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Home > Resources > Articles

Valuing Freight Options with FINCAD XL

To view the FINCAD workbook that values freight derivatives, please download a free 7-day trial version.

» To download the latest trial version of FINCAD Analytics, contact a FINCAD Representative.

The Market

The freight derivatives market has been experiencing rapid growth. New players are entering the market due to high volatilities and increased liquidity resulting from clearing house participation and e-trading platforms. According to IMAREX, as of 2004, the total market for freight derivatives had a value exceeding $25 billion USD (1).

A freight derivative is a financial instrument that allows for the trading in future freight rates. In its simplest form, it allows the BUYER to lock in a shipping rate for a pre-specified forward period. A freight option is simply an option on forward shipping freight rates. The underlying daily index, know as the Baltic Index of Tanker Rates (BITR), is compiled from contributing brokers by the Baltic Exchange. The freight options traded are Asian style options which are cash settled.

How can FINCAD help?

In FINCAD XL v9.1, FINCAD introduced a workbook to value freight options using our Asian options functions. The workbook has been designed with numerous flexible features such as:

• Valuation using arithmetic or geometric averaging.
• European, Bermudan and American options are supported.
• Arithmetic averaging valuation using a either a closed form or Monte Carlo solution.
• Calculate an implied volatility given an option price
• Ability to enter in a forward curve. The forward curve should follow the same frequency as the sampling frequency inputted by the user.
• Detailed pricing grid for a range of simulated strikes. The user selects the strikes and model that will be used in the simulation.

The Freight Options Workbook

The outputs include fair value and various risk statistics including delta, gamma and theta. As can be seen from the list above, the workbook and related functions give the user flexibility and can be used in valuing many different types of structures.

The pricing methodology that is used involves Asian options. As noted above, FINCAD has functions that can value an Asian option using either arithmetic (closed form or Monte Carlo) or geometric averaging.

List of functions used for pricing:

aaAsian - Calculate fair value and delta for an European average price (asian) option. This function uses an analytical approximation using (Turnbull S. and Wakeman, L.M.). This approximation is fast and reliable and can be considered accurate for volatilities up to 30%. As the volatility increases, the approximation becomes less accurate and a Monte Carlo technique is preferred.

aaGeoAsian - Calculate fair value and risk statistics for a European-style geometric Asian option with periodic sampling dates.

aaAsian_am_MC: Calculate the fair value and risk statistics of an American or Bermudan style Asian option with periodic sampling dates. This pricing technique should be used if the volatility is high, which is usually the case in the freight options market where volatilities in excess of 100% are not uncommon.

Utility functions used:

aaSwap_crv3 - Allows the user to select either a flat risk free rate or a term structure of rates to be used in the valuation of the option.

aaInterp - Creates the daily forward curve using market days by interpolating on the data provider by the user.

References

(1) IMAREX, http://www.imarex.com/education/the_ffa_market

Disclaimer

Your use of the information in this article is at your own risk. The information in this article is provided on an "as is" basis and without any representation, obligation, or warranty from FINCAD of any kind, whether express or implied. We hope that such information will assist you, but it should not be used or relied upon as a substitute for your own independent research.

For more information or a customized demonstration of the software, contact a FINCAD Representative.