Risk Exposure - Finance in Shipping Sector - Assignment Example

Risk exposure By: Course: Tutor: University: City/State Date: Identification and categorization of shipping business risks related to the project. Business: this risk type of risk exposure is related to losses incurred from unanticipated changes in business related factors like competition and technology or government policy. Market risk exposure- this type of risk is associated with loss from unexpected changes in freight rates. Shipping company being a multinational enterprise faces great foreign exchange risks, which may arise as a result of appreciation or depreciation of Euro against other currencies, which denominate the company income from foreign markets. As majority of the company’s income are made in foreign markets and this contributes to the exchange risk that the company faces for recognizing its sales in other countries. The currency risk facing the financial sector not only affects the value of its sales made in the international markets but also the cost of shipping as the companies purchases its components from vendors located in different countries. Credit: - this type of risk is associated with loss from parties to the contract. Operational: this type of risk is associated with loss from failures of internal systems. Other types: Other risk is piracy, as vessels navigate through oceans there is a possible invasion of pirates as well as the illegal trade. Shipping companies encounters piracy while moving cargo which will increase cost. Freight rate volatility which affects fleet cash flow. The most important factor that affect freight rate is the intended destination of the cargo. For longer and more perilous journeys, freight rate will be higher. Perilous journey refer to areas of political instability and maritime insecurity like the Gaza Strip and the Coast of Somalia where terrorist and military attacks and pirate activities are incessant in both places respectively. Service charges levied by the port authorities of the cargo’s destination will significantly affect freight rate. The season of the time is also another important factor. Perishable goods and goods transported during peak production season will attract higher freight rates. The daily fluctuations of the US dollar on the foreign exchange market will be reflected too in freight rate since the dollar is used as the internationally accepted currency of transaction. Fines and fees, and terminal fees may be levied in instances of delays in delivery of cargo due to port-overcrowding. Terminal fees are fees levied on embarking a journey and on reaching its destination All risk exposures related to the project based on proper justification. In order to manage economy related and business related risks shipping companies employs independent treasury centers in order to foresee the market conditions and forecast changes in risks rates which may affect the company’s cash flows in respective markets and overall earnings when profits are remitted. The company employs different models for measuring Freight rate volatility, exchange rate risks including cash-flow-at-risk models and scenario analysis. In particular, the company employs cash-flow-at-risk models to estimate the exposure of the companies in different currencies within a period and estimates its value for the next period. This model uses probability distributions and input factors such as volatilities and correlations between currency rates to estimate the impact of exchange exposures on the Group’s operating cash flows. These exposures include all three types of classification of currency risk as highlighted including translation, translation, and operating exposures. The effectiveness and relevance of the hedging process can be assessed by analyzing its impact on the item or asset being hedged. This is by checking or finding out how the value of the underlying asset/item changes. If significant difference in value arises in the hedged item then the hedging is effective to that extent. Moreover, if the freight rate changes of the item and the derivative in hedging settles off or offset each other than the hedge is said to be effective. The main reason and objective of the hedging process is to minimize risks of possible loss that may arise, and thus effectiveness of hedging is the reduction in variance. However, the above techniques did not take into account the elements of risk that arises in future contracts due to their incorrect and inappropriate assumptions when designing a measure for the effectiveness of hedging. This prompted a number of studies to be carried out and attempts to fix the issues of risks were done by various individuals. The Minimum Variance (MV) technique has in recent years been used widely to test how efficient is the hedging process on different commodities and other futures. This means that variance is taken as a risk measure. However, there exist some challenges to this measure. In the situations where the investor are avoiding risks, or the prices of the futures follow specific patterns, then the mean variance ratio of the hedge will be equal to the minimum variance ratio. This is true for the freight rate futures since it is usually common that changes in the prices of the futures is normally zero, therefore it follows a certain process. This also means that, given the properties of freight rate markets and futures, the challenge of the minimum variance can be dealt with. MV hedge ratio – the derivation The process of deriving the minimum variance hedge ratio is includes the optimal hedge ratio. For us to get the MV ratio, the return on the freight is given. This is because the sole objective of the MV is to minimize return on the freight. , therefore is: Cs units of a long spot position Cf number of units of a short futures position St spot freight rate at time t Ft Futures price at time t. Thus, the hedge ratio (h) will be: , A period returns for spot position A period returns for future position Sometime the ratios are described in terms of profits realized from price changes instead of returns. Thus profit on the hedged freight portfolio (∆), is given by ∆= And the hedge ratio (H), H = , It is now important to derive the optimal hedge ratio, which is the most important process in hedging the futures Some important issues should be taken into account: 1. hedge ratio can be static or dynamic 2. optimal hedge ratio depends on objective that needs to be optimized MV ratio remains unchanged over time therefore is a static hedge ratio, and it is generated by minimizing the risk of the freight. The variance represents the risk, and given as Var = With the above equation, it is possible go get the Minimum Variance Ratio as OLS Technique - The OLS technique is an estimation process that involves regression of changes in spot prices over changes in future prices, in which the equation is given as; ∆ ∆and Δare the changes in spot and future prices as mentioned earlier The slope β is the estimate of the MV hedge ratio α is the constant term is the error term OLS estimation technique is clear and simple to use, however, it has some shortcomings such as the many assumptions that has to be made for OLS to be used and be valid. They hence suggested the use of conditional covariance and the conditional variance as the new adjusted optimal hedge version. Hedging methods Generally, futures mostly exhibits some behavior that is seen to be highly pronounced during certain times and seasons of the year. The prices tend to fluctuate at high rates at the end of the futures contracts, i.e. as the contracts nears their maturity, the prices of futures tend to change a lot than during the inception of contracts. The Available methods of risk hedging include Estimation of the loss to insure it Apportionment of funds Contract forward pricing Setting of risks to taken Carrying performance evaluation and then adjust for risk The competition in the futures market helps to stabilize the prices to the extent that the prices of the futures equal the expected spot prices of the futures as the futures contract comes towards the maturity. This behavior of the futures prices and the futures markets will help understand why certain methods of testing the effectiveness of hedging are used or chosen and further help realize their importance and relevance Freight rate volatility is one major concern in any business and hence for the case of the futures markets, there exist some risks and impacts that come with the fluctuating prices. The imperfection can lead to hedging imperfections and this is known as the basis risk. The basis risk is the uncertainty or a possibility of loss arising from the difference associated with the instrument used in hedging and the spot price. This also occurs when there is mismatch at the maturity and the mismatch with asset that is being hedged. Freight rate are affected by several factors from fuel prices to government policies. There has not being a single freight rate has freight rate itself varies with diversification of cargoes being transported. However, there have been indications of a general consistent increase in freight rate across most cargoes being transported. Cargo price is measured in ton/mile Available hedging product Freight rate fluctuation - Hedging is an investment position that is created for a financial instrument so as to offset potential losses incurred from a companion financial instrument. Due to the risk associated with freight price, a profusion of financial instrument derivatives were created to hedge against them (Kavussanos & Nomilos 2008). Types of hedging includes cash flow hedging, transactions hedging, fair value hedging, measuring and hedging economic exposure and hedging accounting or Foreign Direct Investment exposure . Freight derivatives is the value of a financial instrument that is dependent on the future levels of freight rates , such as oil tanker rates and “dry bulk” carrying rates. Types of freight derivatives are the Container Freight Swap Agreements and the Forward Freight Agreement. The FFA is a financial futures contract that give ship owners, charterers and speculators the opportunity to hedge against the volatility of freight rates; in this instance, the contract holder gets to buy and sell the freight prices for future dates (Alizadeh, Kavussanos and Menachof, 2004). Contracts of the FFA are traded ‘over the counter’ (OTC) on a principal-to-principal basis that could be cleared through a clearing house. This type of financial instrument is built on an index that is made up of a shipping route for a basket of routes for dry bulk or for a tanker. The two types of FFA derivatives are Swaps and Futures. A drawback to the FFA derivatives is the limited liquidity and traders’s exposure to uncertainty and credit risk; there is too much flexibility in contract routes, pricing structures and quantities(Alizadeh, Kavussanos and Menachof, 2004). The CFSA is a type of futures financial contract that similarly provides an avenue for hedgers and speculators to protect themselves against the price volatility of seaborne, intermodal container box-rates (Holliday 2010). This cash-settled agreement is entered into by two parties who have an equal but opposite opinion of the future market. A price is then agreed on by both parties on the amount per container for a select number of containers and a pre-agreed route for a specified period of time. At the contract maturity or expiration of the contract, the two parties then settle the differences in predetermined contract price in monetary equivalent and the actual spot market price (Holliday 2010). A weakening of the market will result in a simultaneous decrease in box rates and this move will favor the trader on the short position. A converse situation arises on the strengthening of the market which will also result in an increase in box rates which will favor the long position. These agreements are also available in clearing houses. Hence, the financial derivative instrument that will be best suited is the Forward Freight Agreement; this instrument will not only secure the interest of the company but will protect profits by reducing risk, locking on profits and limiting future price uncertainties (Alizadeh and Nomikos, 2009). The spot rates of the for contracts are shown below Calculation of Hedging Parameters Stats Spot C1 Mean (%) 0.000 0.000 Variance (%) 0.002 0.001 Skewness 0.516 0.649 Kurtosis 20.111 5.585 Max (%) 0.577 0.324       Min (%) -0.568 -0.198       Data Points 2803 2803 It is clear from the figures that during the inception of futures contracts, the spot prices are relatively low compared with future prices. This is because there is perceived or expected price increase in the prices of natural gas. The buyers and sellers expect that prices will fluctuate but also takes the worst case scenario where they speculate high prices in future, thus making future prices continue rising in the subsequent contracts. 5. Provide a clear and concise list of recommendations supported by appropriate arguments based on your risk management analysis in the report. As applicable in several financial instruments such as derivatives, futures, spot trading, foreign exchange, and options trading, the price of freight is a conglomerate of all and every factor that affects the maritime i.e. the price is a true and complete reflection of the current trend in the sector, or any sector for that matter. Hence, it is expedient of every exporter to fully understand the factors that affect and determine freight rate in order to carry out effective and profitable trades with the carrier. Freight rates symbolize the complex and intriguing areas that must be comprehensible to the rate analyst for the proper costing appraisal of a range of cargo for consignment. Factors that affect freight rates include service cost, market environment opportunities; value added services, cost of palletized and indivisible loads, and disparities in cost of operation of different vessels. The buyers and sellers expect that freight rate will fluctuate but also takes the worst case scenario where they speculate high prices in future, thus making future prices continue rising in the subsequent contracts. However, the effectiveness of the futures market is not satisfactory in that there is and increasing difference between the spot and future prices as more and more contracts are made. This indicates that although there is little difference. This is quite against the intended view of hedging since the main aim of hedging is to reduce the difference between spot and future prices; hence there is still a risk in the fluctuations of future spot prices brought about by the futures markets. The future spot prices are also affected by transport factors and the strategies that traders use to manage risks. An increase in freight rates index directly increases share value which aid shareholders’ optimization. Hence, the financial derivative instrument that will be best suited is the Forward Freight Agreement (FFA); this instrument will not only secure the interest of the company but will protect profits by reducing risk, locking on profits and limiting future price uncertainties There is a correlation between demand factors and the futures prices. It can be seen that during when there is high volatility freight rate, spot and future prices fluctuated just like during the different times of the year. The irregular fluctuations also occur due to inaccurate forecasting of future spot prices. This makes the MV quite inefficient and hence testing the effectiveness of hedging can be quite unsatisfactory in this case. There is also the problem of error correction between spot and future prices which are asymmetric, thus linear error correction cannot be applied to shipping services. The aim of the MV is to reduce risk using variances of future prices and spot prices. MV assumes that the effectiveness of the hedging by minimizing the variance. According to the above data, variance of the spot price is higher than that of future prices. The skewness also is high with future prices than with spot prices, showing the weakness of the hedging in futures as a way to avoid risk of fluctuating prices. REFERENCES Alizadeh, A. H., & Nomikos, N. K. (2009). Shipping Derivatives and Risk Management. New York: Palgrave Macmillian. Alizadeh, A. H., Kavussanos, M. G., & Menachof, D. A. (2004). Hedging against bunker price fluctuations using petroleum futures contracts: constant versus time-varying hedge ratios. Applied Economics , 36 (12), 1337-1353. Bender, R & Ward, K 2008, Corporate Financial Strategy, Burlington, MA: Elsevier Butterworth-Heinemann. Cullinane, K & Khanna, M 2000, ‘Economies of scale in large containerships: optimal size and geographical implications’, Journal of Transport Geography, vol. 8, pp. 181-195. Holliday, K 2010, Container swap derivative clearing to boost market, Energy Risk, London. Available from: [12 April 2017]. Kavussanos, MG, & Nomikos, NK 2000, 'Hedging in the Future Futures Market,' The Journal of Derivatives, vol. 8, no. 1, pp. 41-58. Notteboom, TE. Vernimmen, B 2008, ‘The effect of high fuel costs on liner service configuration in container shipping,’ Journal of Transport Geography, vol. 17, no. 5, pp. 325-337. Upton, J 2008, ‘Best Practice in freight transport operations’, Environment Canterbury, Report No. R08/59. Wijnolst, N. & Wergeland, T 2009, Shipping innovation, Amsterdam: IOS Press. Read More