A charterer is interested in transporting coal to continental Europe around the middle of July. In order to protect himself from adverse freight movements, which may occur by the day of the physical fixture the charterer decides to use FFA contracts. At the beginning of June he enters into a Q3 FFA contract which works as a strip of three monthly FFAs. Currently the trip charter contract for route BPI P4 trades at $11,800/day and the Q3 BPI P4 FFA at 12,200/day. At the end of June he fixes a contract in the physical market at a freight rate of $16,800 with duration of 90 days.

The charterer holds the FFA to expiration and settles at the end of each month. The settlement rates are: $15,200/day for July, $15,500/day for August, $16,200/day for September.

a) Explain what FFA position the charterer would use and why. Calculate the profit/loss from the FFA position for the charterer. [15 marks] b) Calculate the cost in the physical market for the charterer.

c) Calculate the hedged total cost for the charterer. Explain what has been achieved by the hedging.

d) Calculate the profit/loss of the hedged position.

e) Draw in the same graph the payoff profile from the FFA and the physical position (cost). Draw the combined payoff and comment. How would the profile change if the hedging were undertaken using options?

f) Calculate the hedging error as a percentage of the expected cost. Explain any discrepancy from the expected value. What would the profit/loss be in an ideal hedging case?

g) The standard deviation of the monthly changes in the spot freight rate is 0.08. The standard deviation of the monthly changes in the FFA rate is 0.06. The correlation between the futures price changes and the spot price changes is 0.98. Estimate the minimum variance hedge ratio and explain how the hedging strategy would change if the charterer takes it into account.

h) Calculate the total hedged cost in the above case.