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Risk Management in ShippingModeling, Measuring, Managing Freight Market Uncertainty Risk management is a notion that exists in financial markets for decades, having experienced significant technological and modeling advances over the years. Shipping has proved rather slow in adopting modern risk management techniques and best practices from other industries. Our motivation is to present a modern framework for measuring freight market risk, using the paradigm of other marketsensitive industries.

Risk Management in Shipping Modeling, Measuring, & Managing Freight Market Uncertainty Presented at: National Technical University of Athens School of Naval Architecture & Marine Engineering 29 May 2003 Risk Management in Shipping Presentation Outline  Introduction  About this presentation  About FreightMetrics  About Risk Management  Defining risk  The risk management process  Scope of risk management  Modern applications of risk management  Measuring Market Risk  The traditional approach to market risk measurement  The Value-at-Risk (VaR) approach www.freightmetrics.com Risk Management in Shipping Presentation Outline  Measuring Market Risk in Shipping  Justification for risk management in shipping  Market risk measurement vs market forecasting  Identifying the impact of freight market risk on fleet cash flow  Developing a framework for measuring freight market risk  Measuring Market Risk in Shipping Using the Fr8Metrics TM Methodology  Main methodological features  How does Fr8MetricsTM work?  Benefits of the Fr8MetricsTM methodology  Potential users and managerial applications  Software implementation  Managing Freight Market Risk  Altering the risk profile using managerial decisions  Altering the risk profile using freight derivatives www.freightmetrics.com Risk Management in Shipping Introduction About This Presentation   Our objective  Shipping is a business activity exposed to a wide variety of risks  In this presentation we are concerned with the measurement of one particular form of risk – namely freight market risk, or the risk of loss arising from unexpected changes in freight rates Our motivation  Risk management is a notion that exists in financial markets for decades, having experienced significant technological and modeling advances over the years  Shipping has proved rather slow in adopting modern risk management techniques and best practices from other industries  Our motivation is to present a modern framework for measuring freight market risk, using the paradigm of other market-sensitive industries www.freightmetrics.com Risk Management in Shipping Introduction About FreightMetrics   What FreightMetrics is…  A provider of consulting services and software solutions for measuring and managing freight market risk  Working closely with Shipping Banks, Shipowners, and Freight Traders, in order to quantify their exposure to freight market risk in terms of cash-flow sensitivity  Our approach lies in transferring best practices and modern methodologies from the area of financial risk management to shipping What FreightMetrics is NOT…  Shipbroker  Forecasting agency  Market news vendor  Financial intermediary For more information about FreightMetrics, visit our website at www.freightmetrics.com www.freightmetrics.com Risk Management in Shipping About Risk Management Defining Risk  Definition of Risk   We define (financial) risk as the prospect of financial loss due to unforeseen changes in underlying “risk factors” These risk factors are the key drivers affecting portfolio value and financial results Such risk factors are equity prices, interest rates, exchange rates, commodity prices, freight rates, etc Types of Risks  Business: The risk of loss due to unforeseen changes in demand, technology, competition, etc., affecting the fundamentals of a business activity  Market: prices  Credit: counterparty to make a  Operational: or the The risk of loss arising from the failures of internal systems people who operate in them  Other types: Legal, Liquidity, etc www.freightmetrics.com The risk of loss arising from unexpected changes in market or market rates The risk of loss arising from the failure of a promised payment Risk Management in Shipping About Risk Management The Risk Management Process  The Risk Management process  There is a wide misconception amongst practitioners, especially within the shipping industry, who consider risk management as synonymous to hedging This is an oversimplification and does not reflect the true dimension of risk management  In fact, risk management is a process that involves three separate steps: Risk Modeling: Before any attempt to take decisions on risk considerations, we must identify the underlying risk factors, understand their behavior, and try to model their dynamics This is the basic foundation on which the other phases of the risk management cycle are built Risk Measurement: After identifying and modeling the underlying risk factors, we must determine their significance and quantify their influence on portfolio value and financial results Risk Management : Having identified and measured our risks, we are then able to take informed decisions on whether to reduce our exposure or alter our risk profile based on our risk preferences – hedging is one such alternative course of action www.freightmetrics.com Risk Management in Shipping About Risk Management Scope of Risk Management  Risk Management ≠ Hedging  As already mentioned, risk management is not synonymous to hedging Hedging is just one alternative for the active management of risk  Moreover, risk management does not necessarily imply risk reduction In fact, the objective of risk management is NOT to reduce risk, but – more importantly – to quantify and control risk  Most of the times, the objective is not to eliminate risk, but rather to alter our risk profile according to the prevailing market conditions, our risk preferences, and potential regulatory or contractual requirements  Risks are embedded in any business activity For a shipowner, the decision to invest in a vessel signifies his belief that freight rates will go up, earning him a return on his investment that is higher than the “risk-free” interest rate However, there is no “free lunch” in the economy; his decision to invest creates at the same time a natural exposure to freight rates, accepting the risk that freight rates may in fact go down Risks are simply unavoidable in any profit-taking activity www.freightmetrics.com Risk Management in Shipping About Risk Management Scope of Risk Management  Uncertainty vs Variability “Variability is a phenomenon in the physical world to be measured, analysed and where appropriate explained By contrast, uncertainty is an aspect of knowledge.” Sir David Cox  Risk management is only useful for the mere fact that we cannot predict the future There are two components of our inability to be able to precisely predict what the future holds: these are variability and uncertainty  Variability is the effect of chance and is a function of the system It is not reducible through either study or further measurement, but may be reduced through changing the physical system  Uncertainty is the assessor’s lack of knowledge (level of ignorance) about the parameters that characterize the physical system that is being modeled It is sometimes reducible through further study, or through consulting more experts  Risk management can very little to reduce variability (markets will continue to fluctuate no matter how advanced risk management gets), but can be very effective in reducing uncertainty for those involved in risk-taking decisions www.freightmetrics.com Risk Management in Shipping About Risk Management Modern Applications of Risk Management  Modern applications of Risk Management  Exposure measurement and reporting  Market risk (since early 90s)  Credit risk (since late 90s)  Operational risk (new area)  Economic capital estimation  Allocation of capital  Risk-based pricing  Risk limits  Risk-adjusted performance evaluation www.freightmetrics.com 10 Risk Management in Shipping Measuring Market Risk in Shipping A Framework for Measuring Freight Market Risk  A practical example  Assuming a simple O-U process, we modeled the 1-year Time-Charter rate for dry bulk handysize vessels and simulated 1000 different scenarios Below we compare the distribution of actual monthly returns (282 observations –from Feb-76 to Jul-99) with the distribution of simulated (random) monthly returns From this we can compute the cash flow of the vessel and produce the distribution of possible cash flows for next month 90 Empirical Simulated 80 70 60 50 40 30 20 10 -19% www.freightmetrics.com -16% -14% -11% -9% -6% -4% -1% 1% 4% 33 6% 9% 11% 14% 16% 19% Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM Main Methodological Features  Main methodological features  Fr8Metrics™ is a framework for quantifying freight market risk in shipping portfolios Fr8Metrics™ is generally based on the Value-at-Risk (VaR) concept, but differs in the use of proprietary stochastic models developed to simulate the evolution of freight rates These models are designed to replicate the unique seasonal and cyclical characteristics of shipping markets  The Fr8Metrics™ methodology is simulation-based rather than forecast-based It draws on advanced Monte-Carlo simulation techniques to generate future freight market scenarios from which we estimate the likely distribution of various financial measures, such as cash flow, accumulated liquidity, hull cover, NPV, etc  Fr8Metrics™ is able to incorporate the influence of correlations, not only across different market segments within the shipping industry, but also between shipping and financial markets Thus, it is possible to capture potential diversification effects within a portfolio that combines both shipping and financial assets  Fr8Metrics™ is able to support portfolios that combine both physical assets (vessels) and “paper” assets (derivatives) www.freightmetrics.com 34 Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM How Does Fr8MetricsTM Work?  Step 1: Portfolio Definition   Step 2: Risk Mapping   Input details for the fleet (charter agreements, cost data, etc.), loans (repayment schedules, interest cost, collateral vessels, etc.), and derivatives Assign risk factors to vessels and derivatives Step 3: Project Definition  Select the portfolio(s) which will be simulated  Specify cash flow model  Specify risk metric  Specify simulation parameters (number of scenarios, horizon, confidence level, etc.) www.freightmetrics.com 35 Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM How Does Fr8MetricsTM Work?  Step 4: Scenario Generation  Generate n (=number of scenarios specified in Step 3) future realizations for each risk factor for the time horizon specified in Step 3, in accordance with the underlying stochastic process of each risk factor: www.freightmetrics.com 36 Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM How Does Fr8MetricsTM Work?  Step 5: Metric Computation  Iteratively substitute values from each of the n scenarios from Step into the cash flow model specified in Step 3, calculate the n future cash flow results, and plot them in a histogram: www.freightmetrics.com 37 Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM How Does Fr8MetricsTM Work?  Step 6: Risk Inference  Using the distribution of cash flow results from Step 5, find the cash flow estimate corresponding to the desired confidence level specified in Step  Having exposed the complete risk profile of the portfolio(s) specified in Step 3, the user (banker, shipowner, etc.) is able to take calculated, risk-informed decisions in accordance with his risk preferences: www.freightmetrics.com 38 Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM Benefits of the Fr8MetricsTM Methodology   General benefits of Monte-Carlo based methods  Flexibility to support a wide range of stochastic processes  Not restrictive in terms of distributional assumptions  Ability to incorporate correlations among risk factors  Ability to incorporate decision rules along the simulated paths (e.g exercise of charter options) Particular benefits of the Fr8MetricsTM methodology  Utilizes stochastic models specifically developed to capture freight rate dynamics  Reveals diversification effects across shipping assets, as well as between shipping and financial exposures  Provides a framework for monitoring derivatives, developing hedging strategies and assessing hedge effectiveness www.freightmetrics.com 39 Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM Potential Users and Managerial Applications    Shipping Banks  Determining credit terms: maximum advance ratio, liquidity covenant, loan spread  Risk assessment: repayment risk, probability of covenant breach  Estimating default probabilities, verifying internal risk ratings  Promoting cross-selling, derivatives sales, hedge proposals Shipowners  Investment decisions, e.g dry bulk vs tanker segments  Chartering decisions, e.g time charter vs spot employment  Financing decisions, e.g high-yield bond vs bank debt  Hedging decisions, e.g derivatives vs long-term charter Freight Traders  Risk assessment and monitoring  Risk-adjusted performance evaluation www.freightmetrics.com 40 Risk Management in Shipping Measuring Market Risk with Fr8MetricsTM Software Implementation   Product features  Hierarchical portfolios  Multi-currency environment  Periodic updates of parameter estimates for underlying stochastic models  cash flow model formats (Fleet, GAAP, Sources and Uses)  User-defined cash flow items  Generation of pro-forma cash flow statements Technology  Windows-based  Developed in NET environment  Extensive use of XML  Databases: SQL / Access www.freightmetrics.com 41 Risk Management in Shipping Managing Freight Market Risk Altering the Risk Profile with Managerial Decisions  Risk-informed decision-making  As mentioned previously, the objective of risk management is not necessarily to eliminate risk, but rather to alter our risk profile according to the prevailing market conditions, our risk preferences, and potential regulatory or contractual requirements  Having exposed the complete risk profile of a shipping portfolio within a VaR framework, we are able to decide whether it suits our risk preferences or to make comparisons among alternative business strategies Choice of strategy is subject to risk preference (Strategy B: higher expected return, but higher risk) www.freightmetrics.com Strategy A is dominant (Strategy A: higher expected return AND lower risk) 42 Risk Management in Shipping Managing Freight Market Risk Altering the Risk Profile with Managerial Decisions    Asset Allocation decisions  Expand the fleet in the dry cargo or the tanker segment?  Buy one VLCC or two Aframaxes?  Buy one 5-year old vessel or two 15-year old vessels?  Order a newbuilding in Korea (cheaper, but FX risk) or in the US? Chartering decisions  Trade in the spot market or lock in a 3-year time charter at a rate that is – currently- lower than the spot rate?  Accept a high time charter rate or a lower time charter rate with an option to renew?  Charter-in or charter-out for the next one year? Funding decisions  Finance new acquisitions through bank debt or high yield issue?  Go for a 5-year loan with low spread or a 7-year loan with higher spread? www.freightmetrics.com 43 Risk Management in Shipping Managing Freight Market Risk Altering the Risk Profile with Freight Derivatives  Definition of derivatives  In chemistry, a derivative is a “substance related structurally to another substance and theoretically derivable from it ( ) a substance that can be made from another substance”.1 Derivatives in finance work on the same principle They are financial instruments whose promised payoffs are derived from the value of something else, generally called the underlying This definition comes from the online version of the Merriam-Webster Collegiate Dictionary See http://www.britannica.com/cgi-bin/dict?va=derivative  Types of freight derivatives  Forward Freight Agreements (FFAs): An agreement between two counterparties to settle a freight rate for a specified quantity of cargo or type of vessel, for a certain route, and at a certain date in the future  The underlying asset of the FFA contracts can be any of the routes that constitute the indices produced by the Baltic Exchange  FFAs are settled in cash on the difference between the contract price and an appropriate settlement price at expiration  To establish an FFA, we need to specify: route, price, duration/quantity, settlement  Other www.freightmetrics.com types of derivatives: Options, Swaps, Swaptions, etc 44 Risk Management in Shipping Managing Freight Market Risk Altering the Risk Profile with Freight Derivatives  The market of freight derivatives    Historical development of freight derivatives:  Freight derivatives existed since 1985 with the creation of the BFI (Baltic Freight Index), a basket of individual dry cargo routes This index served as a settlement mechanism for freight futures listed on BIFFEX (subsequently merged with LIFFE, contracts de-listed in April 2002)  Since 1992, the individual shipping routes could be traded “over the counter” (i.e not through an exchange) in the form of FFAs Current market size and players:  Estimated annual turnover: $4.0 billion in notional value of freight  Types of players: Shipowners, Charterers, Trading Houses, Shipbrokers The role of the Baltic Exchange:  www.freightmetrics.com Sets the rules and oversees the process of collecting and processing the brokers’ assessments of freight rates in more than 30 cargo routes These prices are used for the settlement of FFA transactions 45 Risk Management in Shipping Managing Freight Market Risk Altering the Risk Profile with Freight Derivatives  Fundamentals of freight derivatives trading   Trading process  Price discovery through brokers  FFA negotiation  Counterparty clearance  Documentation  Basis risk (sources: correlation, time lag)  Marking-to-Market Designing a hedging program Understand the distribution / dynamics of freight rates Estimate the impact of adverse freight rate movements on fleet cash flow Decide whether to hedge, depending on external and internal considerations Choose the appropriate financial instruments Determine how much to hedge www.freightmetrics.com 46 Risk Management in Shipping References, Links, and Further Reading  References  Adland, Roar (June 2000), Theoretical Vessel Valuation and Asset Play in Bulk Shipping, Thesis submitted for the MS in Ocean Systems Management, MIT Attikouris, Kyriakos (April 2000), Modeling Freight Rates, Thesis submitted for the Diploma in Mathematical Finance, University of Oxford Attikouris, Kyriakos (March 1996), Time Series Applications in the Ocean Shipping Business, Project submitted for the course Applied Time Series Analysis (MBA program), University of Rochester Concalves, Franklin de Oliveira (September 1992), Optimal Chartering and Investment Policies for Bulk Shipping, Thesis submitted for the PhD in Ocean Systems Management, MIT Dowd, Kevin (2002), Measuring Market Risk, Wiley Drewry Shipping Consultants (1997), Shipping Futures and Derivatives, Briefing Report Moody’s Investor Services (2002), Default & Recovery Rates of European Corporate Bond Issuers, 1985-2001 Stopford, Martin (1997), Maritime Economics, Routledge Vose, David (2000), Risk Analysis, Wiley Wilmott, Paul (1998), Derivatives, Wiley Magazines: Risk, Marine Money, Lloyd’s Shipping Economist Seminar notes: Freight Derivatives seminar, organized by the Cambridge Academy of Transport and the Baltic Exchange (25 November 2002)             Links    www.riskmetrics.com www.gloriamundi.org www.balticexchange.com www.freightmetrics.com RiskMetrics Group GloriaMundi (the best internet source on VaR material) The Baltic Exchange 47