Physical basis risk in freight market hedging

Basis risk arises when the contract to be hedged and the hedging instrument are not perfectly correlated. The literature has considered primarily short-term hedging efficiency when comparing spot rates and forward freight rate agreement (FFA) prices. However, in practical hedging, long-term FFAs are usually held until maturity. In this case what matters for hedging efficiency is the basis risk resulting from physical differences in the technical specifications and trading patterns of the ships compared to the standard assumptions of the spot rate index. Basis risk also stems from the fact that ships are fixed at irregular time intervals and so its earnings do not mimic the continuous spot rate indices against which FFA contracts are settled. In this paper we evaluate the magnitude of such physical basis risk in the freight market by simulating the earnings of Capesize ships based on historical trading patterns and Baltic tripcharter rates. We find that increasing the number of ships in a fleet improves hedging efficiency through the diversification of geographical and fixture timings but that the marginal diversification effect is low beyond a relatively small fleet size (5-10 ships). These results are important for shipowners and operators in the design of cost-efficient hedging programmes.