Shipping Derivatives and Risk Management Amir H. Alizadeh & Nikos K. Nomikos Faculty of Finance, Cass Business School, City University, London palgrave macmiuan
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 1 1.2 Types of risks facing shipping companies 3 1.3 The risk-management process 6 1.3.1 Why should firms manage risks? 7 1.4 Introduction to derivatives: contracts and applications 8 1.4.1 Forward contracts 9 1.4.2 Futures contracts 10 1.4.3 Swaps 12 1.4.4 Options 12 1.5 Applications and uses of financial derivatives 13 1.5.1 Risk management 13 1.5.2 Speculators 14 1.5.3 Arbitrageurs 14 1.5.4 The price discovery role of derivatives markets 15 1.5.5 Hedging and basis risk 16 1.5.6 Theoretical models of futures prices: the cost-of-carry model 18 1.6 The organisation of this book 20 Appendix 1.A: derivation of minimum variance hedge ratio 23 Chapter 2: Introduction to Shipping Markets 24 2.1 Introduction 24 2.2 The world shipping industry 24 2.3 Market segmentation in the shipping industry 28 2.3.1 The container shipping market 30 2.3.2 The dry-bulk market 31 2.3.3 The tanker market 34
vi Contents 2.4 Shipping freight contracts 35 2.4.1 Voyage charter contracts 37 2.4.2 Contracts of affreightment 39 2.4.3 Trip-charter contracts 40 2.4.4 Time-charter contracts 41 2.4.5 Bare-boat or demise charter contracts 41 2.5 Definition and structure of costs in shipping 42 2.5.1 Capital costs 42 2.5.2 Operating costs 43 2.5.3 Voyage costs 43 2.5.4 Cargo-handling costs 44 2.6 Spot freight-fate formation 44 2.7 Time-charter rate formation 48 2.7.1 Time-charter equivalent of spot rates (TCE) 51 2.8 Seasonal behaviour of freight rates 52 2.9 The market for ships 55 2.9.1 Factors determining ship prices 55 2.9.2 The newbuilding market 56 2.9.3 The second-hand market 58 2.9.4 The scrap or demolition market 60 2.10 Summary and conclusions 63 Chapter 3: Statistical Tools for Risk Analysis and Modelling 65 3.1 Introduction 65 3.2 Data sources and data-collection methods 65 3.3 Descriptive statistics and moments of a variable 67 3.3.1 Measures of central tendency (location) 67 3.3.2 Measures of dispersion 69 3.3.3 The range 69 3.3.4 Variance and standard deviation 70 3.3.5 Coefficient of skewness 73 3.3.6 Coefficient of kurtosis 74 3.3.7 Coefficient of variation 75 3.3.8 Covariance and correlation 77 3.3.9 Comparison of risk across different vessel size and contracts 78 3.4 Time-varying volatility models 80 3.4.1 Rolling-window or moving-average variance 82 3.4.2 Exponentially weighted average variance (EWAV) 83 3.4.3 Realised volatility models 84
Contents vii 3.5 ARCH and GARCH models 85 3.5.1 The theory of ARCH models 85 3.5.1.1 GARCH models 86 3.5.2 Asymmetric GARCH models 88 3.5.3 GJR threshold GARCH model 90 3.5.4 Exponential GARCH model 90 3.5.5 Markov regime-switching GARCH models 94 3.5.6 The term structure of forward-curve and freight-rate volatility 97 3.5.7 Stochastic volatility models 99 3.5.8 Multivariate GARCH models 100 3.6 Forecasting volatility 102 3.6.1 Historical volatility forecast 102 3.6.2 Exponentially weighted average volatility (RiskMetrics) 103 3.6.3 GARCH models 103 3.7 Summary and conclusions 106 Chapter 4: Freight Market Information 107 4.1 Introduction 107 4.2 Baltic Exchange freight-market information 108 4.2.1 Baltic Capesize Index (BCI) 108 4.2.2 Baltic Panamax Index (BPI) 110 4.2.3 Baltic Supramax Index (BSI) 111 4.2.4 Baltic Handysize Index (BHSI) 111 4.2.5 Baltic Dry Index (BDI) 112 4.2.6 Baltic Clean Tanker Index (BCTI) 113 4.2.7 Baltic Dirty Tanker Index (BDTI) 115 4.2.8 Other indices 117 4.3 Calculation of the Baltic Indices and the role of the panellists 118 4.3.1 Route selection and route changes 120 4.3.2 Calculation of the Baltic Indices 120 4.4 The freight-futures market - historical developments 121 4.5 Summary and conclusions 123 Chapter 5: Forward Freight Agreements 125 5.1 Introduction 125 5.2 What is a forward freight agreement (FFA)? 125 5.2.1 Volume by sector and trade 127
viii Contents 5.3 How are forward freight agreements traded? 131 5.3.1 Trading FFAs in the OTC market 133 5.3.2 Contract documentation in the OTC market 134 5.3.2.1 The FFABA contract 135 5.3.2.2 ISDA Master Agreement and Schedule 137 5.3.3 Credit risk and clearing 137 5.3.3.1 How clearing houses operate 138 5.3.3.2 Margining and marking to market 141 5.3.3.3 A marking-to-market example 143 5.3.4 Trading via a 'hybrid' exchange 145 5.4 Hedging using forward freight agreements 147 5.4.1 Hedging trip-charter freight-rate risk 148 5.4.2 Hedging using voyage FFAs 149 5.4.3 Time-charter hedge 152 5.4.4 Tanker hedge 157 5.4.5 Hedge-ratio calculation for tanker FFAs 157 5.5 Issues to consider when using FFAs for hedging 158 5.5.1 Settlement risk 158 5.5.2 Basis risk 160 5.6 Uses of forward freight agreements 164 5.7 Price discovery and forward curves 166 5.7.1 Baltic Forward Assessments (BFA) 169 5.8 Summary and conclusions 173 Appendix 5.A: FFABA 2007 Forward Freight Agreement contract 174 Chapter 6: Technical Analysis and Freight Trading Strategies 181 6.1 Introduction 181 6.2 Technical analysis 181 6.2.1 Chart analysis 182 6.3 Technical trading rules 186 6.4 Moving averages (MA) 186 6.4.1 Moving average crossover trading rule 186 6.4.2 Stochastic oscillators 18? 6.5 Filter rules 192 6.5.1 Moving average envelopes 193 6.5.2 Bollinger Bands 194 6.6 The momentum trading model 197 6.7 Spread trading in FFA markets 199 6.7.1 Tanker spread trading 201 6.7.2 Dry-bulk spread trading 203
Contents ix 6.8 Time-charter and implied forward rates 6.8.1 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 7.3.1 Boundary conditions for European call prices 7.3.2 Boundary conditions for European put prices 7.3.3 Put-call parity 7.3.4 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 7.5.1 An example of hedging using options 7.5.2 Hedging using a collar 7.5.2.1 Constructing a zero-cost collar in the dry-bulk market 7.6 Option-trading strategies 7.6.1 Bull spreads 7.6.2 Bear spreads 7.6.3 Ratio spreads 7.6.4 Box spread 7.6.5 Straddle combinations 7.6.6 Strangle combinations 7.6.7 Strips and straps 7.6.8 Butterfly spreads 7.7 Summary and conclusions Appendix 7.A: FFABA 2007 Freight Options Contract 207 211 211 215 217 217 217 222 222 224 224 225 226 227 231 232 234 236 236 240 241 243 244 245 247 248 249 250 Chapter 8: Pricing and Risk Management of Option Positions 258 8.1 Introduction 258 8.2 Pricing freight options 258 8.2.1 Which approach is better for pricing freight options? 259 8.2.2 The Black-Scholes-Merton (BSM) model (1973) 261 8.2.3 The Black Model (1976) 263
x Contents 8.2.4 The Turnbull and Wakeman Approximation (1991) 264 8.2.5 Levy (1997) and Haug et al. (2003) Discrete Asian Approximation 265 8.2.6 Curran's Approximation 266 8.2.7 Applications for freight markets 267 8.2.8 An option-pricing example 269 8.3 Asian options with volatility term structure 271 8.4 Implied volatility 273 8.5 Pricing Asian options using Monte Carlo simulation 276 8.6 Risk management of option positions 281 8.7 Hedging a short-call position: an example 282 8.8 Option-price sensitivities: 'Greeks' 283 8.9 Delta (A) 284 8.9.1 Delta hedging 286 8.9.2 Delta hedging of Asian options 290 8.10 Gamma (r) 292 8.10.1 Gamma-neutral strategies 294 8.11 Theta(0) 295 8.11.1 The relationship between theta, delta and gamma 297 8.12 Vega (A) 298 8.13 Rho(P) 299 8.13.1 Interpretation of Greek parameters: reading the Greeks 300 8.14 Dynamic hedging in practice 300 8.14.1 Greeks and trading strategies 302 8.15 Summary and conclusions 302 Chapter 9: Value-at-Risk in Shipping and Freight Risk Management 303 9.1 Introduction 303 9.2 Simple VaR estimation 305 9.2.1 VaR of multi-asset portfolios 310 9.3 VaR estimation methodologies 312 9.3.1 Parametric VaR estimation 312 9.3.1.1 The sample variance and covariance method 313 9.3.1.2 The exponential weighted average variance and RiskMetrics method 313
Contents xi 9.3.1.3 GARCH Models and VaR estimation 313 9.3.1.4 Monte Carlo simulation and VaR estimation 314 9.3.1.5 Recent advances in parametric VaR models 317 9.3.2 Nonparametric VaR estimation methods 319 9.3.2.1 Historical simulation 319 9.3.2.2 The bootstrap method of estimating VaR 321 9.3.2.3 The quantile regression method 322 9.4 VaR for non-linear instruments 322 9.4.1 Mapping VaR for options 323 9.4.2 Delta approximation 325 9.4.3 Delta-gamma approximation 325 9.5 Principal component analysis and VaR estimation 328 9.6 Backtesting and stresstesting of VaR models 333 9.7 Summary and conclusions 335 Appendix 9.A: Principal component analysis 336 Chapter 10: Bunker Risk Analysis and Risk Management 338 10.1 Introduction 338 10.2 The world bunker market 339 10.3 Bunker-price risk in shipping operations 341 10.4 Hedging bunker risk using OTC instruments 343 10.5 Hedging bunker prices using forward contracts 343 10.5.1 Long hedge using forward bunker contract 343 10.5.2 Short hedge using forward bunker contract 344 10.6 Bunker swap contracts 346 10.6.1 Plain vanilla bunker swap 347 10.7 Exotic bunker swaps 350 10.7.1 Differential swap 350 10.7.2 Extendable swap 351 10.7.3 Forward bunker swap 352 10.7.4 Participation swap 353 10.7.5 Double-up swap 354 10.7.6 Variable volume swap or swing 354 10.8 Hedging bunker price using options 354 10.8.1 Bunker caps and floors 355 10.8.2 Collars or cylinder options 356 10.9 Summary and conclusions 362
xii Contents Chapter 11: Financial and Interest Rate Risk in Shipping 363 11.1 Introduction 363 11.2 Reference rates and international financial markets 364 11.3 Term loans 366 11.3.1 A fixed-rate loan example 367 11.3.2 Floating-rate loans examples 369 11.4 Hedging interest-rate risk 371 11.5 Forward-rate agreements 371 11.6 Interest-rate futures 374 11.6.1 Eurodollar futures contracts 374 11.7 Interest-rate swaps 375 11.7.1 Pricing and unwinding of interest-rate swaps 378 11.8 Interest-rate options 381 11.8.1 Interest-rate caplets and floorlets 381 11.8.1.1 An example of a caplet option hedge 382 11.8.2 Interest-rate caps and floors 384 11.8.3 Interest-rate collars 388 11.8.3.1 An example of a zero-cost collar 389 11.9 Pricing caps and floors using Black's model 391 11.10 Forward swaps and swaptions 395 11.11 Hedging using currency swaps 396 11.11.1 Pricing currency swaps 397 11.12 Summary and conclusions 398 Chapter 12: Credit Risk Measurement and Management in Shipping 399 12.1 Introduction 399 12.2 What is credit risk? 399 12.3 What is the source of credit risk in shipping? 400 12.3.1 Qualitative vs. quantitative credit-risk analysis 401 12.4 Credit ratings and rating agencies 402 12.4.1 Shipping high-yield bond issues 404 12.5 Estimating probability of default 407 12.5.1 Extracting default probabilities from traded bonds 407 12.5.2 Historical default probabilities 409
Contents xiii 12.5.3 Estimating default probabilities using Merton's model 411 12.6 Credit-risk management and credit derivatives 414 12.6.1 Collateralisation 415 12.6.2 Downgrade triggers 415 12.6.3 Contract design and netting 416 12.6.4 Diversification 416 12.6.5 Credit derivatives 417 12.6.5.1 Credit default swap (CDS) 418 12.6.5.2 Total return swap (TRS) 420 12.6.5.3 Credit spread options (CSO) 422 12.7 Summary and conclusions 424 Chapter 13: Ship Price Risk and Risk Management 425 13.1 Introduction 425 13.2 Ship-price formation 426 13.3 Comparison of ship-price risk across sectors 428 13.3.1 Dynamics of volatility of ship prices 430 13.4 Ship-price risk management 432 13.4.1 Portfolio theory and diversification 432 13.4.2 Derivatives on ship values 439 13.4.3 Forward Ship Value Agreements (FoSVA) 439 13.4.4 Forward curves for ship prices 444 13.4.5 Baltic Demolition Index (BDA) 446 13.5 Summary and conclusions 450 Chapter 14: Real Options and Optionalities in Shipping 451 14.1 Introduction 451 14.2 Financial versus real options 451 14.3 Conventional NPV versus real option valuation 452 14.3.1 Valuation of a shipping project 454 14.4 Real options in shipping 455 14.4.1 Option to abandon/exit 455 14.4.2 Option to expand 457 14.4.3 Option to contract 459 14.4.4 Option to switch 460 14.4.5 Option to lay-up 461 14.4.6 Option to delay (wait) 462 14.5 Other options in shipping 463 14.5.1 Option to extend a period time-charter contract 463
xiv Contents 14.5.2 Option on newbuilding orders 465 14.5.3 Purchase option on a time-charter contract 467 14.5.4 Option on writing-off part of a debt 470 14.6 Pricing real options using simulation 472 14.6.1 Sensitivity analysis and interval estimates 474 14.7 Summary and conclusions 475 Appendix 14.A: The binomial option pricing model (BOPM) 477 References 481 Index 490