Effectiveness of forward freight agreement in mitigating capesize shipowner's business risk between 2009 and 2014

Abstract

Shipowners have employed various risk management tools to reduce their exposure in the inherently risky freight market to ensure survival. Traditionally, they utilize physical hedging tools such as Time Charters (TC) to hedge their earnings. The advent of Forward Freight Agreements (FFA), a paper hedge, provide shipowners with an alternative tool to reduce their risk through the financial market. This paper aims to investigate which hedging tool is more effective in helping shipowners mitigate their business risk. This paper first discusses extensively on the various risks facing a shipowner and how can TC reduce their business risk. This paper then adopts a quantitative approach and creates a corporate finance model to model the cash flow of a real-life practical shipowner. Using publicly available information from Clarkson Intelligence Network, Bloomberg, and Moores Stephen OpsCost, the model simulates the financial performance of a shipowner acquiring Capesize Vessels and deploying them via a TC. The risk and returns derived from the use of TC is then determined and compared with that of FFA over the period of 2009-2014. Overall, it was found that TC are more effective than FFA as a hedging tool as the returns from the asset classes hedged with TC are far superior than that of FFA. This study provides a structure with objective metrics of measurement for future investigation of other hedging tools on their effectiveness.