simulation (HS)Hybrid historical simulation (HHS)Parametric modelsThe variance-covariance methodRandom walk model (Exponentially Weighted Moving Average, EWMA)Integrated GARCH-RiskMetrics VaRExample 1: Estimating daily 95% VaR with the RiskMetrics model for BCI route C4Generalised Autoregressive Conditional Heteroskedasticity (GARCH) modelsSemi-parametric modelsFiltered historical simulation (FHS)Extreme value theoryExpected shortfallAn example on the estimation of the ESThe evaluation of VaR models: backtestingPractical examples on estimating market risk in shippingEstimating multiperiod risk for freight rate exposures when freight rate fixtures do not overlapEstimating the VaR by scaling volatility with the square root of timeEstimating medium-term VaRCase 1: VaR estimation with volatility scalingCase 2: KiR estimation by applying the scaling lawCase 3: Estimating the portfolio’s risk for freight rate exposuresSummaryNotesBunker price derivativesIntroductionThe bunker marketKey economic variables affecting the bunker marketForward bunker agreementsThe bunker fuel oil futures marketEarly efforts on bunker fuel oil futuresCross-hedging bunker price riskThe market of bunker futures contractsBunker swapsBunker optionsBunker collarsCase 1: Zero-cost collarsCase 2: Participating collarsSwaptionsSummaryNotesVessel value derivativesIntroductionThe Forward Ship Value Agreements (FoSVAs) and Sale & Purchase Forward Agreements (SPFAs)Practical applications of SPFAsHedging vessel price risk using an SPFA contractVessel hedging with a multiple maturity SPFAPricing SPFA contractsBaltic Ship Recycling Assessments (BSRAs)Overview of the vessel scrapping industrySummaryNoteForeign exchange derivativesIntroductionMoney market hedgingCurrency forwards and futuresHedging an expected cash outflowHedging an expected cash inflowSpeculating currency tradeCurrency swapsSwapping liabilitiesSwapping transaction exposuresCurrency optionsComparison of derivative transactions in the currency marketCase 1: Alternative trading strategiesAlternative 1: Money market tradeAlternative 2: Currency forward tradeAlternative 3: Currency options trade 1Alternative 4: Currency options trade 2Case 2: Alternative hedging strategiesAlternative 1: Remain unhedgedAlternative 2: Currency forward hedgeAlternative 3: Money market hedgeAlternative 4: Currency futures hedgeAlternative 5: Currency options hedgeSummaryNotesInterest rate derivativesIntroductionThe underlying assetsTreasury bonds and notesTreasury billsEurodollarLondon Interbank Offer RateForward Rate Agreements (FRAs)Interest rate futuresHedging positionsPricing of contractsHedging and trading applicationsCase 1: Trading with Eurodollar futuresCase 2: Hedging with Eurodollar futuresCase 3: Hedging with T-Bond futuresCase 4: Hedging with T-Bill futuresCase 5: Interest rate futures spreadsInterest rate swapsThe comparative advantage in an interest rate swapShipowner’s schedule of payments in an interest rate swapExotic interest rate swapsInterest rate optionsInterest rate capsInterest rate floorsInterest rate collarsSummaryNotesCredit risk and credit derivativesIntroductionSources of credit risk in the shipping businessTypes and measures of credit riskTypes of credit riskMeasures of credit riskCredit ratings and credit rating agencies (CRAs)Credit ratings in the shipping industryCredit ratings transitionsEstimating ratings transitions matricesCredit spreads of shipping bondsEstimating probabilities of defaults (PDs) from bond pricesCredit scoring modelsFinancial accounting measures of credit riskDefault risk drivers of shipping bank loansThe Basel frameworkStructural models of credit riskEstimating probabilities of defaults (PDs) using the Merton modelCredit risk in derivative transactionsCredit risk in OTC FFA contractsCredit risk in bunker fuel oil transactionsCredit risk managementThe use of collateral for credit risk managementCredit enhancementsDiversification as a tool for credit risk managementDowngrade triggers and credit risk managementNetting of contractsCredit Value-at-Risk (VaR)Credit derivativesCredit Default Swap (CDS)Total Return Swap (TRS)Credit Spread Option (CSO)SummaryNotesStatistical tools for risk management in shippingIntroductionData sources and methodsDescriptive statistics and the moments of random variablesMeasures of central tendency (location) – first momentsArithmetic meanMedianModeGeometric meanThe choice of measure for the first moment (location)Measures of dispersion – second moments of the dataRangeInterquartile rangeVariance and standard deviationPeriod returnsMeasures of relative dispersion – the Coefficient of Variation (CV)Measures of skewness – the third moment of the dataMeasures of kurtosis – the fourth moment of the dataMeasuring the relationship between two variables – covariance and correlationExamples of calculating descriptive statistics in freight rate dataData recorded at different frequenciesMeasuring causal relationships between variables – simple and multiple regression analysisDeriving the OLS (Ordinary Least Squares) estimatorsProperties of the fitted OLS lineThe problem of statistical inferenceGoodness of fit: R2 – The coefficient of determinationExtension of results to multivariate regressionTime-series models, Autoregressive Integrated Moving Average (ARIMA)Moving Average (MA) processesAutoregressive processesARMA processes and the Box–Jenkins approachTime-varying volatility modelsMoving averages estimates of varianceExponentially Weighted Moving Average (EWMA)Realised volatility modelsThe class of ARCH and GARCH modelsIntroduction to ARCH and GARCH modelsAsymmetric GARCH modelsGJR Threshold GARCH modelExponential GARCH modelGARCH in meanMarkov regime switching GARCH modelsMultivariate GARCH modelsStochastic volatility modelsImplied volatilityForecasting volatilityHistorical volatility forecastExponential Weighted Moving Average (EWMA) volatility forecastGARCH models forecastSummaryNoteBibliography
 
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