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Latest Developments in Academic Research

of the Freight Derivatives Market

Over 10 years research in the area

Professor Manolis Kavussanos

Athens University of Economics and Business

INTERTANKO CONFERENCE

ATHENS, 11-13 APRIL 2005

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Introduction

• Risk management is extremely important in the highly cyclical shipping industry –see BFI graph

• Traditional methods for risk management include choice between spot and T/C, and choice of vessel / sector

• Derivatives found their way into shipping: – freight futures contracts, were launched by the Baltic

Exchange in 1985, – forward contracts picked up since 1992, – options and swaps have also appeared.

• Research has uncovered new results in the topic of risk management in the shipping industry – studies by Kavussanos et al. (1993 – 2005)

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The highly cyclical shipping industry as seen in the BFI

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July 86Index at all time low at 554.

April 88Idle Bulk tonnage at its lowest since1980.

February 87Soviet Grain Purchasesrecommence after 9 monthsof inactivity.

September 87Sharp rise in SovietGrain purchases.

July 88End of Iran/IraqWar

December 89US Invasion of Panama.Panama Canal closed.

February 91Iraqi withdrawalfrom Kuwait.

October 92BFI lowest level of1992: 1033 points.

April 94Active S. AmericanGrain Exports.August 90

Iraqi invasionof Kuwait. October 96

BFI lowest level since1987: 992 points.

January 95Earthquake onKobe - Japan.

May 95BFI reaches all time high at2352 points.

June 93Port Congestionin China.

1996Record bulk carriers deliveries 17.5 Mill dwt.

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Sources of Risk in the Shipping Industry

• Operational Risk: Revenue & bunker price fluctuations, cause fluctuations in operating earnings: – In voyage contracts, volatility

in freight rates and bunker prices affect operating profits.

– In period T/C contracts, volatility in freight rates only affect profits

– Thus, voyage rates are considered riskier

– Also, period T/C is sum of voyage rates, hence smoother.

• Ownership risk: – Fluctuations in value

of the asset, the ship – including its scrap value

• Interest rate risk – relates to the capital

charges associated with debt finance

• Exchange rate risk• Counterparty (credit)

risk • Accidents and losses

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• Volatility of freight rates arises due to: – Cyclical Fluctuations, Seasonal Fluctuations, Random Shocks

• Freight and Revenue – Voyage operation vs. Period Time-charter operation. In general, voyage rates are

more volatile than period T/C rates – owners are prepared to offer a discount for the relative security of period T/C rates Kavussanos, Logistics and Transportation Review - LTR, 1996

• Seasonality in tanker freight rates – Freight rates increase during November and December, drop between

January and April, rise for VLCC’s in June/July, drop for Suezmax and Aframax in July,

– Seasonality differences amongst sectors are eliminated by locking into longer duration freight contracts – e.g. 3 year T/C,

– Seasonal movements in freight series are more pronounced during market expansions than under market contractions.Kavussanos et al, LTR, 2001 and Economic Modelling 2002

Freight Risk & Risk Management

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• Large vs. Small vessels– Freight rates for larger vessels seem to show higher volatility

than smaller ones – the portfolio risk is affected by the choice of vessels owned Kavussanos, Journal of Transport Economics and Policy & LTR, 1996/7

• Time-varying volatilities – Volatilities of freight rates and ship prices change over time

depending on the expectations and uncertainty in the market– it is worth rebalancing the mix of operational strategies over

time, as market conditions change Kavussanos, Applied Economics, 1997

Freight Risk & Risk Management

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The Use of Derivatives for Risk Management in Shipping

• The introduction of freight futures (BIFFEX) in 1985 and OTC (Over-the-Counter) freight forward (FFA’s) contracts in 1992 has made freight risk management:– cheaper, – more flexible and – readily available to parties exposed to freight risks

• BIFFEX and FFA contracts have been used to hedge freight risks.

• Derivatives are also used to hedge against – foreign exchange, bunker, interest rate, vessel value and

scrap value risk.

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In May 1985 the Baltic Exchange introduced the Baltic Freight Index (BFI), in order to have an:

aggregate shipping market indicator index for freight futures trading,

BFI is a weighted index which was initially constructed from daily freight fixtures in 13 routes and several commodities

The composition of the index has been revised to reflect the movements in the shipping market as closely as possible

Other Indices for sub-sectors such as tanker and dry cargo markets are available

BCI, BPI, BHI and BDI BITR

The Freight Futures Market (BIFFEX)

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Baltic International Tanker Rates Index (BITR)ROUTES SIZE OF VESSELS DESTINATIONS

Panel A: Baltic Dirty Tanker Routes

TD1 280,000 Middle East to US Gulf. Ras Tanura to Loop.

TD2 260,000 Middle East Gulf to Singapore. Ras Tanura to Singapore.

TD3 250,000 Middle East Gulf to Japan. Ras Tanura to Chiba.

TD4 260,000 West Africa to US Gulf. Off Shore Bonny to Loop.

TD5 130,000 West Africa to USAC. Off Shore Bonny to Philadelphia.

TD6 135,000 Black Sea / Mediterranean.

TD7 80,000 North Sea to Continent. Sullom Voe to Wilhelmshaven.

TD8 80,000 Kuwait to Singapore. Mena al Ahmadi to Singapore.

TD9 70,000 Caribbean to US Gulf. Puerto La Cruz to Corpus Christi.

TD10 50,000 Caribbean to USAC. Aruba to New York.

TD11 80,000 Cross Mediterranean.

TD12 55,000 ARA to US Gulf

Panel B: Baltic Clean Tanker Routes

TC1 75,000 Middle East Gulf to Japan. Ras Tanura to Yokohama.

TC2 37,000 Continent to USAC.

TC3 30,000 Caribbean to USAC. Aruba to New York.

TC4 30,000 Singapore to Japan.

TC5 55,000 Middle East to Japan.

TC6 30,000 Algeria / Euromed.

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Failure of BIFFEX (May 1985 – April 2002):

Studies by Kavussanos et al (1999 - 2003) showed that: Despite several attempts to revise the index, hedging

effectiveness remained low compared to other futures markets Cross hedging problems produced poor hedging

effectiveness

Thin trading and low liquidity of contracts - the market could not attract enough participants

Market players were not familiar with derivatives and were not ready to use them

The Freight Futures Market (BIFFEX)

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Yearly Volumes of the BIFFEX Contract (May 1985 – June 1999)

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1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

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Source: Baltic Exchange

Source: Baltic Exchange

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Dry-Bulk FFA Contracts Traded (January 1992-December 2004E)

Source: Clarkson Securities Ltd. and FIS Ltd.

0500

1000150020002500300035004000450050005500600065007000

Volume

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Tanker Freight Derivatives

• A Tanker FFA is an OTC agreement for a specified notional tanker voyage, fixing a freight today for a defined future period

• Cash settlement against BITR or PLATTS

• Settlement at the end of each month - fixed forward price settled against BITR monthly average

• Tanker owners sell FFAs while oil refineries buy them

• Other parties can be banks, oil companies, oil traders, hedge funds

• Credit risk eliminated for deals going through NOS clearing house

• Advantage of FFAs is that terms and conditions are tailored to the specific needs of the two parties

– e.g. route, cargo size, initiation and length of contract

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Benefits of FFAs

• Risk Management (stabilize cash-flow)• Guarantees freight rate up to 3 years forward • Buy/Sell positions prior to expiry (flexibility) • Easy to fix and close out positions• Price Discovery (leads physical market and gives market

insight)• No physical performance• No restrictions to physical operation (retain control of

vessels and of specific types of cargos)• Easily understood and quickly traded• No re-negotiations from parties as in the spot market• No re-letting of the vessel to other parties as in the spot

market

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The Forward Pricing Function of the FFA Market

• FFA prices (for routes 1, 1A, 2, and 2A of the BPI): – 1 & 2 month contracts are unbiased forecasts of spot prices (in all routes) – a bias exists in the 3-months FFA prices in routes 1 and 1A – The same was also true for BIFFEX contracts

– That is, FFA (and BIFFEX) prices send accurate signals of future spot

prices. Information can guide physical market decisions

– In addition, FFAs react faster (lead) to information arriving in the market in

comparison to spot rates - they serve as a focal point of information

assimilation, and can be used as price discovery vehicles – This can lead to a better assessment of risk management and budget

planning decisions

• Kavussanos (2002), Lloyds of London Press• Kavussanos, Visvikis & Menachof (Review of Derivatives Research, 2004)

• Kavussanos and Visvikis (Journal of Banking and Finance, 2004)

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• Derivative contracts have been viewed with suspicion for increasing spot market price volatility.

• Research indicates that the onset of FFA trading has:

– decreased the spot price volatility in voyage routes of BPI;

– improved the quality and speed of information flow in most routes of BPI;

– By attracting more & possibly better informed participants into the market, FFA trading has improved the incorporation of information into prices

Kavussanos, Visvikis &Batchelor (Transportation Research –Part E, 2004)

The Impact of FFA Trading on Spot Market Price Volatility

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Other Results on FFAs

Hedging Performance of the FFA Market: • For routes of the BPI, more efficient control of risk by using:

– Constant (1) hedge ratios in voyage routes – time-varying hedge ratios in time-charter routes

Kavussanos and Visvikis (IAME Conference, Panama, 2002)

Expected Volatility and Bid-Ask Spreads in the FFA Market: • Positive relationship between bid-ask FFA spreads and expected price

volatility in FFA trading routes

• Market agents then can better time their FFA transactions and predict the direction of the FFA market, as widening bid-ask spreads are indicators of increased future volatility.

Batchelor, Visvikis & Alizadeh (Derivatives, Use Trading & Regulation, Forthcoming, 2005)

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The Use of Risk Management and Shipping Derivatives: The Case of Greece

• Kavussanos, Visvikis and Goulielmou (IAME Conference, Cyprus, 2005) - survey of Greek companies

– Risk management and shipping derivatives are not part of the decision making of most Greek companies, but they are looking into it.

– Traditional ways of thinking often prevents the use of modern risk management techniques, which should be part of the general business strategy of the company.

– There seems to be a positive view of the future of shipping derivatives in Greece, especially if the banks endorse them.

– Improved education in the subject is essential for widespread acceptance.

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Two-day Educational Program on Shipping Derivatives and Risk Management by

Athens University of Economics and Business • World Leader - Introduced since February 2004 • Over 100 participants: Major Shipping Companies, Charterers,

Industrials, Banks. • More than 10 years’ research and practice incorporated in the program • Brings market participants to the forefront of developments in the areas

of risk management and derivatives in shipping • Combines academic rigor with practical knowledge, in offering

essential skills and guidance to company personnel wishing to implement shipping derivatives for risk management purposes.

• Instructors: Professor M. Kavussanos & Assistant Professor I. Visvikis

• Sixth Series 3 & 10 July 2005 – Mr.Kalkanis 210 8665371-3

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DAY 1: INTRODUCTION TO RISK MANAGEMENT IN SHIPPING

– A1. BUSINESS RISKS IN THE SHIPPING INDUSTRY AND RISK MANAGEMENT STRATEGIES 

– A2. FUTURES AND FORWARDS DERIVATIVES MARKETS – THE BASICS

– A3. SHIPPING FREIGHT DERIVATIVES (FROM BIFFEX TO IMAREX AND FFAs - WITH PRACTICAL EXAMPLES)

– A4. Q&A SESSION (PRACTITIONERS VIEWS)

DAY 2: ADVANCED SHIPPING DERIVATIVES TRADING AND STRATEGIES

– B1. RISK MANAGEMENT IN SHIPPING OPERATIONS WITH DERIVATIVES (BUNKER, VESSEL VALUE, SCRAP, FOREX, AND INTEREST RATE RISKS)

– B2. ADVANCED DERIVATIVES ANALYSIS FOR FUTURES AND FORWARDS (OPTIMAL HEDGE RATIOS, PRICING OF FUTURES AND FORWARS)

– B3. ADVANCED DERIVATIVES ANALYSIS FOR OPTIONS

– B4. Q&A SESSION (CURRENT ISSUES AND FUTURE PROSPECTS)