Shipping is a business that is extremely in tune with prevailing market sentiment. Its success depends on a prospering economy, due to the increased global trade. It is also partially sheltered from temporary downturns because businesses will switch from more expensive air freight, and save costs by using shipping as their means of transporting their goods instead.
The industry is also an extremely competitive one, as there are only two main considerations why businesses will prefer one shipping company over another - the price and speed at which their goods are delivered to their destination. This has made it difficult for companies to differentiate themselves and demand a higher premium for their services.
As a highly volatile business, shippers are subjected to three main types of risk: freight price risk, fuel price risk and interest rate risk.
1) Freight price risk
Freight rates have historically been very volatile, and this has made it difficult to accurately predict the cash inflows of the company. This is due to the impact of unforeseen geo-political influences and the slow speed of adjusting supply to demand. Freight price risk is thus the risk of loss arising from unexpected changes in freight rates. As a result, shippers commonly buy and sell futures contracts called freight forward agreements based on the Baltic Dry Index of bulk rates to hedge against the risk that a rise or fall in the spot rate might cut into the profit they expect from the voyage.
2) Fuel price risk
Fuel prices take up a large amount of variable costs and companies try to hedge against any upward spikes. Although, it is possible to pass on these fuel surcharges to the customers, there is a limit to any increases in order for the firm to continue offering competitive pricing. Call options are often used as the solution and bought at a certain fuel strike price, to hedge against a rise in the future. If the actual price rises...