Hedging through time-charter contracts vs. hedging through FFAs: A real option approach

Abstract

The current study investigates the equivalence of hedging freight rate risk through time-charter with hedging through Forward Freight Agreements (FFAs), and explores whether any discrepancy between the two strategies can be attributed to the existence of a “flexibility option”. A Vector Error Correction Model (VECM) along with a GARCH-family model are employed. The study focuses on the dry bulk sector of the shipping market and in two routes, one in the Pacific and one in the Atlantic Ocean. The results indicate that: the two strategies share a common stochastic trend; there exists a constant term that equates the two strategies; this constant term, the value of flexibility, is time-varying and its sign and magnitude depend on the agreement between market participants on the freight rates’ future evolution.