Integration and Causality in International Freight Markets: Modeling with Error Correction and Directed Acyclic Graphs

Abstract

1. IntroductionIn January 1985, the Baltic Exchange developed the then known Baltic Freight Index (BFI), which, in May 1985, would become the underlying asset of the Baltic International Freight Futures Exchange (BIFFEX) contract, a contract designed to hedge uncertainty associated with volatile freight rates. On the basis of their exposure to the risk of adverse freight-rate fluctuations, ship owners and cargo owners (charterers) could buy or sell BIFFEX contracts to protect their freight-rate revenue or control their freight-rate cost, respectively. In addition to its once use for futures trading, the BFI is also considered to be the leading indicator of the condition in the dry-bulk shipping markets. On a daily basis, it provides accurate information about the level of freight rates across a variety of shipping routes worldwide. This information is extremely valuable for shipping market agents and is an invaluable tool in their decision-making process. This is so because in an industry such as shipping, where trades are being concluded across the globe, there is not a central reporting place to record and monitor the level of activity in the markets.The principal objective of this article is to assess the degree of interconnectivity between the major shipping routes that constitute the BFI, across different time horizons, reflecting the typical trading patterns in this market. To this end, we employ directed acyclic graphs (DAGs) (Spirtes, Glymour, and Scheines 1993), which enable us to assess this issue in a dynamic manner. Based on an error correction model (ECM) of freight rates, we also develop a framework for estimating forecast error decompositions by employing DAGs. From a practical standpoint, the information provided by innovation accounting techniques, coupled with DAG analysis, provides an intuitive method for assessing the information flows from the shipping markets and allows us to make an assessment on whether the underlying freight index, on which the futures contract is traded, is correctly composed.The current article, therefore, makes significant contributions to the literature from several angles. To date, research has not estimated the relationships in a truly dynamic manner and has, as such, failed to discuss the implications for derivatives and physical trading. In addition, the application of innovation accounting in this study is different from most other studies in the sense that we use the causal ordering of variables, as indicated by the estimated DAGs, for the orthogonalization of the contemporaneous innovation covariance; as suggested by Swanson and Granger (1997), this step is crucial in providing sound inference in innovation accounting techniques. Finally, investigation of this issue has important implications for the purposes of futures trading, as the BIFFEX contract was eventually delisted in April 2002. In this article, we identify whether the index is correctly composed and whether there are any obvious patterns or redundancies within the index that may have led to the demise of the futures contract. Indeed, our analysis provides a mechanism for deciding upon the correct index and has obvious, yet profound, implications for other research in the area of index construction.The rest of the article is as follows. Section 2 offers a brief discussion of freight indices. Section 3 outlines the methodologies employed in the article, including an introduction to DAGs, and section 4 describes the underlying properties of the data series. Section 5 presents the empirical results, and section 6 concludes.2. Freight Indices and Freight FuturesGiven uncertainty surrounding freight rates, the benefits of providing a futures market in freight rates has been recognized by market practitioners for a long time. However, the freight futures market was eventually established only in 1985. The reason is that the underlying asset of the market--the service of seaborne transportation--is not a physical commodity that can be delivered at the expiry of the futures contract. …