Hedging in the Freight Futures Market

Abstract

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.

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