Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 12. Risk Management in Freight Markets with Forwards and Options Contracts

JUBY GEORGE

Valuation Risk Group, Credit Suisse, London

RADU TUNARU, PhD

Senior Lecturer in Financial Mathematics, City University, CASS Business School

Abstract: The freight market is one of the most volatile markets where not many financial instruments are available for hedging the associated financial risks. The same type of risk can take different magnitudes on different routes and major operators need constantly to come up with innovative solutions for financial risk management. Derivatives were successfully introduced in other financial markets mainly to hedge out the risks. The development of liquid derivatives contract contingent on freight rates has been relatively slow but in the last couple of years two main contracts have been used with increased confidence. The freight forward agreement and their contingent options are two main instruments that are used in practice to hedge away some of the risk. The particular characteristics of the market lead to special contractual differentiation that must be taken into account when pricing these contracts.

Keywords: financial risk, risk management, freight rates, freight forward agreement (FFA), freight options, caps and floors, geometric Brownian motion, Ito's lemma, Black model, Monte Carlo simulation

The freight market has received increased attention in recent years due to the unprecedented growth, mainly related to the boom trade with China. The volatility ...