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Question

Write a report on the risk management in the  shipping industry and emphasize upon the models used to price freight derivatives.

Solution

• Introduction
  • Research Background

Shipping is the largest transportation medium that derives industrial production at large (approximately 99%).  The global shipping industry revenue from freight charges accounts nearly $ 500 billion, which is approximately 5% of the total global economy[1]. The ship is an important asset which comprises of significant value. Shipping business is a volatile business which primarily links with the business cycle. The effect global economic environment is important since the downturn in the economy cause, a downside in the shipping industry too. The volatility in shipping business causes much volatile cash flows, revenues, etc and hence the financing shipping companies are also difficult. Considering this it is discernible to understand the various risk factors involved in shipping business. Therefore from the finance perspective understanding of risk issues involved in shipping business is one facet.

• Research Objective

Therefore, it is important to highlight various risk factors such as oil price risk, interest rate risk, counter party risk and freight rate risk, which are required to manage. There can be various risk management tools to manage the risk and uncertainties, but, here in this report our main objective is to highlight the pricing methods and models used in derivative instruments relevant to the shipping risk management, such as Freight rate derivatives including FFA (Freight forward agreement), freight options etc. We have following objectives

• Describing various theoretical aspects for freight derivatives taken from financial derivative markets.
• The origin and nature of risk hedging models used in the freight derivatives with help of literature review.
• Describe various types of freight derivatives, their pricing methods and models used for hedging purpose.
• Describing how and why VaR is used and the reason behind the availability of parametric, non-parametric, and semi-parametric models.

Further, the report is organized as: part 2 describes methodology; part 3 focuses upon theoretical aspects of derivatives; part 4 focus upon discussion and analysis and section 5 concludes the report.

2) Research methodology and Research questions

2.1. Research Methodology

In this research report, various aspects of freight derivatives have been covered after reviewing research papers and reports. To explain fright derivative models and nature/types of risk involved, I consider reviewing various journals, academic online sources and reports. I download the relevant research papers from various academic sources like Google scholar, Ebesco, Jstore, Oxford online and e library. From these journal papers, a broad understanding of the freight derivatives, types, pricing and theoretical underpinnings have included in detail in the forthcoming section of this report. This report's main focus is to give an insight of pricing models used in the fright derivatives, theoretical underpinnings; model related issues and associated solution in respect of freight rate risk management. We also focus upon the reason why econometric time series models, parametric models (Black-Scholes) and their combination is used.

2.2. Research Questions

• • What are the types of different freight derivative products available for freight risk management?
  • Describe the distinguishing features of these products?
  • What are the various pricing methods available to these derivative products?
  • Describe the VaR analysis to calculate the market risk of freight market?
  • Give an overview of time series models used in calculating volatilities in Freight derivatives?

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