Implementing the New Science of Risk Management to Tanker Freight Markets Wessam M. T. Abouarghoub A thesis submitted in partial fulfilment of the requirements of the University of the West of England, Bristol For the Degree of Doctor of Philosophy Bristol Business School, University of the West of England, Bristol August 2013 This thesis is dedicated to my father, Mohamed Taher, Abouarghoub He was and remains my inspiration and best role model in life. Acknowledgements All Thanks And Praises Are Due To Allah, The Sustainer Of All The Worlds, And May Allah’s Mercy And Peace Be Upon Our Master, Muhammad, His Family And All His Companions. Many people have contributed greatly to this thesis. Without their assistance, completing this work would not have been possible. To each of them, I owe my sincere thanks and gratitude. First and foremost, I am sincerely grateful to my supervisor Professor Peter Howells for his continued support and patience in reviewing my work. His suggestions and comments helped to greatly improve the standard and quality of this thesis. To him I will be forever grateful. Second, my supervisor Iris Biefang-Frisancho Mariscal, that through her suggestions, comments and stimulating discussions helped to improve the quantitative techniques employed in this thesis. Both of my supervisors have been very patience and supportive, especially during the hard times that my country Libya had to go through after the start of the great revolution of 17th of February. With out their support and encouragement I wouldn‟t have been able to complete an important mile stone in my life. For this I thank both of you. I am also deeply indebted to the University of the West of England for providing me with a four year bursary in acknowledgement of the importance of my work. In particular to the Department of Economics and the Head of Department Paul Dowdall for the continued support and sponsoring numerous conferences at an early stage of my research career. Furthermore, I would like to thank the Imarex Academy for the opportunity to participate in one of their two-day tanker freight derivatives professional trading courses and providing part of the data used in this thesis. Moreover, I sincerely thank the research team at Clarkson Intelligence Network for providing access to their much valuable website on numerous occasions to update the data set used in this thesis. Finally, I wish to thank my family, dad, mum, sisters and my lovely wife, Carima, for always being there for me. Thank you for your patience and understanding. Without your love and support I would not have the strength to complete this journey. I am very fortunate to have all of you in my life. 1 | P a g e Table of Contents Acknowledgements ............................................................................................................... 1 Table of Contents ................................................................................................................. 2 List of Tables ........................................................................................................................ 7 List of Figures ....................................................................................................................... 9 List of Diagrams ................................................................................................................. 11 Abstract ............................................................................................................................... 12 Chapter one ........................................................................................................................ 13 1. Introduction .................................................................................................................. 13 1.1. Background and structure ...................................................................................... 13 1.2. The thesis objectives and contributions ................................................................. 16 Chapter two ........................................................................................................................ 20 2. An overview of maritime economic literature ........................................................... 20 2.1. Introduction ........................................................................................................... 20 2.2. The effect of oil prices on tanker freight markets ................................................. 20 2.3. Conditional freight limitations .............................................................................. 21 2.4. Classic maritime theory ......................................................................................... 22 2.5. Freight data in the literature .................................................................................. 24 2.6. Stationarity of freight rates .................................................................................... 26 2.7. Value at risk ........................................................................................................... 27 2.8. Conclusion ............................................................................................................. 32 Chapter Three .................................................................................................................... 33 3. Methodology: An overview of the framework within this thesis .............................. 33 3.1. Introduction ........................................................................................................... 33 3.2. Value-at-risk for single assets and a portfolio of returns ...................................... 33 3.3. Single-state conditional variance models .............................................................. 36 3.4. Two-state Markov regime-switching distinctive conditional variance models ..... 37 3.5. Uncorrelated freight risk factors ............................................................................ 39 3.6. Two-state conditional volatility freight-beta ......................................................... 40 3.7. The dynamics of tanker freight earnings ............................................................... 41 3.7.1. Multi-state Markov regime-switching models ............................................... 41 3.8. Conditional five-beta freight-return model ........................................................... 42 3.9. Summary ............................................................................................................... 45 2 | P a g e Chapter Four ...................................................................................................................... 46 4. Value-at-Risk: Measuring freight risk for single tanker routes ............................... 46 4.1. Introduction ........................................................................................................... 46 4.2. Literature review ................................................................................................... 48 4.3. Methodology ......................................................................................................... 55 4.3.1. A normal value-at-risk measure ..................................................................... 56 4.3.2. A non-normal value-at-risk measure .............................................................. 57 4.3.3. Historical simulation (HS) method ................................................................ 59 4.3.4. A filtered historical simulation value-at-risk (FHS-VaR) measure ............... 59 4.3.5. Modelling conditional volatility ..................................................................... 60 4.3.5.1. The symmetric GARCH (SGARCH) model .......................................... 61 4.3.5.2. The asymmetric GARCH (AGARCH) model ........................................ 64 4.3.5.3. The RiskMetrics model ........................................................................... 65 4.3.5.4. A fractionally integrated GARCH (FIGARCH) model .......................... 65 4.3.5.5. A conditional variance extreme value theory model (CV-EVT) ............ 66 4.3.5.6. Markov-switching GARCH models ....................................................... 68 4.3.6. Backtesting VaRs ........................................................................................... 72 4.3.6.1. The unconditional coverage test ............................................................. 73 4.3.6.2. The independence test ............................................................................. 73 4.3.6.3. Conditional coverage testing .................................................................. 74 4.3.7. Misspecification tests ..................................................................................... 74 4.4. Empirical work ...................................................................................................... 78 4.4.1. Simple analysis and the data sample .............................................................. 78 4.4.2. Conditional volatility model estimations ....................................................... 84 4.4.3. Back-testing results for VaR models.............................................................. 90 4.4.4. Markov regime-switching estimations ........................................................... 96 4.5. Conclusion ........................................................................................................... 107 Chapter