The application of modern portfolio theory to hedging in the dry bulk shipping markets
Risk and uncertainty have a vital impact on any business, but are particularly influential in the shipping industry. Although risk and uncertainty constitute the life-blood that courses through the veins of business, decision makers typically , attempt to reduce the risks , to which their decisions are subject. This is because there inevitably exists a level of risk which the decision maker is unwilling to accept. In May 1985 a new method of risk reduction in shipping became available through the introduction of BIFFEX - the Baltic International Freight Futures , Exchange. Participants in shipping can now hedge against their risks in the physical market by, taking a, position on the new futures market. This adds a new dimension to the situation as it existed before the introduction of BIFFEX, when the hedging of market risk was undertaken solely by holding alternative forms of physical contract. Typically, decision makers in shipping have formulated hedging strategies on the basis of ad hoc, inconsistent and subjectively judgemental criteria. This work is concerned with the optimization of the risk reduction process by integrating the different forms of market investment in a portfolio context. ,_ The methodology used is based on Modern Portfolio Theory (MPT). This provides a formal structure for the deduction of a subjectively optimal portfolio, in the sense that it yields the 'best' risk/return, trade-off in line with a decision maker's own attitude to risk. Previously, MPT has been applied solely to the determination of optimum portfolios of stocks and shares. The theory is, therefore, refined in accordance with the requirements of shipping. Similarly, the theory has previously only been applied to investors who are 'risk averse'. In this work, it is expanded to include those investors who are 'risk prone' or 'risk neutral'. The objective of the thesis is thus the successful implementation of MPT to allow the deduction of a subjectively optimal portfolio of shipping market investments.