The Theoretical Foundations of the Freight Market

In the traditional model of the freight market, which dates back to the 1930s, freight rates are determined in a perfectly competitive market, where the stock of fleet is predetermined at any point in time. This implies that freight rates adjust instantly to clear the demand-supply balance, where supply is fixed. Accordingly, freight rates respond exclusively to fluctuations in demand, rising when demand increases and falling when demand falls. This assumption introduces an element of irrationality on the part of both owners and charterers because the supply is constantly changing — new ships arrive in the market all the time. A cursory look at deliveries of new vessels shows that there are significant changes in supply from month to month. Hence, the assumption that supply is fixed in the short run is not appropriate. Instead, both charterers and owners form expectations of demand and supply and this requires a dynamic analysis rather then a static one in which the fleet is fixed. In this chapter we suggest an alternative theorising of the freight market, which captures this dynamic analysis of freight rates. This new framework consists of a bargaining process over freight rates in which charterers and owners form expectations of demand and supply over an investment horizon relevant to their decisions. In this framework, freight rates are viewed as asset prices, which are determined by discounting future economic fundamentals.