Simulating physical basis risks in the Capesize freight market

The purpose of this paper is to evaluate the characteristics of the time-varying differential between the Baltic global trip-charter average and simulated earnings from a fleet of Capesize vessels. We interpret the standard deviation of this differential as a measure of physical basis risk in freight market hedging, resulting from differences in assumed trading patterns and the sequential fixing of vessels at different regional rates around the world. We simulate the average earnings of a fleet over time by sequentially assigning vessels to any of the four main trading routes (trans-Atlantic, trans-Pacific, fronthaul and backhaul) with a conditional probability based on known historical commodity flows. We show that increasing the fleet size lowers the basis risk but that this diversification effect is low beyond a relatively small fleet size of about 10 ships. Furthermore, we show that this physical basis risk never disappears, even for a very large fleet, due to a moving-average effect in earnings. Finally, we illustrate that physical basis risk is greater for short hedging durations. The results are important for shipowners and operators in the design of cost-efficient hedging programmes and for the Baltic Exchange and its stakeholders engaged in the continuous improvement of the quality of its spot rate indices.