Pricing and Hedging in the Freight Futures Market
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Pricing and Hedging in the Freight Futures Market CCMR Discussion Paper 04-2012 Marcel Prokopczuk Pricing and Hedging in the Freight Futures Market Marcel Prokopczuk∗ April 2010 Abstract In this article, we consider the pricing and hedging of single route dry bulk freight futures contracts traded on the International Maritime Exchange. Thus far, this relatively young market has received almost no academic attention. In contrast to many other commodity markets, freight services are non-storable, making a simple cost-of-carry valuation impossible. We empirically compare the pricing and hedging accuracy of a variety of continuous-time futures pricing models. Our results show that the inclusion of a second stochastic factor significantly improves the pricing and hedging accuracy. Overall, the results indicate that the Schwartz and Smith (2000) two-factor model provides the best performance. JEL classification: G13, C50, Q40 Keywords: Freight Futures, Hedging, Shipping Derivatives, Imarex ∗ICMA Centre, Henley Business School, University of Reading, Whiteknights, Reading, RG6 6BA, United Kingdom. e-mail:[email protected]. Telephone: +44-118- 378-4389. Fax: +44-118-931-4741. Electronic copy available at: http://ssrn.com/abstract=1565551 I Introduction In a globalised world, efficient goods transport from continent to continent is an increasingly indispensable economic growth factor. More than 95 % of world trade (in volume) is carried by marine vessels. Transport volume has risen worldwide from 2800 Mio tons in 1986 to 4700 in 2005.1 The world relies on fleets of ships with a cargo carrying capacity of 960 million deadweight tons (dwt)2 to carry every conceivable type of product. In fact, from grain to crude oil, iron ore to chemicals, seaborne trade amounted to more than 7.1 billion tonnes in 2005.3 The market for freight rates is complex. Market participants include shipowners, operators and charterers, all of whom are exposed to significant price risk. Reasons for changes in freight rates are manifold. From a long-term perspective, vessel supply determines the supply curve of shipping services. Thus, information on vessel availability, production and scrapping has a direct influence on equilibrium price levels. Demand for shipping services is closely linked to the demand for the commodities that require transportation. The more goods used in industrial production, the greater the demand for delivery services. Thus, the equilibrium freight rate level responds to changes in industry-specific demand and economic growth in general. In the short run, the cost of operating a vessel greatly fluctuates with the cost of shipping fuel, also known as ‘bunker’, which comprises up to 30 % of operating costs. Naturally, bunker prices are closely linked to crude oil prices and, therefore, freight rates react to changes in oil price levels. Weather may also strongly influence short-term changes in demand for shipping services; a harvest that occurs earlier than expected in one region of the world increases the need for transportation immediately, as many products cannot be stored indefinitely. 1See Kavussanos and Visvikis (2006a). 2Deadweight ton (dwt) is a measurement to express the weight of cargo, fuel, stores, passengers and crew carried by a ship when loaded to its maximum. 3See the Baltic Exchange Web site: www.balticexchange.com. 1 Electronic copy available at: http://ssrn.com/abstract=1565551 From a financial perspective, freight rates are typically considered part of the commodity market.4 However, freight rates exhibit some characteristics that distinguish them from most other markets. In contrast to all major traded commodities freight rates can be considered costs of services, not products. Therefore, they are essentially not storable, a property that makes simple cost-of-carry valuations of futures contracts for freight rates impossible.5 Further, the freight rate spot market shows a high degree of volatility, which causes significant risks for shipowners and charterers alike, creating a substantial hedging demand. Consequently, as for other commodities, futures markets have been established to meet this demand. As a result, the availability of futures in the market creates the need for appropriate valuation models. In the present paper, we study the pricing and hedging performance of four different pricing models for dry bulk freight futures traded on the newly established International Maritime Exchange (Imarex). By doing so, we contribute to the literature in various ways. First, to the best of our knowledge, we are the first to study the pricing and hedging performance of no-arbitrage pricing models in the freight derivatives market as previous research, such as Kavussanos and Nomikos (1999), Haigh (2000), Kavussanos and Nomikos (2003), Kavussanos and Visvikis (2004), and Batchelor et al. (2007), focuses mainly on econometric aspects of the forward freight market.6 Second, we are also first to analyse these pricing models with respect to their hedging performance, an aspect that may be considered even more important than pricing for market participants. Third, extant literature only analyses index futures and forward freight agreements that are traded over-the-counter. In 2001, the Imarex launched the first futures contracts written on individual 4See Geman (2008). 5The only other major nonstorable commodity is electricity. However, in contrast to electricity, freight rate prices behave less erratically as supply and demand need not match at every point in time. 6A survey of previous studies in the freight market in general is provided by Kavussanos and Visvikis (2006b). 2 routes of the freight market. Thus, our paper contributes to the empirical literature as we are the first to study this relatively new market. As stated, the non-storability of freight services makes a simple cost-of- carry valuation of futures contracts impossible. Thus, one must employ an alternate pricing approach/model when valuing freight futures contracts. In this paper, we focus our attention on affine continuous-time models of the spot price dynamics that have been successfully employed for other commodity markets. The affine continuous-time framework has the substantial advantage of allowing closed-form valuation for the freight futures contracts. More specifically, we consider the one-factor price dynamics and pricing models proposed by Black (1976) and Schwartz (1997), as well as the two-factor models developed by Schwartz and Smith (2000) and Korn (2005). All four models are estimated employing a Kalman filter-based approach for the four main dry bulk futures traded at the Imarex. We then study the pricing and hedging performance for each model. The two-factor models are found to significantly improve the pricing accuracy for the considered futures contracts. Moreover, the Schwartz and Smith (2000) model yields the best results when considering the hedging performance. The remainder of the paper is structured as follows. Section II describes the bulk freight market as well as the data used in our empirical study. Section III describes the pricing models considered and outlines their estimation, while Section IV presents the empirical results of our study. Section V concludes. II Market and Data Description A. The Dry Bulk Freight Market Seaborne trade can roughly be divided into five groups: dry bulk, oil tanker, container, gas tanker and other. In this paper, we study the dry bulk futures market. Overall, dry bulk commodities represent about 38 % of all seaborne trade and are thus, a major segment of the entire market. Dry bulk vessels are 3 classified according to their size; principally Handysize, Handymax, Panamax, and Capesize. The first two are of minor importance for the derivatives market, as they primarily carry minor bulks (see below) and thus, represent a small market share. With about 70,000 dwt, Panamax are the largest ships that will fit through the Panama Canal and mainly carry grain and coal from America and Australia to Europe and Asia. Capesize vessels are typically above 150,000 dwt and round Cape Horn to travel between the Pacific and the Atlantic Ocean as they do not fit through the Panama Canal.7 Dry bulk commodities are typically divided into two distinct categories: major and minor bulks. Major bulks comprise two thirds of the dry bulk sector and include iron ore (27 %), coal (26 %) and grain (14 %). Due to their major role in the world economy (iron ore is the raw material for steel production, coal is used to produce electricity and for steel production) they are shipped by larger vessels, such as the Capesize and Panamax. Minor bulks comprise steel, steel products, fertilisers, sugar, cement, non-ferrous metal ores, salt, etc. These are shipped primarily in smaller vessels such as Handymax and Handysize ships. The primary methods of vessel charters include: bareboat, time, and voyage charters. In a bareboat charter, owners rent their vessels in return for monthly payments. The owner has no responsibilities for crewing, victualling, etc. This type of charter is of minor importance to the markets considered in this paper. Time charter shipowners run their vessels under instructions of charterers and have no responsibilities for the commercial management. The charterer pays the shipowner a per-day fee plus costs, such as fuel, port fees, etc. By contrast, the charterer in a voyage charter pays the owner a per ton fee to carry freight from Point A to Point B while the shipowner is responsible for every detail of the operation and bears