Transportation Research Part E 42 (2006) 211–224

www.elsevier.com/locate/tre

The non-linear dynamics of spot freight rates in tanker markets

Roar Adland a, Kevin Cullinane b,*

a
Clarkson Research Studies and Norwegian School of Economics and Business Administration,
12 Camomile Street, London EC3A 7BP, UK
b
School of Marine Science and Technology, University of Newcastle Upon Tyne, Armstrong Building,
Newcastle Upon Tyne NE1 7RU, UK

Received 5 May 2004; received in revised form 1 November 2004; accepted 7 December 2004

Abstract

The purpose of this paper is to investigate the dynamics of the freight rate in the oil transportation mar-
kets using a general non-parametric Markov diffusion model. The empirical results suggest that the dynam-
ics of the spot freight rate in the oil transportation market can best be described by a non-linear stochastic
model. We show that the spot freight rate is mean reverting only in the extremes of the empirical range and
that the volatility of the freight rate changes increases with the level of the freight rate. The former result,
which implies that the spot freight rate process behaves like a Martingale over most of its empirical range,
can explain why non-stationarity is difficult to reject over short samples, yet the spot freight rate process is
globally mean reverting as implied by maritime economic theory.
Ó 2005 Elsevier Ltd. All rights reserved.

Keywords: Tanker markets; Freight rates; Non-linear dynamics; Oil tranportation; Markov; Mean reversion

1. Introduction

The body of literature that devotes itself to the estimation of the spot freight rate process in
ocean shipping is modest at best. However, this issue is very important given the role of the spot

*
Corresponding author. Tel.: +44 191 222 6718; fax: +44 191 222 5491.
E-mail address: kevin.cullinane@newcastle.ac.uk (K. Cullinane).

1366-5545/$ - see front matter Ó 2005 Elsevier Ltd. All rights reserved.
doi:10.1016/j.tre.2004.12.001
212 R. Adland, K. Cullinane / Transportation Research Part E 42 (2006) 211–224

freight rate as the key economic variable for the pricing and hedging of freight rate contingent
claims such as ships, ship charters with embedded options, and forward freight options. However,
the dynamics of the spot freight rate is also of interest in the general economic literature, as it rep-
resents the spot price for a service in a global and perfectly competitive market. Given that this
transportation service cannot be traded (i.e. bought and sold in a secondary market) or stored
(i.e. held for investment or consumption), the dynamics may be very different from the price pro-
cesses of commodity and financial markets investigated previously. For instance, the presence of a
predictable component in the spot freight rate process would be consistent with an efficient market
as such information cannot be traded on the spot market. In effect, the drift of the underlying spot
freight rate process plays a role in assessing the value of freight rate contingent claims, as the usual
no-arbitrage restrictions imposed by Martingale pricing (see e.g. Duffie, 2001) does not apply.
Apart from Adland and Strandenes (2004) and Tvedt (1996, 2003) who model the spot freight
rate in a stochastic partial equilibrium framework, spot freight rate models in the recent literature
have been restricted to simple parametric models adopted from financial economics: the Geomet-
ric Brownian motion (Dixit and Pindyck, 1994), the Ornstein Uhlenbeck process of Vasicek (1977)
(see, for instance, Bjerksund and Ekern, 1995; Tvedt, 1997), and the lognormal process of Bren-
nan and Schwartz (1979) used in Tvedt (1997). These well-known models are convenient as they
usually facilitate closed-form solutions for the term structure of freight rates and certain freight
rate contingent claims. However, in the last few years, the general literature has shown a tendency
to turn to fully functional procedures to identify and estimate the functions that describe the solu-
tion to the stochastic differential equation (cf. Bandi and Phillips, 2003, and the references there-
in). The motivation for this focus is clear. By not imposing a specific parametric structure, fully
functional methods reduce the extent of potential misspecifications. Unfortunately, they do so at
the expense of slower convergence rates and inferior efficiency over their parametric counterparts.
Yet, the informational content of accurately implemented functional methods can be put to work
as a useful descriptive tool to understand more about the underlying dynamics from a general per-
spective and to investigate more effective procedures for parametric inference. In this paper we
extend the recent literature on non-parametric modeling of economic variables to the freight mar-
ket for the first time.
This paper contributes to the literature in at least two important ways. First, the fully func-
tional methodology enables us to investigate the spot freight rate dynamics in a generalized frame-
work, letting the data speak for themselves rather than imposing
arbitrary parametric
restrictions. This is important, as maritime economic theory does not yet offer complete support
for any specific parameterization of spot freight rate models a priori. Given the importance of the
spot freight rate in valuing and hedging a broad array of freight rate contingent claims, non-para-
metric models are particularly suitable to avoid potential misspecifications.
Second, the evidence on the stationarity of the spot freight process is quite ambiguous. Preli-
minary unit-root tests often fail to reject the null of non-stationarity (as in Berg-Andreassen,
1996; Glen and Rogers, 1997; Kavussanos and Alizadeh, 2002) or deliver results very close to
the rejection threshold. This observation explains why spot freight rate series are often modeled
as non-stationary processes in maritime economics (see, for instance, Kavussanos and Alizadeh,
2002). Adland et al. (2004) argue that the failure to reject non-stationarity is in part due to short-
comings of the empirical tests and suggest that such findings go against the basic theoretical con-
cept that prices in a competitive freight market must revert towards long-run costs (Zannetos,
 R. Adland, K. Cullinane / Transportation Research Part E 42 (2006) 211–224 213

1966). Our methodology and empirical results shed some light on this apparent inconsistency in
the maritime economic literature. The empirical findings in this paper suggest that the spot rate is
locally non-stationary over the range of the process corresponding to a drift very close to zero.
Nevertheless, the existence of a non-linear mean-reverting drift at the edges of the range of the
process is sufficient to pull the series back into its middle region and determine global stationarity.
Interestingly, this result is consistent with the empirical findings for short-term interest rates in the
recent non-parametric literature (see, for instance, Ait-Sahalia, 1996; Jiang, 1998; Stanton, 1997;
Bandi, 2002).
The remainder of the paper is organized as follows. Section 2 describes the non-parametric
modeling approach adopted here. In Section 3 we present the spot freight rate data. Section 4 dis-
cusses relevant concepts from maritime economic theory. Section 5 presents the empirical results,
while Section 6 concludes.

2. The model

We model the dynamic evolution of the spot freight rate process as a general Markov stochastic
differential equation:
dX t ¼ lðX t Þdt þ rðX t ÞdZ t ð1Þ
where Zt is a one-dimensional standard Brownian motion, and the drift function (or instanta-
neous conditional mean) l and diffusion function (or instantaneous conditional standard devia-
tion) r are known functions of the contemporaneous value of the spot freight rate Xt. Because
the Brownian increments are Gaussian, the distributions of the process (the marginal and transi-
tional densities) are entirely characterized by the drift and diffusion functions. By the Markov
property, the properties of long transitions can be derived by iterating the shorter transition.
See Bandi and Phillips (2003) and the references therein for the technical conditions on the drift
and diffusion functions that guarantee a unique and strong solution to Eq. (1).
The most general approach to estimating stochastic differential equations is to avoid any func-
tional form specification for the drift and the diffusion term. Accordingly, recent financial litera-
ture has turned to non-parametric estimation of (1). For instance, Ait-Sahalia (1996) estimates the
diffusion function for the spot freight rate non-parametrically, given a linear specification for the
drift. Stanton (1997) and Jiang and Knight (1997) develop a procedure for estimating both func-
tions non-parametrically from data observed only at discrete time intervals under the restriction
that a time-invariant marginal density distribution exists for the process of interest. Boudoukh
et al. (1998) and Knight et al. (1999) extend this procedure to two-factor models of the term struc-
ture of interest rates. Bandi and Phillips (2003) develop a fully functional method that exploits the
spatial properties of the local time diffusion process and can be applied to both stationary and
non-stationary recurrent processes. Bandi (2002) applies this procedure to the short-term Euro-
dollar interest rate. Bandi and Ngyuen (2003) extend this non-parametric framework to jump-
diffusion models.
Let fX Dj : j ¼ 1; 2; 3; . . . ; T g be a sample of size T from the continuous-time process Xt defined
by Eq. (1) and observed at the discrete interval D. Furthermore, let {ui} be a set of N points defin-
ing an equally spaced partition of a subset of the support of the marginal density. The partition
214 R. Adland, K. Cullinane / Transportation Research Part E 42 (2006) 211–224

points {ui} are chosen so as to capture at least the full range of the observed freight rates in the
empirical sample. As shown for example by Chapman and Pearson (2000), the non-parametric
Kernel estimator for the marginal density of the spot freight rate is then given by
!
1 X T
ui  X Dj
^ðui Þ ¼
p K ð2Þ
T
h j¼1 h

where K(Æ) is a suitable kernel function satisfying certain regularity conditions (see e.g. Jiang and
Knight, 1997, p. 17, footnote 5) and h is the window width or smoothing parameter. In this paper,
the Gaussian Kernel function is used:
 
1 1 2
KðzÞ ¼ pffiffiffiffiffiffiffiffiffi exp 
z ð3Þ
2
p 2
The non-parametric density estimator is completely defined by the pair (K, h), and the resulting
density can be thought of as a ‘‘smooth histogram’’. In effect, the Kernel estimate is a weighted
average of the variable of interest, where the weights are determined by the Kernel function. When
the Kernel function is Gaussian, a data point {Xj} will contribute less to the estimated value the
further away it is from the estimation point {ui}. The performance of the Kernel regression esti-
mator is sensitive to the choice of the bandwidth parameter, which is difficult to specify a priori in
the absence of a specific null hypothesis for the regression function. Larger bandwidths involve
more averaging of data observations far from ui and emphasize more global features of the data.
However, with the smoothing of observations that are relatively far from ui, local features of the
data are lost. Small bandwidths have the opposite effect.
The non-parametric estimator for the diffusion function is that of Florens-Zmirou (1993). This
estimator works for both stationary and non-stationary diffusion processes and under mild regu-
larity conditions listed in Banon (1978, conditions A1–A4). In addition, the diffusion function r
must be three times continuously differentiable with bounded derivatives (see, for instance, Flo-
rens-Zmirou, 1993). The diffusion function can then be estimated using the following consistent
non-parametric Kernel estimator from discretely observed data (see Jiang and Knight, 1997,
for proof of consistency):
PT X D u 

ðX Djþ1  X Dj Þ2
j i
j¼1 K h
2
^ ðui Þ ¼
r PT X D u  ð4Þ
j i
j¼1 K h

In general, without any restrictions on the underlying structure of the diffusion process, direct esti-
mation of the drift function is impossible from discretely observed data. In particular, as noted by
Ait-Sahalia (1996), a pair of functions (l, r2) cannot be distinguished from (c Æ l, c Æ r2) for any
constant c with discretely sampled data. However, under the assumption of stationarity, Banon
(1978) integrates the Kolmogorov forward equation to obtain (see, for instance Stanton, 1997)
1 d 2
lðxÞ ¼ ½r ðxÞpðxÞ ð5Þ
2pðxÞ dx
This allows us to estimate the drift non-parametrically, given a non-parametric estimate of the
stationary density p, but only if the diffusion function r is known. Jiang (1998) notes that since,
 R. Adland, K. Cullinane / Transportation Research Part E 42 (2006) 211–224 215

in Eq. (1), the diffusion term has a lower order than the drift term for infinitesimal changes in time
(dZ versus dt), the local time dynamics of the sampling path reflect more of the properties of the
diffusion function than those of the drift term. This suggests the possibility of identifying the dif-
fusion function first, and then deriving the non-parametric drift estimate that is consistent with
the non-parametric estimate of the stationary density, in accordance with Eq. (5). This procedure
is adopted in the subsequent estimations.
The bootstrap approach (Efron, 1979) is used to generate an empirical estimate of the sampling
distribution of the non-parametric functions at each estimation point ui and the corresponding
confidence intervals. This procedure allows us to make inferences about the estimated functional
forms without making the strong a priori distributional assumptions in the parametric literature.
To account for autocorrelation in the data we apply the block-wise bootstrap procedure suggested
by Künsch (1989) to preserve this feature in the bootstrapped data samples. The theoretical and
technical arguments justifying the bootstrap approach are well documented in, for instance, Efron
(1987).

3. The data

The spot freight rate used here is defined as the arithmetic average of timecharter-equivalent
(TCE) spot freight rates for selected round voyages1 for a hypothetical generic vessel. Details on
the calculation of the TCE spot freight rate and assumptions concerning loading and discharge
ports, port days, fuel consumption, cargo size, and vessel speed can be found in Clarksons Re-
search (2004a). We choose to model the TCE spot freight rate ($/day) rather than the spot freight
rate (Worldscale or $/tonne) itself. Firstly, the former measure is used for the valuation of contin-
gent claims such as vessels (see, for instance, Tvedt, 1997) and period timecharters with embedded
options (e.g. profit sharing agreements). Secondly, as the TCE spot freight rate is directly compa-
rable to timecharters, the empirical results developed here can be used to model the term structure
of freight rates. Thirdly, while the available over-the-counter (OTC) freight derivatives in the tan-
ker markets are settled against the Worldscale rate, we avoid the difficulties associated with the
annual change in the Worldscale schedule.
Clarksons Research (2004b) kindly provided time series of weekly2 TCE spot freight rate for
the period from January 5, 1990, through October 1, 2004, for the VLCC, Suezmax, and Aframax
sectors, corresponding to T = 770 observations. As an example, Fig. 1 plots the time series of the
TCE freight rate in the VLCC market.
Descriptive statistics for the time series in levels and first differences are reported in Table 1 (q(j)
denotes the weekly autocorrelation at lag j). Of note in Table 1 is the rejection of the normal dis-
tribution both for the levels and the first differences, as reflected in a very high Jarque-Bera sta-
tistic (Bera and Jarque, 1981). This is to be expected, as the spot freight rate is bounded from
below and so both distributions will be truncated. Both distributions are positively skewed and
fat-tailed.

1
Most large tankers will effectively be employed in shuttle traffic out of a few major loading areas (e.g. West Africa,
Arabian Gulf) Hence, the round voyage assumption will not result in a large error.
2
The time series is based on brokers estimates valid as of Friday morning.
216 R. Adland, K. Cullinane / Transportation Research Part E 42 (2006) 211–224

$/day
120,000

100,000

80,000

60,000

40,000

20,000

0
Jan-90

Jan-91

Jan-92

Jan-93

Jan-94

Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04
Source: Clarkson Research Studies

Fig. 1. VLCC spot freight rates.

Table 1
Descriptive statistics for tanker spot rates
Level 1st differences
VLCC Suezmax Aframax VLCC Suezmax Aframax
Mean 31,306 23,033 20,447 85.1 66.7 46.9
Maximum 99,479 92,089 64,129 39,277 20,033 23,505
Minimum 9213 6236 6943 23,136 18,781 21,409
Std. deviation 17,643 13,101 10,334 4895 3526 2489
Skewness 1.42 1.93 1.79 0.72 0.58 0.21
Kurtosis 4.60 7.23 6.34 13.54 11.22 22.61
Jarque-Bera 338.9 1051.1 769.6 3625.5 2206.8 12329.0
q(1) 0.952 0.954 0.961 0.206 0.262 0.269
q(2) 0.892 0.896 0.918 0.147 0.109 0.000
q(3) 0.849 0.851 0.879 0.015 0.105 0.142
q(4) 0.812 0.814 0.850 0.087 0.058 0.054
q(13) 0.583 0.628 0.634 0.003 0.130 0.106
q(52) 0.030 0.142 0.202 0.007 0.000 0.054

Given that the estimators for the drift function outlined in the previous section are based on the
assumption of stationarity, we must next establish that the time series at hand adhere to this
assumption. We perform the conventional Augmented Dickey Fuller (ADF) test with both a con-
stant term and a constant and a trend (see Dickey and Fuller, 1981). The lag length is chosen
based on a minimization of the Schwartz information criterion. In the literature, even slight rejec-
tions (but this is not the case here) are interpreted as strong evidence in favor of stationarity due to
the low power of the ADF test (for example, Ait-Sahalia, 1996; Jiang and Knight, 1997). There-
fore we also report the results of the unit root tests developed by Kwiatkowski et al. (KPSS, 1992)
and Phillips and Perron (PP, 1988) in Table 2.
Overall, the results in Table 2 support the stationarity of tanker spot freight rates. In particular,
the time series is trend-stationary at the 1% or 5% level of significance in all three tanker sectors
 R. Adland, K. Cullinane / Transportation Research Part E 42 (2006) 211–224 217

Table 2
Unit root tests
ADF (lags) KPSS Phillips-Perron
Constant Cons. + trend Constant Cons. + trend Constant Cons. + trend
VLCC 2.861 (4) 3.571 (4) 0.964 0.166 2.817 3.650
Suezmax 3.297 (2) 4.606 (2) 1.503 0.134 2.542 3.976
Aframax 2.537 (3) 4.886 (1) 1.529 0.165 2.866 4.278
Critical values
1% 3.439 3.970 0.739 0.216 3.439 3.970
5% 2.865 3.416 0.463 0.146 2.865 3.416
10% 2.569 3.130 0.347 0.119 2.569 3.130

according to the ADF and PP tests. With an intercept only, the KPSS test maintains the null
hypothesis of stationarity at the 1% level in all three cases. The finding of stationarity in the spot
freight markets for tankers is consistent with the empirical results in Adland et al. (2004).

4. Theoretical constraints

There is little support in maritime economic theory (see, for instance, Zannetos, 1966; Stopford,
1997) for any particular functional form of the drift function in Eq. (1). What we can say is that
the potential for supply adjustment (newbuilding and demolition) in a perfectly competitive mar-
ket guarantees that extremely high or extremely low freight rates are not sustainable in the long-
run, and so the spot freight rate cannot exhibit the asymptotically explosive behavior implied by a
non-stationary process. As pointed out by Zannetos (1966) and Strandenes (1984), freight rates
should tend to revert towards some long-run equilibrium related to the cost of providing the
transportation service. However, as discussed in Adland et al. (2004), for instance, the long pro-
duction time for new ships means that supply can adjust to unexpected, possibly permanent,
changes in demand only very slowly. Moreover, due to the high volatility of spot freight rates,
it is difficult to detect such slow-speed mean reversion in high-frequency data (see Dixit and Pin-
dyck, 1994, for a general discussion on mean reversion in price data).
We are on firmer ground when arguing for the theoretical shape of the diffusion function
(or conditional standard deviation of spot freight rate changes). This is due to the characteristic
hockey-stick shape of the short-run supply function in bulk shipping, as proposed first by Koop-
mans (1939) and later illustrated empirically by Zannetos (1966); Devanney (1973) and Norman
and Wergeland (1981). The presence of the lay-up option and the absolute limit to transport
capacity in the short run leads to a supply function that is near-perfectly elastic for very low
freight rates and, in theory, perfectly inelastic once the fleet operates at full capacity. Adding
to this that the demand for ocean transportation of oil is very inelastic with respect to the freight
rate (Zannetos, 1966), and it is clear that the volatility of the spot freight rate changes must be an
increasing function of the spot freight rate level. It also seems fair to conjecture that this function
is non-linear, increasing at a greater rate once the ‘‘kink’’ in the supply function is reached at a
freight rate near the operating cost of the least efficient vessels in the fleet, although this thesis
218 R. Adland, K. Cullinane / Transportation Research Part E 42 (2006) 211–224

Fig. 2. Short-run supply and demand functions in bulk shipping.

would hinge on a constant volatility of demand changes. Fig. 2 illustrates the stylised theoretical
supply and demand functions in bulk shipping.
Fig. 2 illustrates a demand function that gradually becomes more elastic as the freight rate in-
creases to extreme levels. This is proposed by Tvedt (1996) and is consistent with the thesis that high
freight rates leads to greater logistical efficiency (Koopmans, 1939), such as increasing use of raw
material from nearby sources (Strandenes and Wergeland, 1982). Where the freight rate is a sub-
stantial part of the CIF price (although this is not the case for crude oil), very high freight rates
may ultimately cause substitution of the commodity or transportation mode. It is worth noting that
an increasingly elastic demand function at extremely high freight rates (at levels that may not be
reached in practice) would imply a decreasing volatility of the freight rate changes at such levels.

5. Empirical results

Figs. 3–8 show the estimated functional forms of the drift and diffusion functions in the three
tanker sectors under investigation, along with their 95% confidence intervals.3 While this is pri-
marily a descriptive exercise, we also consider the specific null hypotheses that (1) the spot freight
rate process is a Martingale (i.e. the drift is statistically insignificant across the observed range of
freight rates) and (2) the conditional standard deviation is constant. Inspection of the graphs re-
veals that both null hypotheses are rejected in all the tanker market sectors under investigation.
All the drift functions appear non-linear, with the speed of mean reversion increasing in the
freight rate level, similar to the lognormal process (Brennan and Schwartz, 1979) applied to the
VLCC market in Tvedt (1997). However, while there is statistically significant mean reversion
at the extremes of the sample range (for instance, below $26,000/day and above $67,000/day

3
We follow Jiang (1998) and estimate the confidence intervals using the asymptotic approximation and the Künsch,
1989 block-wise bootstrap for the diffusion and drift functions, respectively. The bootstrap procedure uses block
length = 52 weeks and 5,000 iterations.
 R. Adland, K. Cullinane / Transportation Research Part E 42 (2006) 211–224 219

Weekly drift ($/day)

1,000
0
-1,000
-2,000
-3,000
-4,000
-5,000
-6,000
9,000 24,000 39,000 54,000 69,000 84,000 99,000
TCE spot freight rate ($/day)

Fig. 3. VLCC drift function.

Cond, std, dev, ($/day)

14,000

12,000

10,000

8,000

6,000

4,000

2,000

0
9,000 24,000 39,000 54,000 69,000 84,000 99,000
TCE spot freight rate ($/day)

Fig. 4. VLCC diffusion function.

for the freight rate process in the VLCC sector), it is not possible to reject Martingale behavior
over most of the range of the spot freight rate. Interestingly, this is consistent with the findings
in the non-parametric literature on the short-term interest rate (see, for instance, Stanton,
1997; Jiang, 1998). This non-linear behavior can explain why non-stationarity can be difficult
to reject over short samples, yet the spot freight rate process is globally mean reverting as sug-
gested by our interpretation of maritime economic theory. We also note that a linear drift spec-
ification does not fit within the non-parametric confidence intervals in the Aframax and Suezmax
sectors, while we cannot reject a linear specification in the VLCC market.
Turning to the estimated diffusion function, the results in all three tanker sectors conform to
our a priori expectation of increasing conditional standard deviation in the spot freight rate level.
In all cases, the constant volatility specification, such as the Ornstein-Uhlenbeck process (Vasicek,
1977) used by Tvedt (1997) and Bjerksund and Ekern (1995), is rejected. While the estimated
220 R. Adland, K. Cullinane / Transportation Research Part E 42 (2006) 211–224

Weekly drift ($/day)

1,000

-1,000

-2,000

-3,000

-4,000

-5,000
6,000 21,000 36,000 51,000 66,000 81,000
TCE spot freight rate ($/day)

Fig. 5. Suezmax drift function.

Cond, std, dev, ($/day)

16,000

14,000

12,000

10,000

8,000

6,000

4,000

2,000

0
6,000 21,000 36,000 51,000 66,000 81,000
TCE spot freight rate ($/day)

Fig. 6. Suezmax diffusion function.

functional forms appear non-linear, it is not possible to reject a constant elasticity of volatility
(CEV) linear parametric specification due to the wide confidence interval at high spot freight rate
levels.
It is worth noting that while the diffusion functions are monotonically increasing in all three
sectors, the VLCC and Aframax diffusion functions exhibit decreasing elasticity of volatility with
respect to the spot freight rate level for very high freight rates. Given that the short-term supply of
transportation will be highly inelastic under such market conditions (the reason why rates are
multiples of the cost of providing the service in the first place), this can be interpreted as weak
 R. Adland, K. Cullinane / Transportation Research Part E 42 (2006) 211–224 221

Weekly drift ($/day)

1,000

-1,000

-2,000

-3,000

-4,000
6,000 16,000 26,000 36,000 46,000 56,000
TCE spot freight rate ($/day)

Fig. 7. Aframax drift function.

Cond, std, dev, ($/day)

10,000

8,000

6,000

4,000

2,000

0
6,000 16,000 26,000 36,000 46,000 56,000
TCE spot freight rate ($/day)

Fig. 8. Aframax diffusion function.

evidence for increasing elasticity of demand with respect to the freight rate, as illustrated in Fig. 2.
However, these non-linearities come into play in a region where the available data is fairly thin, as
demonstrated by the large non-parametric, and so the high degree of uncertainty in this region
suggests caution in interpreting our results.
It is also worth pointing out that non-parametric Kernel regression estimators are subject to at
least two sources of bias in finite samples (see, for instance, Chapman and Pearson, 2000, for a
detailed discussion). The first is the boundary bias associated with the weighting that occurs
through the choice of kernel function and bandwidth parameter. If the estimation point is close
to the boundary of the support the weights are skewed towards the centre of the distribution. This
222 R. Adland, K. Cullinane / Transportation Research Part E 42 (2006) 211–224

implies, for instance, a downward bias in the drift for values close to the lower boundary of the
data, and an upward bias close to the upper boundary. A second source of finite sample bias in the
Kernel regression estimator is from a truncation of the data in finite samples, which implies that
the innovations of X will tend to be skewed in the extreme tails of the range. Because the Kernel
regression estimator uses local information to estimate the expected innovation, the residuals will
tend to be skewed in the same direction. The correlation between the regressor and the residuals
introduces a bias in the estimate. Chapman and Pearson (2000) argue that this truncation bias
may result in spurious non-linearity in the drift.

6. Conclusions

Using fully functional techniques in a generalized stochastic differential equation framework,

this paper provides empirical evidence that the spot rate is locally non-stationary over the range
of the process corresponding to a drift very close to zero. Nevertheless, the existence of a non-lin-
ear mean-reverting drift at the edges of the range of the process is sufficient to pull the series back
into its middle region and determine global stationarity. We emphasize the importance of the
Martingale behavior of the spot-rate series over most of its range in disputing linear mean revert-
ing models and in explaining the difficulty in rejecting non-stationarity in short samples. We also
find a statistically significant level effect in the conditional volatility of spot freight rate changes,
suggesting that the diffusion functions of some parametric models are misspecified. As for the
marked non-linearity of the drift (and in some cases the diffusion function) at the upper edge
of the sample process, its empirical relevance is clouded by the availability of few observations
in this range. Since the sample process barely visits freight rate levels at the upper edge of its
range, we cannot draw firm conclusions about the behavior of the drift and diffusion functions
at high freight rate levels, where non-linearities arise.
Complications arise when investigating the plausibility of a non-linear mean-reverting drift at
high spot freight rate levels. This is in part due to the likely presence of estimation bias near the
edge of the range of the sample process. However, from a practical point of view, there is also little
reason to believe that the speed of mean reversion should increase.4 Moreover, even for a station-
ary process, the drift function is not constrained to display a specific shape at high rates provided
the instantaneous variance is sufficient to balance the drift dynamics and determine reversion to
the center of the stationary distribution of the process. This point is made in Conley et al. (1997),
who show that stationarity can be volatility induced. They show that what matters for mean-
reversion is a pull measure defined as the ratio between the drift and two times the diffusion func-
tion. The infinitesimal first moment can even be positive at high rates, but increasing volatility can
be sufficient to import stationarity into the series.
This poses an interesting question, albeit one that is difficult to answer in empirical work due to
the scarcity of observations at high freight rate levels: Can the stationarity of tanker spot freight
rates also be volatility induced? Our empirical results seem to support the competing hypothesis of

4
It is well known that the scrapping of vessels will cease at extremely high freight rates. However, the rate of delivery
of new vessels into the fleet is set in the short run. Hence, the pull towards the long run mean induced by expanding
supply cannot increase with the freight rate level.
 R. Adland, K. Cullinane / Transportation Research Part E 42 (2006) 211–224 223

drift-induced mean reversion, and we believe there is a strong theoretical motivation for this.
However, the dynamics of the spot freight rate at the extreme upper range deserves further
attention.

References

Adland, R., Strandenes, S.P., 2004. A discrete-time stochastic partial equilibrium model of the spot freight market. In:
Proceedings for the Annual International Association of Maritime Economists (IAME) Conference, Izmir, Turkey,
June 30–July 2, 2004.
Adland, R., Koekebakker, S., Sodal, S., 2004. Non-stationarity of freight rates revisited. In: Proceedings for the Annual
International Association of Maritime Economists (IAME) Conference, Izmir, Turkey, June 30–July 2, 2004.
Ait-Sahalia, Y., 1996. Nonparametric pricing of interest rate derivative securities. Econometrica 64, 527–560.
Bandi, F.M., 2002. Short-term interest rate dynamics: a spatial approach. Journal of Financial Economics 65, 73–110.
Bandi, F.M., Ngyuen, T., 2003. On the functional estimation of jump-diffusion models. Journal of Econometrics 116,
293–328.
Bandi, F.M., Phillips, P.C.B., 2003. Fully nonparametric estimation of scalar diffusion models. Econometrica 71, 241–
283.
Banon, G., 1978. Nonparametric identification for diffusion processes. SIAM Journal of Control and Optimization 16,
380–395.
Bera, A.K., Jarque, C.M., 1981. Efficient tests for normality, heteroscedasticity and serial independence of regression
residuals: Monte Carlo evidence. Economic Letters 7, 313–318.
Berg-Andreassen, J.A., 1996. Some properties of international maritime statistics. Maritime Policy and Management 23
(4), 381–395.
Bjerksund, P., Ekern, S., 1995. Contingent claims evaluation for mean-reverting cash flows in shipping. In: Trigeorgis,
L. (Ed.), Real Options in Capital Investments, Models, Strategies, and Applications. Praeger, Westport, CT.
Boudoukh, J., Stanton, R., Richardson, M., Whitelaw, R., 1998. The stochastic behaviour of interest rates: implications
from a multifactor, nonlinear continuous-time model. Stern School of Business, NY, Working Paper.
Brennan, M.J., Schwartz, E.S., 1979. A continuous time approach to the pricing of bonds. Journal of Banking and
Finance 3, 133–155.
Chapman, D., Pearson, N., 2000. Is the short rate drift actually non-linear. Journal of Finance 55 (1), 355–388.
Clarksons Research, 2004a. Sources and Methods. Shipping Intelligence Network. Available from:
<www.clarksons.net>.
Clarksons Research, 2004b. Shipping Intelligence Network. Available from: <www.clarksons.net>.
Conley, T., Hansen, L.P., Luttmer, E., Scheinkman, J., 1997. Short-term interest rates as subordinated diffusions.
Review of Financial Studies 10 (3), 525–578.
Devanney, J.W., 1973. A model of the tanker charter market and a related dynamic program. In: Lorange, Norman
(Eds.), Shipping Management, Bergen.
Dickey, D., Fuller, W., 1981. Likelihood ratio statistics for autoregressive time series with a unit root. Econometrica 49,
1057–1072.
Dixit, A., Pindyck, R.S., 1994. Investment Under Uncertainty. Princeton University Press, NJ.
Duffie, D., 2001. Dynamic Asset Pricing Theory, 3rd Ed. Princeton University Press, NJ.
Efron, B., 1979. Bootstrap methods: another look at the Jackknife. Annals of Statistics 7, 1–26.
Efron, B., 1987. Better bootstrap intervals (with discussion). Journal of the American Statistical Association 82, 171–
200.
Florens-Zmirou, D., 1993. On estimating the diffusion coefficient from discrete observations. Journal of Applied
Probability 30, 790–804.
Glen, D., Rogers, P., 1997. Does weight matter? A statistical analysis of the SSY capesize index. Maritime Policy and
Management 24 (4), 351–364.
Jiang, G., 1998. Nonparametric modeling of US interest rate term structure dynamics and implications on the prices of
derivative securities. Journal of Financial and Quantitative Analysis 33 (4), 465–497.
224 R. Adland, K. Cullinane / Transportation Research Part E 42 (2006) 211–224

Jiang, G.J., Knight, J.L., 1997. A nonparametric approach to the estimation of diffusion processes—With an
application to a short-term interest rate model. Econometric Theory 13, 615–645.
Kavussanos, M.G., Alizadeh, A., 2002. The expectations hypothesis of the term structure and risk premia in dry bulk
shipping freight markets: An EGARCH-M approach. Journal of Transport Economics and Policy 36 (2), 267–304.
Knight, J., Li, F., Yuan, M., 1999. Pricing interest rate derivatives in a non-parametric two-factor term-structure
model. Bank of Canada, Working Paper.
Koopmans, T., 1939. Tanker Freight Rates and Tankship Building. De Erven F. Bohn, Haarlem, Netherlands.
Künsch, H., 1989. The Jackknife and the bootstrap for general stationary observations. Annals of Statistics 17 (3),
1217–1241.
Kwiatkowski, D.P., Phillips, C.B., Schmidt, P., Shin, Y., 1992. Testing the null hypothesis of stationarity against the
alternative of a unit root: How sure are we that economic time series have a unit root? Journal of Econometrics 54,
159–178.
Norman, V.D., Wergeland, T., 1981. Nortank—a simulation model of the freight markets for large tankers. Center for
Applied Research, Norwegian School of Business Administration, Report 4/81.
Phillips, P.C.B., Perron, P., 1988. Testing for a unit root in time series regressions. Biometrica 75, 335–346.
Stanton, R., 1997. A nonparametric model of term structure dynamics and the market price of interest rate risk. Journal
of Finance 52, 1973–2002.
Stopford, M., 1997. Maritime Economics, second ed. Routledge Publications, London and New York.
Strandenes, S.P., 1984. Price determination in the time charter and second hand markets. Center for Applied Research,
Norwegian School of Economics and Business Administration, Working Paper MU 06.
Strandenes, S.P., Wergeland, T., 1982. Freight markets and bulk demand efficiency. Center for Applied Research,
Norwegian School of Economics and Business Administration, Bergen, Report 3/1982.
Tvedt, J., 1996. Market structures, freight rates and assets in bulk shipping. Ph.D. thesis, Norwegian School of
Economics and Business Administration, Bergen.
Tvedt, J., 1997. Valuation of VLCCs under income uncertainty. Maritime Policy and Management 24 (2), 159–174.
Tvedt, J., 2003. Shipping market models and the specification of freight rate processes. Maritime Economics and
Logistics 5 (4), 327–346.
Vasicek, O., 1977. An equilibrium characterization of the term structure. Journal of Financial Economics 5, 177–188.
Zannetos, Z.S., 1966. The Theory of Oil Tankship Rates. MIT Press, Cambridge, MA.