1Risk Management in Shipping Presentation Outline IntroductionAbout this presentationAbout FreightMetricsAbout Risk ManagementDefining riskThe risk management processScope of risk managementModern applications of risk managementMeasuring Market RiskThe traditional approach to market risk measurementThe Value-at-Risk (VaR) approach
2Risk Management in Shipping Presentation Outline Measuring Market Risk in ShippingJustification for risk management in shippingMarket risk measurement vs. market forecastingIdentifying the impact of freight market risk on fleet cash flowDeveloping a framework for measuring freight market riskMeasuring Market Risk in Shipping Using the Fr8MetricsTM MethodologyMain methodological featuresHow does Fr8MetricsTM work?Benefits of the Fr8MetricsTM methodologyPotential users and managerial applicationsSoftware implementationManaging Freight Market RiskAltering the risk profile using managerial decisionsAltering the risk profile using freight derivatives
3Risk Management in Shipping Introduction About This Presentation Our objectiveShipping is a business activity exposed to a wide variety of risks.In this presentation we are concerned with the measurement of one particular form of risk – namely freight market risk, or the risk of loss arising from unexpected changes in freight rates.Our motivationRisk management is a notion that exists in financial markets for decades, having experienced significant technological and modeling advances over the years.Shipping has proved rather slow in adopting modern risk management techniques and best practices from other industries.Our motivation is to present a modern framework for measuring freight market risk, using the paradigm of other market-sensitive industries.
5Risk Management in Shipping About Risk Management Defining Risk Definition of RiskWe define (financial) risk as the prospect of financial loss due to unforeseen changes in underlying “risk factors”. These risk factors are the key drivers affecting portfolio value and financial results. Such risk factors are equity prices, interest rates, exchange rates, commodity prices, freight rates, etc.Types of RisksBusiness: The risk of loss due to unforeseen changes in demand, technology, competition, etc., affecting the fundamentals of a business activity.Market: The risk of loss arising from unexpected changes in market prices or market rates.Credit: The risk of loss arising from the failure of a counterparty to make a promised payment.Operational: The risk of loss arising from the failures of internal systems or the people who operate in them.Other types: Legal, Liquidity, etc.
6The Risk Management process Risk Management in Shipping About Risk Management The Risk Management ProcessThe Risk Management processThere is a wide misconception amongst practitioners, especially within the shipping industry, who consider risk management as synonymous to hedging. This is an oversimplification and does not reflect the true dimension of risk management.In fact, risk management is a process that involves three separate steps:Risk Modeling: Before any attempt to take decisions on risk considerations, we must identify the underlying risk factors, understand their behavior, and try to model their dynamics. This is the basic foundation on which the other phases of the risk management cycle are built.Risk Measurement: After identifying and modeling the underlying risk factors, we must determine their significance and quantify their influence on portfolio value and financial results.Risk Management : Having identified and measured our risks, we are then able to take informed decisions on whether to reduce our exposure or alter our risk profile based on our risk preferences – hedging is one such alternative course of action.
7Risk Management ≠ Hedging Risk Management in Shipping About Risk Management Scope of Risk ManagementRisk Management ≠ HedgingAs already mentioned, risk management is not synonymous to hedging. Hedging is just one alternative for the active management of risk.Moreover, risk management does not necessarily imply risk reduction. In fact, the objective of risk management is NOT to reduce risk, but – more importantly – to quantify and control risk.Most of the times, the objective is not to eliminate risk, but rather to alter our risk profile according to the prevailing market conditions, our risk preferences, and potential regulatory or contractual requirements.Risks are embedded in any business activity. For a shipowner, the decision to invest in a vessel signifies his belief that freight rates will go up, earning him a return on his investment that is higher than the “risk-free” interest rate. However, there is no “free lunch” in the economy; his decision to invest creates at the same time a natural exposure to freight rates, accepting the risk that freight rates may in fact go down. Risks are simply unavoidable in any profit-taking activity.
8Uncertainty vs. Variability 1 Risk Management in Shipping About Risk Management Scope of Risk ManagementUncertainty vs. Variability 1“Variability is a phenomenon in the physical world to be measured, analysed and where appropriate explained. By contrast, uncertainty is an aspect of knowledge.”Sir David CoxRisk management is only useful for the mere fact that we cannot predict the future. There are two components of our inability to be able to precisely predict what the future holds: these are variability and uncertainty.Variability is the effect of chance and is a function of the system. It is not reducible through either study or further measurement, but may be reduced through changing the physical system.Uncertainty is the assessor’s lack of knowledge (level of ignorance) about the parameters that characterize the physical system that is being modeled. It is sometimes reducible through further study, or through consulting more experts.Risk management can do very little to reduce variability (markets will continue to fluctuate no matter how advanced risk management gets), but can be very effective in reducing uncertainty for those involved in risk-taking decisions.1 Adapted from the book Risk Analysis by David Vose, Chapter 2: “Quantitative Risk Analysis, Uncertainty and Variability”
9Modern applications of Risk Management Risk Management in Shipping About Risk Management Modern Applications of Risk ManagementModern applications of Risk ManagementExposure measurement and reportingMarket risk (since early 90s)Credit risk (since late 90s)Operational risk (new area)Economic capital estimationAllocation of capitalRisk-based pricingRisk limitsRisk-adjusted performance evaluation
10Example: Risk-Adjusted Performance Evaluation Risk Management in Shipping About Risk Management Modern Applications of Risk ManagementExample: Risk-Adjusted Performance EvaluationConsider two traders who are evaluated on the basis of their realized profits at some future date. Trader B ended up with higher profits compared to Trader A. Does this mean he is more skilled than Trader A? Does he deserve a higher bonus? What about the risk incurred by each trader through their trading strategy?
11The Mean-Variance framework Risk Management in Shipping Measuring Market Risk The Traditional Approach to Risk MeasurementThe Mean-Variance frameworkUnder the Mean-Variance framework, we model financial risk in terms of the mean and variance (or standard deviation, the square root of variance) of the Profit/Loss (P&L) or the returns of our portfolio.The Mean-Variance framework often makes the assumption that returns obey a normal distribution (strictly speaking, the mean-variance framework does not require normality, but it is easier to understand its statistics).Portfolio TheoryThe origin of portfolio theory can be traced back to the work of Markowitz (1952) which earned him the Nobel prize.Portfolio theory starts with the premise that investors choose between portfolios on the basis of maximizing expected return for any given portfolio standard deviation or minimizing standard deviation for any given expected return.One of the key insights of portfolio theory is that the risk of any individual asset is measured by the extent to which that asset contributes to overall portfolio risk which depends on the correlation of its return with the returns to the other assets in the portfolio (a result known as diversification effect).Portfolio theory typically makes the assumption of normally distributed returns.
12The origin and development of VaR Risk Management in Shipping Measuring Market Risk The Value-at-Risk (VaR) ApproachThe origin and development of VaRIn the late 70s and 80s, a number of major financial institutions started working on internal models to measure and aggregate risks across the institution as a whole.The best known of these models is the RiskMetrics model developed by JP Morgan. According to industry legend, this model is said to have originated when the chairman of JP Morgan, Dennis Weatherstone, asked his staff to give him a daily one-page report – the famous “4:15 report” – indicating risk and potential losses over the next 24 hours, across the bank’s entire trading portfolio.The report was ready by around 1990 and the measure used was Value-at-Risk (VaR), or the maximum likely loss over the next trading day. VaR was estimated from a system based on standard portfolio theory, using estimates of the standard deviations and correlations between the returns of different traded instruments.In early 1994, JP Morgan set up the RiskMetrics unit to make its data and basic methodology available to outside parties. This bold move attracted a lot of attention and raised awareness of VaR techniques and risk management systems.The subsequent adoption of VaR systems was very rapid, first among securities houses and investment banks, and then among commercial banks, other financial institutions and non-financial corporates.Today, VaR is widely used in almost every market-sensitive industry (with the exception perhaps of shipping!) and has even gained recognition from regulatory authorities.
13Risk Management in Shipping Measuring Market Risk Risk Management in Shipping Measuring Market Risk The Value-at-Risk (VaR) ApproachVaR in practiceVaR Basics:VaR on a portfolio is the maximum loss we might expect over a given holding or horizon period, at a given level of confidence (probability).VaR is less restrictive on the choice of the distribution of returns and the focus is on the tail of that distribution – the worst p percent of outcomes.
14Risk Management in Shipping Measuring Market Risk Risk Management in Shipping Measuring Market Risk The Value-at-Risk (VaR) ApproachVaR in practiceEstimating VaR: The various methodologies for estimating VaR actually differ on their particular technique for constructing the distribution of possible portfolio values from which VaR is inferred. The most common methodologies are:Analytical methods (Variance/Covariance)Historical simulationMonte-Carlo simulationAttractions of VaR:VaR is a single, summary, statistical measure of possible portfolio losses, providing a common and consistent measure of risk across different positions and risk factors.It takes account of the correlations between different risk factors.It is fairly straightforward to understand, even for non-technical people.VaR variants: Following the same logic, other “at risk” measures have been proposed to quantify risk in various settings: Cash Flow at Risk (CaR), Earnings at Risk (EaR), etc.
15Business and market risk in shipping: the two faces of the same coin Risk Management in Shipping Measuring Market Risk in Shipping Justification for Risk Management in ShippingBusiness and market risk in shipping: the two faces of the same coinMost industries can distinguish between business risks and market risks. These industries have to worry about business risks and try to hedge away market risks which may have an adverse side-effect on financial results. For example, an auto manufacturer has to worry about business risks such as technology, competition, production, R&D, but may also have an exposure to FX risk, which may hamper exports, or interest rate exposure which may increase debt service on floating rate obligations.Other industries cannot distinguish between business risks and market risks. The most pronounced example is maybe that of financial institutions. A significant part of the business of financial institutions is to take direct exposure in the world’s equity, interest rate, currency, and commodity markets.Shipping can be said to belong to the industries that cannot distinguish between business risks and market risks. Financial results in shipping are directly affected by movements in the world’s freight rate markets.Shipowners are in effect in the business of managing shipping risk affecting a portfolio of physical assets, rather than simply managing a fleet of vessels.
16High market volatility Risk Management in Shipping Measuring Market Risk in Shipping Justification for Risk Management in ShippingHigh market volatilityFreight rates have historically been very volatile. The impact of unforeseen geo-political events and the slow speed of adjusting supply to demand have often resulted in dramatic fluctuations in the level of freight rates.
17Industry inefficiencies Risk Management in Shipping Measuring Market Risk in Shipping Justification for Risk Management in ShippingIndustry inefficienciesCapital needs vs. sources of funds:Shipping is a capital intensive industry with significant funding needs for fleet expansion and replacement purposes. Yet, it has very limited opportunities to diversify its sources of funding, as most of its financing comes in the form of bank debt.Asset – Liability (mis)matchingAsset economic life >> term of debt financingVariable (uncertain) revenues to meet fixed debt claimsPro-cyclical lending practicesMany banks tend to be influenced by the general sentiment of the market and ignore the cyclical nature of the business. Thus, they appear more willing to lend when the market (and vessel prices) is high, despite the fact that the market will eventually revert back to lower levels. In contrast, they appear rather hesitant to extend credit at a period of low freight rates, although they are likely to rise to more sustainable levels.
18Lessons from the High Yield disaster of the late 90s Risk Management in Shipping Measuring Market Risk in Shipping Justification for Risk Management in ShippingLessons from the High Yield disaster of the late 90sIn the late 90s, many shipping companies decided to tap the public debt markets with high-yield bonds. Historically, it was the first massive attempt of the industry to diversify away from bank debt, using an alternative source of external funding.Unfortunately, nearly all of these high yield issues subsequently defaulted, mainly due to insufficient cash flow generation.This indicated poor risk assessment and a lack of appropriate tools to evaluate shipping market risks.Example:Source: Moody’s (2002)
19Lessons from the High Yield disaster of the late 90s Risk Management in Shipping Measuring Market Risk in Shipping Justification for Risk Management in ShippingLessons from the High Yield disaster of the late 90sExamples:Source: Moody’s (2002)
20Types of maritime forecasting Risk Management in Shipping Measuring Market Risk in Shipping Market Risk Measurement vs. Market ForecastingTypes of maritime forecastingStructural econometric models: Model freight rates as a dependent variable, driven by a number of independent variables, usually representing macro-economic factors that influence shipping demand, e.g. GDP growth, oil prices, industrial output, etc.Time series models: Model freight rates using the structure (serial correlation) in the past history of the data itself. Future freight rates are determined based on lagged values of their own history and do not exploit or infer causality with other economic variables.Difficulties in maritime forecastingDemand for shipping is characterized as derived demand, meaning that it depends on the demand of the commodities that are shipped by sea.Econometric models are prone to specification problems. Model fit can always improve by including more explanatory variables, which may introduce multicollinearity problems.It is possible that a small error in demand estimation may lead to a gross mis-estimation of freight rates (compare D1→D2 vs. D2→D3).
21Differences in methodology Risk Management in Shipping Measuring Market Risk in Shipping Market Risk Measurement vs. Market ForecastingDifferences in scopeScope: Prepare for future vs. Predict the futureMotivation: Prevent unexpected losses vs. Make a profit (beat the market)Horizon: Long-term vs. Short-termEmphasis: Tail of the distribution vs. Mean of the distributionDifferences in methodologyMeasurement does not presuppose causality relations between economic variables.Forecasting models have potentially infinite specifications (depending on choice of explanatory variables).Measurement focuses on producing the complete picture of potential outcomes (entire distribution) rather than producing a point estimate (the mean of the distribution).So, do we discard forecasting? NO, it can serve a useful complementary role, especially in revealing causality relations between economic variables. Forecasting may also assist in certain chartering or trading decisions in the short-run, where it is most effective.
22Identifying the impact of freight rate volatility on fleet cash flow Risk Management in Shipping Measuring Market Risk in Shipping Impact of Freight Rate Volatility on Cash FlowIdentifying the impact of freight rate volatility on fleet cash flowFluctuations in freight rates directly affect fleet cash flow.Cash flow performance is the topmost concern in shipping.Ship financing belongs to the family of “Project Financing” (other forms of project financing include airlines, infrastructure, real estate, etc.). There is a principle in project financing: repayment MUST come from the operating cash flows of the financed asset.So, what really matters in measuring freight market risk is the impact of freight rate variability on cash flow performance.Case studyWe performed a simple exercise (historical simulation) of the cash flow generation of a handysize dry bulker over two separate time periods (period A: Jan-1980 to Dec-1986, and period B: Jan-1987 to Dec-1993).We used the same set of assumptions in both cases (see the following slide), except for using the actual freight rates for each period and the actual second-hand value of the financed vessel at the start of the each period.This exercise not only illustrates the impact of freight rate volatility on cash flow, but also emphasizes the impact of shipping cycles and the importance of proper timing in maritime decision-making.
23Case study: impact of freight rate volatility on fleet cash flow Risk Management in Shipping Measuring Market Risk in Shipping Impact of Freight Rate Volatility on Cash FlowCase study: impact of freight rate volatility on fleet cash flowHistorical simulation assumptions and actual freight rate data (source: Clarksons)
24Case study: impact of freight rate volatility on fleet cash flow Risk Management in Shipping Measuring Market Risk in Shipping Impact of Freight Rate Volatility on Cash FlowCase study: impact of freight rate volatility on fleet cash flowChart of monthly net cash flow (after debt service, but excluding balloon payment):
25Case study: impact of freight rate volatility on fleet cash flow Risk Management in Shipping Measuring Market Risk in Shipping Impact of Freight Rate Volatility on Cash FlowCase study: impact of freight rate volatility on fleet cash flowChart of accumulated liquidity (excluding balloon payment):
26Basic Assumptions and Objectives Risk Management in Shipping Measuring Market Risk in Shipping A Framework for Measuring Freight Market RiskBasic Assumptions and ObjectivesIt is possible to develop a framework for measuring freight market risk using the VaR paradigm.The risk factors in this framework consist of freight rates.Freight rates are assumed to follow a random walk and are modeled using appropriate stochastic processes.The stochastic processes that describe the evolution of freight rates are able to replicate certain known characteristics of freight rate dynamics (cyclicality, seasonality, random shocks).Monte-Carlo simulation is used to generate future freight rate scenarios, in accordance with the underlying stochastic process for each risk factor.The key measure of risk is fleet cash flow.For each freight rate scenario, we re-compute future cash flow, using an appropriate cash flow model which takes into account debt repayment and other cost items (e.g. drydocking costs, special surveys, etc.).Thus we construct the entire distribution of future cash flow, from which we can make VaR-type inferences based on a specified confidence level.
27Modeling the stochastic behavior of freight rates Risk Management in Shipping Measuring Market Risk in Shipping A Framework for Measuring Freight Market RiskModeling the stochastic behavior of freight ratesAny time series data can be thought of as being generated by a particular stochastic or random process, the “true” data-generating process (DGP). A concrete set of data, such as a historical data-series on a freight rate, can be regarded as a particular realization (i.e. a sample) of the underlying true DGP. The distinction between the stochastic process and its realization is akin to the distinction between population and sample in cross-sectional data. Just as we use sample data to draw inferences about a population, in time series we use the realization to draw inferences about the underlying stochastic process.
28Selecting a stochastic process Risk Management in Shipping Measuring Market Risk in Shipping A Framework for Measuring Freight Market RiskSelecting a stochastic processThe modeling of any price variable begins with the choice of a particular stochastic process which captures the characteristics of asset price dynamics. In order to make this selection, we are guided by theoretical considerations, such as the theory concerning the operation of freight equilibrating mechanisms, as well as by empirical analysis of historical data (e.g. mean reversion, fat tails, autocorrelation, volatility clustering, etc.)There is a large number of alternative stochastic processes that can be tested to capture the dynamics of freight rates. Below we provide a few indicative (simplistic) models:Geometric Brownian Motion (GBM):Ornstein-Uhlenbeck (O-U) process:Jump-Diffusion (O-U with Jumps):
29Estimating model parameters Risk Management in Shipping Measuring Market Risk in Shipping A Framework for Measuring Freight Market RiskEstimating model parametersAs discussed previously, a concrete set of historical data can be regarded as a particular realization (i.e. a sample) of the underlying “true” DGP. The objective is to find a theoretical DGP that provides the best fit for the actual data. This is accomplished by estimating the parameters of each theoretical DGP and comparing the various models in terms of some measure of goodness-of-fit.Many stochastic processes admit exact discretization or numerical approximations (using the Euler or higher-order methods) which allow the testing of the underlying processes using standard econometric techniques. Both the GBM and O-U processes admit such discretizations which lead to time-series specifications of a linear autoregressive form.For example, the GBM model can be estimated by running the following regression:The parameters of an O-U process can be estimated using discrete-time data by running the regression:and then calculatingMore advanced models require other techniques, e.g. Maximum Likelihood Estimation
30Simulating the stochastic evolution of freight rates Risk Management in Shipping Measuring Market Risk in Shipping A Framework for Measuring Freight Market RiskSimulating the stochastic evolution of freight ratesHaving discretized the stochastic process and estimated its parameters, we proceed with iterative sampling from the probability distribution(s) used in our model, in order to generate future freight rate scenarios.This technique is known as Monte-Carlo simulation and includes several steps:Random number generation (pseudo-random or low-discrepancy numbers)Transformation of independent random number into correlated random numbersVariance reduction methods (to improve the accuracy for a given number of runs)Example: As discussed in the previous slide, the O-U process can be interpreted as the continuous-time version of a first-order autoregressive process in discrete time. Specifically, the O-U process is the limiting case as Δt 0 of the following AR(1) process:where ε(t) is normally distributed with mean zero and standard deviation σεThus, we can simulate an O-U process, by drawing random numbers from a normal distribution with mean zero and standard deviation σε and generating r(t) as follows:
31Building the distribution of future fleet cash flows Risk Management in Shipping Measuring Market Risk in Shipping A Framework for Measuring Freight Market RiskBuilding the distribution of future fleet cash flowsFor each freight rate scenario produced by our simulation, we re-compute the fleet cash flow based on some cash flow model and plot the results in a histogram. This represents the distribution of future fleet cash flows.Making risk inferences from the distribution of future fleet cash flowsThe distribution of cash flow results reveals the risk profile of the fleet, in terms of the range of possible cash flows that the fleet is able to generate in the future.We can “read” this distribution in order to make probabilistic inferences about the risk of our fleet. For example:What is the probability that the fleet will breakeven?What is the maximum possible cash deficit at the 95% probability level?
32Risk Management in Shipping Measuring Market Risk in Shipping Risk Management in Shipping Measuring Market Risk in Shipping A Framework for Measuring Freight Market RiskA practical exampleAssuming a simple O-U process, we modeled the 1-year Time-Charter rate for dry bulk handysize vessels and simulated 1000 different scenarios. Below we compare the distribution of actual monthly returns (282 observations –from Feb-76 to Jul-99) with the distribution of simulated (random) monthly returns. From this we can compute the cash flow of the vessel and produce the distribution of possible cash flows for next month.
33Main methodological features Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM Main Methodological FeaturesMain methodological featuresFr8Metrics™ is a framework for quantifying freight market risk in shipping portfolios. Fr8Metrics™ is generally based on the Value-at-Risk (VaR) concept, but differs in the use of proprietary stochastic models developed to simulate the evolution of freight rates. These models are designed to replicate the unique seasonal and cyclical characteristics of shipping markets.The Fr8Metrics™ methodology is simulation-based rather than forecast-based. It draws on advanced Monte-Carlo simulation techniques to generate future freight market scenarios from which we estimate the likely distribution of various financial measures, such as cash flow, accumulated liquidity, hull cover, NPV, etc.Fr8Metrics™ is able to incorporate the influence of correlations, not only across different market segments within the shipping industry, but also between shipping and financial markets. Thus, it is possible to capture potential diversification effects within a portfolio that combines both shipping and financial assets.Fr8Metrics™ is able to support portfolios that combine both physical assets (vessels) and “paper” assets (derivatives).
34Step 1: Portfolio Definition Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM How Does Fr8MetricsTM Work?Step 1: Portfolio DefinitionInput details for the fleet (charter agreements, cost data, etc.), loans (repayment schedules, interest cost, collateral vessels, etc.), and derivatives.Step 2: Risk MappingAssign risk factors to vessels and derivatives.Step 3: Project DefinitionSelect the portfolio(s) which will be simulated.Specify cash flow model.Specify risk metric.Specify simulation parameters (number of scenarios, horizon, confidence level, etc.)
35Step 4: Scenario Generation Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM How Does Fr8MetricsTM Work?Step 4: Scenario GenerationGenerate n (=number of scenarios specified in Step 3) future realizations for each risk factor for the time horizon specified in Step 3, in accordance with the underlying stochastic process of each risk factor:
36Step 5: Metric Computation Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM How Does Fr8MetricsTM Work?Step 5: Metric ComputationIteratively substitute values from each of the n scenarios from Step 4 into the cash flow model specified in Step 3, calculate the n future cash flow results, and plot them in a histogram:
37Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM How Does Fr8MetricsTM Work?Step 6: Risk InferenceUsing the distribution of cash flow results from Step 5, find the cash flow estimate corresponding to the desired confidence level specified in Step 3.Having exposed the complete risk profile of the portfolio(s) specified in Step 3, the user (banker, shipowner, etc.) is able to take calculated, risk-informed decisions in accordance with his risk preferences:
38General benefits of Monte-Carlo based methods Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM Benefits of the Fr8MetricsTM MethodologyGeneral benefits of Monte-Carlo based methodsFlexibility to support a wide range of stochastic processes.Not restrictive in terms of distributional assumptions.Ability to incorporate correlations among risk factors.Ability to incorporate decision rules along the simulated paths (e.g. exercise of charter options).Particular benefits of the Fr8MetricsTM methodologyUtilizes stochastic models specifically developed to capture freight rate dynamics.Reveals diversification effects across shipping assets, as well as between shipping and financial exposures.Provides a framework for monitoring derivatives, developing hedging strategies and assessing hedge effectiveness.
39Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM Potential Users and Managerial ApplicationsShipping BanksDetermining credit terms: maximum advance ratio, liquidity covenant, loan spreadRisk assessment: repayment risk, probability of covenant breachEstimating default probabilities, verifying internal risk ratingsPromoting cross-selling, derivatives sales, hedge proposalsShipownersInvestment decisions, e.g. dry bulk vs. tanker segmentsChartering decisions, e.g. time charter vs. spot employmentFinancing decisions, e.g. high-yield bond vs. bank debtHedging decisions, e.g. derivatives vs. long-term charterFreight TradersRisk assessment and monitoringRisk-adjusted performance evaluation
40Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM Software ImplementationProduct featuresHierarchical portfoliosMulti-currency environmentPeriodic updates of parameter estimates for underlying stochastic models3 cash flow model formats (Fleet, GAAP, Sources and Uses)User-defined cash flow itemsGeneration of pro-forma cash flow statementsTechnologyWindows-basedDeveloped in .NET environmentExtensive use of XMLDatabases: SQL / Access
41Risk-informed decision-making Risk Management in Shipping Managing Freight Market Risk Altering the Risk Profile with Managerial DecisionsRisk-informed decision-makingAs mentioned previously, the objective of risk management is not necessarily to eliminate risk, but rather to alter our risk profile according to the prevailing market conditions, our risk preferences, and potential regulatory or contractual requirements.Having exposed the complete risk profile of a shipping portfolio within a VaR framework, we are able to decide whether it suits our risk preferences or to make comparisons among alternative business strategies.Choice of strategy is subject to risk preference(Strategy B: higher expected return, but higher risk)Strategy A is dominant(Strategy A: higher expected return AND lower risk)
42Asset Allocation decisions Risk Management in Shipping Managing Freight Market Risk Altering the Risk Profile with Managerial DecisionsAsset Allocation decisionsExpand the fleet in the dry cargo or the tanker segment?Buy one VLCC or two Aframaxes?Buy one 5-year old vessel or two 15-year old vessels?Order a newbuilding in Korea (cheaper, but FX risk) or in the US?Chartering decisionsTrade in the spot market or lock in a 3-year time charter at a rate that is –currently- lower than the spot rate?Accept a high time charter rate or a lower time charter rate with an option to renew?Charter-in or charter-out for the next one year?Funding decisionsFinance new acquisitions through bank debt or high yield issue?Go for a 5-year loan with low spread or a 7-year loan with higher spread?
43Definition of derivatives Risk Management in Shipping Managing Freight Market Risk Altering the Risk Profile with Freight DerivativesDefinition of derivativesIn chemistry, a derivative is a “substance related structurally to another substance and theoretically derivable from it (...) a substance that can be made from another substance”.1 Derivatives in finance work on the same principle. They are financial instruments whose promised payoffs are derived from the value of something else, generally called the underlying.1 This definition comes from the online version of the Merriam-Webster Collegiate Dictionary. SeeTypes of freight derivativesForward Freight Agreements (FFAs): An agreement between two counterparties to settle a freight rate for a specified quantity of cargo or type of vessel, for a certain route, and at a certain date in the future.The underlying asset of the FFA contracts can be any of the routes that constitute the indices produced by the Baltic Exchange.FFAs are settled in cash on the difference between the contract price and an appropriate settlement price at expiration.To establish an FFA, we need to specify: route, price, duration/quantity, settlementOther types of derivatives: Options, Swaps, Swaptions, etc.
44The market of freight derivatives Risk Management in Shipping Managing Freight Market Risk Altering the Risk Profile with Freight DerivativesThe market of freight derivativesHistorical development of freight derivatives:Freight derivatives existed since 1985 with the creation of the BFI (Baltic Freight Index), a basket of individual dry cargo routes. This index served as a settlement mechanism for freight futures listed on BIFFEX (subsequently merged with LIFFE, contracts de-listed in April 2002).Since 1992, the individual shipping routes could be traded “over the counter” (i.e. not through an exchange) in the form of FFAs.Current market size and players:Estimated annual turnover: $4.0 billion in notional value of freight.Types of players: Shipowners, Charterers, Trading Houses, ShipbrokersThe role of the Baltic Exchange:Sets the rules and oversees the process of collecting and processing the brokers’ assessments of freight rates in more than 30 cargo routes. These prices are used for the settlement of FFA transactions.
45Fundamentals of freight derivatives trading Risk Management in Shipping Managing Freight Market Risk Altering the Risk Profile with Freight DerivativesFundamentals of freight derivatives tradingTrading processPrice discovery through brokersFFA negotiationCounterparty clearanceDocumentationBasis risk (sources: correlation, time lag)Marking-to-MarketDesigning a hedging programUnderstand the distribution / dynamics of freight rates.Estimate the impact of adverse freight rate movements on fleet cash flow.Decide whether to hedge, depending on external and internal considerations.Choose the appropriate financial instruments.Determine how much to hedge.
46Risk Management in Shipping References, Links, and Further Reading Adland, Roar (June 2000), Theoretical Vessel Valuation and Asset Play in Bulk Shipping, Thesis submitted for the MS in Ocean Systems Management, MITAttikouris, Kyriakos (April 2000), Modeling Freight Rates, Thesis submitted for the Diploma in Mathematical Finance, University of OxfordAttikouris, Kyriakos (March 1996), Time Series Applications in the Ocean Shipping Business, Project submitted for the course Applied Time Series Analysis (MBA program), University of RochesterConcalves, Franklin de Oliveira (September 1992), Optimal Chartering and Investment Policies for Bulk Shipping, Thesis submitted for the PhD in Ocean Systems Management, MITDowd, Kevin (2002), Measuring Market Risk, WileyDrewry Shipping Consultants (1997), Shipping Futures and Derivatives, Briefing ReportMoody’s Investor Services (2002), Default & Recovery Rates of European Corporate Bond Issuers,Stopford, Martin (1997), Maritime Economics, RoutledgeVose, David (2000), Risk Analysis, WileyWilmott, Paul (1998), Derivatives, WileyMagazines: Risk, Marine Money, Lloyd’s Shipping EconomistSeminar notes: Freight Derivatives seminar, organized by the Cambridge Academy of Transport and the Baltic Exchange (25 November 2002)LinksRiskMetrics GroupGloriaMundi (the best internet source on VaR material)The Baltic Exchange