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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 xvi Foreword xviii Figures xix Tables xxv Chapter 1: Introduction to Risk Management and Derivatives 1 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 207 6.8.1 The relative value trading rule 211 6.9 Technical trading rules and shipping investment 211 6.10 Summary and conclusions 215 Chapter 7: Options on Freight Rates 217 7.1 Introduction 217 7.2 A primer on options 217 7.3 Properties of option prices 222 7.3.1 Boundary conditions for European call prices 222 7.3.2 Boundary conditions for European put prices 224 7.3.3 Put-call parity 224 7.3.4 Factors affecting the value of call and put options 225 7.4 Practicalities of trading options in the freight market 226 7.5 Risk-management strategies using options 227 7.5.1 An example of hedging using options 231 7.5.2 Hedging using a collar 232 7.5.2.1 Constructing a zero-cost collar in the dry-bulk market 234 7.6 Option-trading strategies 236 7.6.1 Bull spreads 236 7.6.2 Bear spreads 240 7.6.3 Ratio spreads 241 7.6.4 Box spread 243 7.6.5 Straddle combinations 244 7.6.6 Strangle combinations 245 7.6.7 Strips and straps 247 7.6.8 Butterfly spreads 248 7.7 Summary and conclusions 249 Appendix 7.A: FFABA 2007® Freight Options Contract 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
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