Freight option strategies for finance purposes

The prices of options are directly affected by their implied volatility. In turn, implied volatility' is directly affected by' the volatility observed in the market. Thus, possible changes in freight volatility also change the shape of the forward freight curve. As it can be seen in Figure 7.8, historical volatility in the physical market increased during early 2019, resulting in an increase of the implied volatility of freight options and their premiums. As a

Figure 1.8 Historical price volatility ofPanamax 4TC (%) Source: Bloomberg

comparison based on historical data, an increase of 10% in implied volatility, during the global financial crisis of2008—2010, would increase the cost of premium for buying an at- the-money Panamax CAL10 call option, with a strike price at $13,250, by approximately 17% (S450 per day, i.e. an increase from S2,650 to $3,100), implying a total additional cost rise of $164,250 per calendar contract. Since volatility is positively related with option prices, high volatility implies high option prices, which makes an investor more willing to be an option writer (seller), anticipating to receive income from the inflated option premium sold. This is not possible through a position in the physical market.

A second very important factor to be considered when deciding on the rate and duration of any charter agreement is the shape of the forward price curve. This shape may be: (i) flat — observed at markets at equilibrium; (ii) in backwardation, i.e. forward prices decline as we move from spot to longer maturities, typically observed during strong spot markets/high spot prices; or (iii) in contango, i.e. forward prices rise as the maturity increases, typically observed at weak markets/low spot prices. Contango is a shape that can favor mid—long-term hedging, as owners can fix prices for a specified period above spot rates. Backwardation has the opposite effect. As a result, a shipowners chartering outlook should be adjusted accordingly to the shape of the curve.

For example, in Figure 7.9 it can be observed that Panamax forward price curves were in contango in June 2017 and May 2018 for the next one—two quarters, reflecting ample spot supply and expectations for recovery in the back curve, but in backwardation for further in the future, i.e. next calendar years, reflecting expectations for strong demand in the front curve and market concerns for the back curve. The market was also in backwardation in November 2018 and August 2019.

Visvikis and Antonopoulos (2009a) demonstrate the use of freight option positions in the context of shipping bank loan agreements. They argue that forward curve shapes can offer arbitrage opportunities between physical and derivatives markets, as physical markets tend to be more “sticky” compared to the paper markets and there can be a window of opportunity which only freight derivatives can capture. The following two examples are adapted from Lloyds Shipping Economist to illustrate this case. They refer to the period that historically exhibited record high volatility in the markets, the global financial crisis, as a time period of special interest.

Figure 1.9 Panamax forward curves Source: Bloomberg

Example 1: Price volatility (business cycle) trading

Suppose that it is 14 May 2008 and the BDI stands at 10,649 points, with a 30-day volatility of 18.50%. The shape of the forward curve indicates that the market is in backwardation, as spot rates are at $79,817/day, while the two-year forward rates are at S49,250/day. At that time, the forward curves were offering shipowners high spot income levels, indicating to them to stay in the spot market and enjoy great profits for the duration of the rally. However, as shown in Table 7.5, following the low volatility structure and the backwardation shape of the curve, by buying a put option for a two-year period (January 2009—December 2010), at a $35,000 strike price with a $2,100/day premium, a shipowner could give up some of the super-profits in return for an insurance against any unexpected market drops.

The result of this strategy is presented in Table 7.6. Specifically, if a shipowner has used this freight derivative strategy she would receive an average net income (spot and paper positions combined) of $34,894/day and would also achieve to: (i) fix average net income 80.69% higher than the average spot income (of $19,480/day) for the period; (ii) stay spot and have the chance to enjoy super-profits; (iii) diversify with a freight option, which accounts for almost 50% of net income; and (iv) be less dependent on charterers and maintain bargaining power.

Example 2: Forward curve shape trading

Suppose that it is 5 January 2009 and the BDI stands at 772 points, with a 30-day volatility of 45.0%. The shape of the forward curve indicates that the market is in contango,

Table 7.5 Strategies using freight derivatives according to implied volatility and forward curve shape

Table 7.6 Backwardation and low volatility strategy result

Note: * All prices that refer to future dates are derived from the forward curves on 8 May 2009.

as spot rates are at $4,201/day, while the two-year forward rates are at $13,625/day. At that date, spot prices were at $4,000 levels and all market participants were having crisis management meetings, as charterers were defaulting on fixtures, owners were cancelling newbuildings and banks were restructuring loans to guarantee loan payments. In such a market environment, with high volatility' and the shape of the curve to be in contango, according to Table 7.5, a spot shipowner could buy' an at-the-money CAL09 put option (January 2009—December 2009), at a $12,500 strike price with a $2,200/day premium and sell an out-of-money CAL09 call option, at a $16,000 strike price with a $1,200/ day premium. The reasoning behind buying the at-the-money CAL09 put option is to guarantee an income that can maintain company viability through the year, while by' selling the out-of-money CAL09 call option the put purchase is partially' financed, as the net strategy cost is $l,000/day, and at the same time he takes advantage of the high volatility which inflates premia.

The result of the strategy is presented in Table 7.7. More specifically', if the market stayed at the $4,000—$6,000 levels as initially anticipated, this strategy in Q1 would have saved the shipowner from bankruptcy, as he is guaranteed a net income of $11,500/day (179% higher than spot at the time of the execution) and would also: (i) allow a profit potential up to a maximum of $15,000/day (= $16,000 call strike price — $1,000 strategy cost) by exercising the call if the freight market rises later in the year; (ii) maintain a minimum income level at $11,500, whatever happens for the rest of the year and therefore allow easier loan restructuring with the banks if required; and (iii) permit to be independent from charterers and retain bargaining power.

Table 7.7 Contango and high volatility strategy' result