Freight Derivatives and Risk Management in Shipping

Manolis G. Kavussanos, Dimitris A. Tsouknidis, Ilias D. Visvikis

• Publisher: Routledge
• Year: 2021
• ISBN:
  9781000369014
• Edition: 2
• Topic: Tecnologia e ingegneria
• Subtopic: Trasporti marittimi

This advanced practical textbook deals with the issue of risk analysis, measurement and management in the shipping industry. It identifies and analyses the sources of risk in the shipping business and explores in detail the "traditional" and "modern" strategies for risk management at both the investment and operational levels of the business.

The special features and characteristics of all available freight derivative products are compared and contrasted between them. Practical applications of derivatives are showcased through realistic practical examples, while a number of concepts across the contents of this book appear for the first time in the literature. The book also serves as "the reference" point for researchers in the area, helping them to enhance their knowledge of risk management and derivatives in the shipping industry, but also to students at both undergraduate and postgraduate levels. Finally, it provides a comprehensive manual for practitioners wishing to engage in the financial risk management of maritime business. This second edition has been fully updated in order to incorporate the numerous developments in the industry since its first edition in 2006. New chapters have been introduced on topics such as Market Risk Measurement, Credit Risk and Credit Derivatives, and Statistical Methods to Quantify Risk. Furthermore, the second edition of this book builds upon the successful first edition which has been extensively (i) taught in a number of Universities around the world and (ii) used by professionals in the industry.

Shipowners, professionals in the shipping industry, risk management officers, credit officers, traders, investors, students and researchers will find the book indispensable in order to understand how risk management and hedging tools can make the difference for companies to remain competitive and stay ahead of the rest.

1
Introduction to the shipping markets and their empirical regularities

1.1 Introduction

The aim of this chapter is to discuss the structure of the maritime industry and outline some of its empirical regularities which are related to the concept of risk management. The chapter is organised as follows: Section 1.2 describes the market segmentation of the shipping industry. Section 1.3 considers the market conditions prevailing in the different cargo carrying segments of the industry. Section 1.4 continues the discussion of the previous section, identifying the relationships that determine freight rates for different duration contracts and the factors affecting them, as well as the seasonality properties displayed by the observed freight rates in the various segments of the freight market, while Section 1.5 extends the discussion to present equilibrium models for ship prices, treating them as capital assets/investments that offer operating cash-flows and possible capital gains emanating from their fluctuating vessel values. Finally, Section 1.6 summarises the chapter.

1.2 Market segmentation of the shipping industry

The maritime industry comprises a number of broad segments, according to the characteristics of the vessels involved in carrying the cargos or passengers in these segments. They include the sectors of dry-bulk, tankers, liner shipping, the offshore sector, ferries, cruises, etc. The characteristics of the vessels involved in each sector have developed in such a way so as to serve the purpose for which they are built. For instance, smaller dry-bulk cargo carrying vessels have fitted cranes on board, in order to enable them to load and unload cargo in ports where the infrastructure is not sufficient for that purpose. Moreover, the economics of the industries, which generate the demand for the service the vessels offer, have been very important in determining the vessel characteristics. For instance, low-price commodities, such as iron ore and coal, are typically carried in large quantities using Capesize or Panamax vessels, thereby reducing the freight cost per unit, typically measured in $/ton for the voyage. The use of these larger vessels is important because the freight cost per ton for these commodities may not make it worth transporting them from the more distant producing regions of the world, mainly Australia and Brazil, unless it is low and represents a relatively small proportion of the final price of the commodity. Technical developments in vessel design have been instrumental to that effect. Larger vessel sizes, more efficient engines and smoother hulls have been made possible through developments in naval engineering, thereby enabling the reduction of freight costs over time to unprecedented levels.

This book concentrates on the ocean cargo carrying segments of the maritime industry, although the conclusions drawn and the risk management techniques developed are also applicable to other sectors of the industry or even to other industries/businesses with similar characteristics. The reason for concentrating on the dry and liquid bulk sectors of the maritime industry but also over the past years to the container segment, is that conditions of perfect or near-perfect competition prevail in these segments, and as a result the level of freight rates at any point in time is determined through the forces of the inelastic demand and the slow to respond supply for the shipping transportation service. As a consequence, freight rates and vessel prices are rather volatile, making the pursuit of effective risk management techniques a necessity. This is not necessarily the case with other sub-sectors of shipping, at least not to the same extent.

1.2.1 General cargo and bulk cargo movements

The growth in international trade (exports/imports) over time has been the driving force behind seaborne transportation. This is because the demand for the shipping transportation service is derived from the demand for the commodity transported. According to UNCTAD (2019) more than 80% of world trade, in volume terms, is carried by vessels. The development in international seaborne trade, by major commodities carried by sea from 1980 to 2018, is shown in Figure 1.1. As can be observed, total seaborne trade has almost tripled over these years, and the point should be made that this has been a continuation of the growth in world trade observed over previous decades also.

Figure 1.1 World seaborne trade by commodities

Notes:

• For the period 1980 to 2005 figures for main bulks include iron ore, grain, coal, bauxite/alumina and phosphate.
• From 2006 onwards, main bulks include iron ore, coal and grain only; while bauxite/alumina and phosphate are included under “Other dry cargo”.

Source: UNCTAD (2019) Review of Maritime Transport

The liberalisation of international trade, the trend towards the transnationalisation of business, with the associated expansion of industrial processes over countries and continents of the world and the discovery of new sources of raw materials has seen the world trade flourish over the years. The economies of scale associated with seaborne transportation have played its role in facilitating these changes. This in itself has called for the construction of specialised types of vessels of various sizes, which can carry these commodities between regions of the world. Therefore, specialised markets have developed for each of these vessels, with common driving forces, but also distinct features in terms of factors affecting demand, supply and, as a consequence, risk and return profiles. These features are established in studies such as those of Glen (1997) and Kavussanos (1996a,b, 1997, 1998).

An easy way to understand the distinction of vessel sizes into categories is the Parcel Size Distribution (PSD) of each commodity, which determines the shipping consignment of the cargo carried by vessels – see Stopford (2009). It rests on the observation that some commodities are typically moved in larger sizes than others. For example, iron ore and grain consignments are much larger than phosphate rock or bauxite and alumina. Furthermore, the consignment size or PSD of each commodity changes over time and may be different on different routes. The PSD depends on:

• Commodity demand and shipping supply forces. For instance, low value goods move in large consignments as economies of scale make the freight cost per unit very low. Such examples include the shipping transportation of crude oil, coal, iron ore, etc. The economics of the industrial processes generating the demand for raw materials and finished products of these commodities are also important. Physical characteristics of the commodities transported have a role to play, as agricultural goods, for instance, are perishable and require specialised and more expensive storage facilities – often refrigerated – in comparison to commodities such as coal and iron ore. In general, storage, insurance and financial costs must be weighed against transportation costs in the decision of charterers over what consignment size to transport.
• Cargo consignments. These are proportional to transport distances, as economies of scale are important for the long-haul transportation of commodities. It is more economical than to use larger vessels to transport commodities over long distances.
• Transport system restrictions, such as limitations in ports (i.e. maximum draught, berth size and cargo handling facilities). These may be particularly important in developing countries with limited infrastructure, and regulations dictating a certain PSD in certain regions of the world. For instance, it is not possible for large gearless vessels with deep draughts to approach certain relatively shallow ports in developing countries, and as a consequence consignment sizes and vessels used in these trades are smaller.
• Vessel availability. Consignments of over 2,000–3,000 tons can fill a whole vessel (or hold of a vessel) rather than part of a vessel and are transported in bulk. Smaller consignments, which fill only part of the vessel (or hold), move as general cargo.

Following these observations, it can be said that bulk cargoes refer mainly to transportation of raw materials, which are transported on a one-vessel one-cargo...