NATIONAL TECHNICAL UNIVERSITY OF ATHENS School of of Naval Architecture and Marine Engineering. Financial Risk Assessment, Part I.

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1 NATIONAL TECHNICAL UNIVERSITY OF ATHENS School of of Naval Architecture and Marine Engineering Financial Risk Assessment, Part I.2 (Derivatives)

2 Scope It is far better to predict without certainty, than never to have predicted at all. Ηenri Poincare Summary of stock exchange derivatives In particular some basic information on shipping derivatives Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 2

3 Features of contemporary economic Environment Volatile interest rates Changes in currency exchange rates Fluctuations in commodity prices Intense competition Competition among financial institutions Globalisation of trade Financial Risk Management Techniques Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 3

4 Derivatives Definition: "Financial securities whose price is derived from the actual value of the assets that underlie, whether they are financial or physical" An economic agreement between two parties (contractors), exchange of assets in the future They are an asset in themselves Aimed at effective management of asset accounting Contribute positively to the stability and development of the market Εργαστήριο Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 4

5 Nomenclature Spot: The physical (real) market in which transactions are settled immediately Assets: Any asset (physical or financial) which is traded in the Spot market and is substituted by derivatives in the derivatives market Short position Short or negative position taken by the trader who agrees to sell a commodity (physical or financial) Positive position (Long position) Long or positively received by the market maker who agrees to buy a commodity (physical or financial) Εργαστήριο Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 5

6 EXAMPLES OF UNDERLYING ASSETS Seeds and Fruits Shares Livestock and Meat Interest Rates Wood, yarn food contracts Foreign exchange Precious and Industrial Metals Indices Energy Products Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 6

7 Uses and users of derivatives Uses Users RiskReduction (Hedging) Speculation Arbitrage Cost reduction Input / Output from the market performance Enhancement Price discovery Banks Investment companies Insurance companies Investors Various companies Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 7

8 Main types of derivatives Forward Agreements Future Contracts Options Swaps Others Εργαστήριο Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 8

9 Uses (Hedging) Speculation Scope Asset value protection Main principle Open counter derivative market position than in physical market Users Participants of Physical Market Scope Directional bets for value fluctuations Main principle Buy low, sell how Users All investors Εργαστήριο Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 9

10 Derivative Instruments Term Base Contracts between two parties that require a specific act at a later date Trading mode : Out or In Regulated Exchanges Forwards Futures Counterparties: Buying and selling property in agreed future time default value Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 10

11 Futures vs. Forwards Futures They are subject to trading on trading hours of stock exchanges Standard (contract size, duration, delivery) Safety Margin Daily settlement: Gains / Losses credited daily Forwards OTC Products Traded as with all conditions Identities of counterparties are important Final payment on the due date Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 11

12 Example reflecting differences, if instead of forwards, both companies sign Futures Standard - Non-optimal risk coverage Standard delivery dates daily Settlement Can terminate the contract whenever they wish before the end guaranteed Warranty for Fulfillment of Contracts Settlement Completion of deliveries Marking to Market Margin call management clearing house - role Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 12

13 Future Contracts Derivatives traded on the stock exchanges The transactions are performed by the Clearing House Clearing (Paper-Brokers) At the closing date of Contract (Final Settlement) or earlier Marking to Market Gains or losses are settled on a daily basis Εργαστήριο Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 13

14 Options It is a contract that gives the holder the right but not the obligation to buy or sell an asset at a predetermined price at a certain time period The other party has the obligation to honor the contract Call option Put option European Type American Type Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 14

15 Swap Is an agreement between two parties to exchange payment obligations eg interest for a specified period and a specific notional capital OTC contract They can be considered a series of forward contracts Interest Rate Swap FOREX Swap Other Derivatives Floor Cap Options Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 15

16 Shipping derivatives Characteristics of the Shipping Market - Financial risk Sources Volatile freight rate prices (70% change in 20 days) large capital at stake Seasonality shipping cycle effect Extrinsic factors (military events, new deposits of oil, etc.) Changes in interest rates and exchange rates Changes in ships asset values A favorable environment for the development of derivatives Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 16

17 Definition The shipping derivatives are a financial product that is traded based on a future date index value linked on the bulk and tanker freight rates. Indicators: Baltic Exchange & Platts They do not include physical delivery They do not refer to real-life ships 1985 BIFFEX 1992 FFAs Main Users of Shipping Derivatives Shipping companies in general Companies trading oil & seeds Banks and other financial institutions Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 17

18 Types of Shipping Derivatives Forward Freight Agreements (FFAs) Contracts determine the price of the fare for a specific amount of load (or vessel type) for a route (or a combination of routes) of the main routes of the tanker & bulk carriers Freight Futures In organized exchanges: NYMEX, IMAREX E.g. IMAREX Directly to the online market through brokers in Oslo and Singapore Through independent brokers shipping derivatives: Clarkson's, Simpson Spence & Young, Freight Investor Services Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 18

19 Types of Shipping Derivatives (continued) Hybrid FFAs OTC agreements Cleared by LCH.Clearnet Freight Options Available in individual routes of Stock Baltic Exchange in baskets and the FFA linked to them Monthly, quarterly, annual They use indicators of the Baltic Exchange Option to buy or sell Example: Shipowner (sales contract) agrees to sell his ship at a certain date in the future at the predetermined price Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 19

20 The contract shipping derivatives should consist of: The route The price of futures / forwards In month contract The duration of the contract The quantity Settlement terms Clearance (if applicable) A contract of FFABA (Forward Freight Agreement Brokers Association) or a custom ISDA (International Swap Derivatives Association) Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 20

21 The main trading exchanges for shipping derivatives are: The IMAREX from spring 2000 is engaged in the trading and clearing of futures Futures on the Baltic Exchange indices. NYMEX since the May 2005 negotiates and clears it and Futures contracts. The LCH since September 2005 clears FFA which negotiated OTC by brokers and so creates hybrid FFA. IMAREX Norwegian company Open since May 2000 Collaborates with the NOS (Norwegian Futures & Options Clearinghouse) Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 21

22 Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 22

23 Routes of IMAREX Περιοχή Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 23

24 Forward Freight Agreements Traded by ΙΜΑREX Cleared by NOS and others (ΝΟS, LCH, ΝΥΜΕΧ) BDI Baltic Indices BTI BCI BPI BHI BSI BDTI BCTI BITR IMAREX Routes Sector Route Description Cargo Size C4 Capesize Richards Bay Rotterdam C7 Capesize Bolivar Rotterdam P2A Panamax T/C Skaw Gibraltar Far East P3A Panamax T/C S.Korea Japan Pacific Panel B: Listed Basket of T/C Dry-Bulk Futures CS4TC Capesize T/C Average n/a PM4TC Panamax T/C Average n/a HM6TC Handymax T/C Average n/a Routes Liquid Cargo Units: $ / day Duration of contracts: Annual / Quarterly / Monthly Routes Dry Cargo Units: World Scale (WS) Duration of contracts: Annual / Quarterly / Monthly Εργαστήριο Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 24

25 Clearing Performed by the IMAREX platform of NOS NOS enters into the transaction as the CCP offering: (Norwegian Futures and Options Clearing House) Reliability Balance Discreteness Value of Freight Future contract : Π = R - I Π > 0 : Profit from buying futures Α = Π Π < 0 : Profit from selling futures N O S R: Price Spot ($/day) I : Price Future ($/day) ΑΓΟΡΑΣΤΗΣ ΡΙΣΚΟ ΑΝΤΙΣΥΜΒΑΛΛΟΜΕΝΟΥ ΠΩΛΗΤΗΣ R refers to settlement day Εργαστήριο Θαλασσιών Μεταφορών, Σχολή Ναυπηγών Μηχανολόγων Μηχανικών ΕΜΠ 25