Nikos K. Nomikos

Constant vs. time-varying hedge ratios and hedging efficiency in the BIFFEX market

This paper estimates time-varying and constant hedge ratios, and investigates their performance in reducing freight rate risk in routes 1 and 1A of the Baltic Freight Index. Time-varying hedge ratios are generated by a bivariate error correction model with a GARCH error structure. We also introduce an augmented GARCH (GARCH-X) model where the error correction term enters in the specification of the conditional covariance matrix. This specification links the concept of disequilibrium (as proxied by the magnitude of the error correction term) with that of uncertainty (as reflected in the time varying second moments of spot and futures prices). In- and out-of-sample tests reveal that the GARCH-X specification provides greater risk reduction than a simple GARCH and a constant hedge ratio. However, it fails to eliminate the riskiness of the spot position to the extent evidenced in other markets in the literature. This is thought to be the result of the heterogeneous composition of the underlying index. It seems that restructuring the composition of the Baltic Freight Index (BFI) so as to reflect homogeneous shipping routes may increase the hedging effectiveness of the futures contract. This by itself indicates that the imminent introduction of the Baltic Panamax Index (BPI) as the underlying asset of the Baltic International Financial Futures Exchange (BIFFEX) contract is likely to have a beneficial impact on the market.

Hedging in the Freight Futures Market

Price risks are everywhere, and a profusion of derivative instruments have been created to hedge them. The BIFFEX Baltic Freight Index futures contract, based on an index of ocean shipping costs for a set of standard routes, is one of the more unusual. An important problem with such a futures contract based on a nonstorable service is that there is no arbitrage trade to enforce cost of carry pricing. This allows considerable basis risk in the contract. In this article, Kavussanos and Nomikos examine the hedging characteristics of the BIFFEX contract within a GARCH framework that takes account of cointegration between the spot and futures markets. They find that allowing for time variation in the hedge ratio does improve hedge performance, but basis risk remains very large compared with other futures markets. A recent change in the contract, to use a narrower index, appears to have reduced the problem somewhat, but not enough to produce much increase in trading activity so far.

Futures hedging when the structure of the underlying asset changes: The case of the BIFFEX contract

This article is concerned with the hedging effectiveness of futures contracts whose underlying asset is an index, when the structure of this index is changing. The case of the freight futures (BIFFEX) contract is examined here. Investigation of this issue is particularly interesting as the composition of its underlying asset, the Baltic Freight Index (BFI), has been revised on a number of occasions in order to improve the hedging performance of the market; previous empirical evidence on the market indicates substantially lower variance reduction (4–19%), compared to other markets (up to 98%). The BFI is a weighted average dry‐cargo freight rate index, compiled from actual freight rates on 11 shipping routes that are dissimilar in terms of vessel sizes and transported commodities. The hedging effectiveness of the market is investigated using both constant and time‐varying hedge ratios, estimated through bivariate error correction GARCH models. Our results indicate that the effectiveness of the BIFFEX contract as a centre for risk management has strengthened over the recent years as a result of the more homogeneous composition of the index. This by itself indicates that the latest restructuring of the index, in November 1999, which is aimed at increasing its homogeneity even further, is likely to have a beneficial impact on the market.

The price-volume relationship in the sale and purchase market for dry bulk vessels

This paper investigates, for the first time, the relationship between prices and trading activity in a market where real assets are traded, i.e. in the sale and purchase market for second-hand dry bulk vessels. Investigation of this issue is of interest since the level of trading activity may contain information about the sentiment and the future direction of the prices in the market. Several important conclusions emerge from this analysis. It is found that price changes are useful in predicting trading volume, which suggests that higher capital gains encourage more transactions in the market. Additionally, it seems that volume has a negative impact on the volatility of price changes. More specifically, in contrast to what is reported for financial markets, we find evidence that, in the market for ships, increases in trading activity lead to a reduction in market volatility. This can be explained by the unique underlying characteristics of the market for ships, including thin trading, which imply that increases in trading activity result in price transparency and stability. These findings indicate that practitioners in the market may use the information contained in the level of trading activity so as to guide their market decisions in the sale and purchase market.

Trading strategies in the market for tankers

This paper introduces a new approach in timing the sale and purchase of ships in the tanker market and examines the performance of this trading strategy over the period January 1976 to September 2004. Based on the long-run cointegration relationship between earnings and price, we establish a trading model which can be used as an indicator of investment or divestment timing decisions. We also perform statistical tests using the bootstrap approach in order to discount the possibility of data snooping biases and test the robustness of our trading models. Our results indicate that trading strategies based on earning-price ratios significantly out-perform buy and hold strategies in the tanker market.

Integration and Causality in International Freight Markets: Modeling with Error Correction and Directed Acyclic Graphs

Using directed acyclic graphs (DAGs) and error correction models, we study the dynamics of freight prices that comprise the Baltic Panamax Index (BPI), the index on which freight futures trading was based. The DAGs are used to make statements about the contemporaneous correlations between prices and allow us to address the construction of the data-determined orthogonalization on contemporaneous innovation covariance, which is crucial in providing inference in innovation accounting techniques. Our results provide a source of information on price discovery and suggest that the index is not appropriately composed and weighted, which may help explain the failure of the Baltic International Freight Futures Exchange (BIFFEX) contract.

Using Affine Jump Diffusion Models for Modelling and Pricing Electricity Derivatives

A seasonal affine jump diffusion spike model with regime switching in the long‐run equilibrium level is applied to model spot and forward prices in the Scandinavian power market. The spike part of the model incorporates different coefficients of mean reversion in the spike and normal variables and thus improves the spot–forward relationship, particularly at time periods when spikes occur. The regime switching part of the model contains two separate regimes to distinguish between periods of high and low water levels in the reservoirs, reflecting the availability of hydropower in the market. The performance of the models is compared with that of other models proposed in the literature in terms of fitting the observed term structure, as well as by generating simulated price paths that have the same statistical properties as the actual prices observed in the market. In particular, the model performs well in terms of capturing the spikes and explaining their fast mean reversion as well as in terms of reflecting the seasonal volatility observed in the market. These issues are very important for the pricing and hedging of derivative instruments.

Performance replication of the Spot Energy Index with optimal equity portfolio selection: Evidence from the UK, US and Brazilian markets

This paper reproduces the performance of a geometric average Spot Energy Index by investing only in a subset of stocks from the Dow Jones Composite Average, the FTSE 100 and Bovespa Composite indexes, and in two pools that include only energy-sector stocks from the US and the UK respectively. Daily data are used and the index-tracking problem for passive investment is addressed with two evolutionary algorithms – the differential evolution algorithm and the genetic algorithm. The performance of the suggested investment strategy is tested under three different scenarios: buy-and-hold, quarterly and monthly rebalancing, accounting for transaction costs where necessary.

The efficiency of the forward bunker market

The aim of this paper is to investigate the pricing efficiency of the forward bunker markets in different geographical locations and across different maturities. Following the recent growth in the use of bunker fuel derivatives for risk management in the shipping industry, it is interesting to investigate whether these instruments serve the needs of market participants. Forward bunker contracts are available for all the major ports of the world on an over-the-counter basis, although the most liquid contracts are for delivery in New York, US Gulf, Singapore and Rotterdam. In order to test the validity of the efficient market hypothesis in the formation of forward bunker prices, we employ a battery of statistical tests. The results from these tests over different maturities indicate conclusively that the forward bunker market is efficient and hence market participants receive accurate signals from forward bunker prices which they can use as a guidance in their activities in the physical market.

Affine‐Structure Models and the Pricing of Energy Commodity Derivatives

We consider a seasonal mean-reverting model for energy commodity prices with jumps and Heston-type stochastic volatility, and three nested models for comparison. By exploiting the affine form of the log-spot models, we develop a general valuation framework for futures and discrete arithmetic Asian options. We investigate five major petroleum commodities from Europe (Brent crude oil, gasoil) and US (light sweet crude oil, gasoline, heating oil) and analyse the effects of the competing fitted spot models in futures pricing, Asian options pricing and hedging. We find evidence that price jumps and stochastic volatility are important features of the petroleum price dynamics.