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1 Shipping Derivatives and Risk Management Amir H. Alizadeh & Nikos K. Nomikos Faculty of Finance, Cass Business School, City University, London palgrave macmiuan
2 Contents About the Authors. xv Preface and Acknowledgements Foreword Figures Tables xvi xviii Chapter 1: Introduction to Risk Management and Derivatives 1 xix xxv 1.1 Introduction Types of risks facing shipping companies The risk-management process Why should firms manage risks? Introduction to derivatives: contracts and applications Forward contracts Futures contracts Swaps Options Applications and uses of financial derivatives Risk management Speculators Arbitrageurs The price discovery role of derivatives markets Hedging and basis risk Theoretical models of futures prices: the cost-of-carry model The organisation of this book 20 Appendix 1.A: derivation of minimum variance hedge ratio 23 Chapter 2: Introduction to Shipping Markets Introduction The world shipping industry Market segmentation in the shipping industry The container shipping market The dry-bulk market The tanker market 34
3 vi Contents 2.4 Shipping freight contracts Voyage charter contracts Contracts of affreightment Trip-charter contracts Time-charter contracts Bare-boat or demise charter contracts Definition and structure of costs in shipping Capital costs Operating costs Voyage costs Cargo-handling costs Spot freight-fate formation Time-charter rate formation Time-charter equivalent of spot rates (TCE) Seasonal behaviour of freight rates The market for ships Factors determining ship prices The newbuilding market The second-hand market The scrap or demolition market Summary and conclusions 63 Chapter 3: Statistical Tools for Risk Analysis and Modelling Introduction Data sources and data-collection methods Descriptive statistics and moments of a variable Measures of central tendency (location) Measures of dispersion The range Variance and standard deviation Coefficient of skewness Coefficient of kurtosis Coefficient of variation Covariance and correlation Comparison of risk across different vessel size and contracts Time-varying volatility models Rolling-window or moving-average variance Exponentially weighted average variance (EWAV) Realised volatility models 84
4 Contents vii 3.5 ARCH and GARCH models The theory of ARCH models GARCH models Asymmetric GARCH models GJR threshold GARCH model Exponential GARCH model Markov regime-switching GARCH models The term structure of forward-curve and freight-rate volatility Stochastic volatility models Multivariate GARCH models Forecasting volatility Historical volatility forecast Exponentially weighted average volatility (RiskMetrics) GARCH models Summary and conclusions 106 Chapter 4: Freight Market Information Introduction Baltic Exchange freight-market information Baltic Capesize Index (BCI) Baltic Panamax Index (BPI) Baltic Supramax Index (BSI) Baltic Handysize Index (BHSI) Baltic Dry Index (BDI) Baltic Clean Tanker Index (BCTI) Baltic Dirty Tanker Index (BDTI) Other indices Calculation of the Baltic Indices and the role of the panellists Route selection and route changes Calculation of the Baltic Indices The freight-futures market - historical developments Summary and conclusions 123 Chapter 5: Forward Freight Agreements Introduction What is a forward freight agreement (FFA)? Volume by sector and trade 127
5 viii Contents 5.3 How are forward freight agreements traded? Trading FFAs in the OTC market Contract documentation in the OTC market The FFABA contract ISDA Master Agreement and Schedule Credit risk and clearing How clearing houses operate Margining and marking to market A marking-to-market example Trading via a 'hybrid' exchange Hedging using forward freight agreements Hedging trip-charter freight-rate risk Hedging using voyage FFAs Time-charter hedge Tanker hedge Hedge-ratio calculation for tanker FFAs Issues to consider when using FFAs for hedging Settlement risk Basis risk Uses of forward freight agreements Price discovery and forward curves Baltic Forward Assessments (BFA) Summary and conclusions 173 Appendix 5.A: FFABA 2007 Forward Freight Agreement contract 174 Chapter 6: Technical Analysis and Freight Trading Strategies Introduction Technical analysis Chart analysis Technical trading rules Moving averages (MA) Moving average crossover trading rule Stochastic oscillators 18? 6.5 Filter rules Moving average envelopes Bollinger Bands The momentum trading model Spread trading in FFA markets Tanker spread trading Dry-bulk spread trading 203
6 Contents ix 6.8 Time-charter and implied forward rates The relative value trading rule 6.9 Technical trading rules and shipping investment 6.10 Summary and conclusions Chapter 7: Options on Freight Rates 7.1 Introduction 7.2 A primer on options 7.3 Properties of option prices Boundary conditions for European call prices Boundary conditions for European put prices Put-call parity Factors affecting the value of call and put options 7.4 Practicalities of trading options in the freight market 7.5 Risk-management strategies using options An example of hedging using options Hedging using a collar Constructing a zero-cost collar in the dry-bulk market 7.6 Option-trading strategies Bull spreads Bear spreads Ratio spreads Box spread Straddle combinations Strangle combinations Strips and straps Butterfly spreads 7.7 Summary and conclusions Appendix 7.A: FFABA 2007 Freight Options Contract Chapter 8: Pricing and Risk Management of Option Positions Introduction Pricing freight options Which approach is better for pricing freight options? The Black-Scholes-Merton (BSM) model (1973) The Black Model (1976) 263
7 x Contents The Turnbull and Wakeman Approximation (1991) Levy (1997) and Haug et al. (2003) Discrete Asian Approximation Curran's Approximation Applications for freight markets An option-pricing example Asian options with volatility term structure Implied volatility Pricing Asian options using Monte Carlo simulation Risk management of option positions Hedging a short-call position: an example Option-price sensitivities: 'Greeks' Delta (A) Delta hedging Delta hedging of Asian options Gamma (r) Gamma-neutral strategies Theta(0) The relationship between theta, delta and gamma Vega (A) Rho(P) Interpretation of Greek parameters: reading the Greeks Dynamic hedging in practice Greeks and trading strategies Summary and conclusions 302 Chapter 9: Value-at-Risk in Shipping and Freight Risk Management Introduction Simple VaR estimation VaR of multi-asset portfolios VaR estimation methodologies Parametric VaR estimation The sample variance and covariance method The exponential weighted average variance and RiskMetrics method 313
8 Contents xi GARCH Models and VaR estimation Monte Carlo simulation and VaR estimation Recent advances in parametric VaR models Nonparametric VaR estimation methods Historical simulation The bootstrap method of estimating VaR The quantile regression method VaR for non-linear instruments Mapping VaR for options Delta approximation Delta-gamma approximation Principal component analysis and VaR estimation Backtesting and stresstesting of VaR models Summary and conclusions 335 Appendix 9.A: Principal component analysis 336 Chapter 10: Bunker Risk Analysis and Risk Management Introduction The world bunker market Bunker-price risk in shipping operations Hedging bunker risk using OTC instruments Hedging bunker prices using forward contracts Long hedge using forward bunker contract Short hedge using forward bunker contract Bunker swap contracts Plain vanilla bunker swap Exotic bunker swaps Differential swap Extendable swap Forward bunker swap Participation swap Double-up swap Variable volume swap or swing Hedging bunker price using options Bunker caps and floors Collars or cylinder options Summary and conclusions 362
9 xii Contents Chapter 11: Financial and Interest Rate Risk in Shipping Introduction Reference rates and international financial markets Term loans A fixed-rate loan example Floating-rate loans examples Hedging interest-rate risk Forward-rate agreements Interest-rate futures Eurodollar futures contracts Interest-rate swaps Pricing and unwinding of interest-rate swaps Interest-rate options Interest-rate caplets and floorlets An example of a caplet option hedge Interest-rate caps and floors Interest-rate collars An example of a zero-cost collar Pricing caps and floors using Black's model Forward swaps and swaptions Hedging using currency swaps Pricing currency swaps Summary and conclusions 398 Chapter 12: Credit Risk Measurement and Management in Shipping Introduction What is credit risk? What is the source of credit risk in shipping? Qualitative vs. quantitative credit-risk analysis Credit ratings and rating agencies Shipping high-yield bond issues Estimating probability of default Extracting default probabilities from traded bonds Historical default probabilities 409
10 Contents xiii Estimating default probabilities using Merton's model Credit-risk management and credit derivatives Collateralisation Downgrade triggers Contract design and netting Diversification Credit derivatives Credit default swap (CDS) Total return swap (TRS) Credit spread options (CSO) Summary and conclusions 424 Chapter 13: Ship Price Risk and Risk Management Introduction Ship-price formation Comparison of ship-price risk across sectors Dynamics of volatility of ship prices Ship-price risk management Portfolio theory and diversification Derivatives on ship values Forward Ship Value Agreements (FoSVA) Forward curves for ship prices Baltic Demolition Index (BDA) Summary and conclusions 450 Chapter 14: Real Options and Optionalities in Shipping Introduction Financial versus real options Conventional NPV versus real option valuation Valuation of a shipping project Real options in shipping Option to abandon/exit Option to expand Option to contract Option to switch Option to lay-up Option to delay (wait) Other options in shipping Option to extend a period time-charter contract 463
11 xiv Contents Option on newbuilding orders Purchase option on a time-charter contract Option on writing-off part of a debt Pricing real options using simulation Sensitivity analysis and interval estimates Summary and conclusions 475 Appendix 14.A: The binomial option pricing model (BOPM) 477 References 481 Index 490
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