Making transportation options possible

Abstract

Transportation options provide the buyer the right, but not the obligation, to buy or sell transportation capacity at a future date. These options can provide shippers, carriers and logistics companies a significant opportunity to reduce risks and increase capacity flexibility. This paper summarizes some of these benefits, describes a number of issues to be resolved before trading transportation options can become a reality, and presents possible resolutions for these issues. INTRODUCTION In 2006, Tibben-Lembke and Rogers presented the concept of transportation options, a new tool for providing flexibility for supply chain managers. Despite the fact that transportation options are not currently traded, this proposed concept has already been discussed in the supply chain press (Lynch, 2007). Firms have begun looking to hedge their transportation risk, and since financial derivatives are utilized to ameliorate the risk of physical commodities, we believe applying them to transportation could provide managers an additional tool to manage costs. As described in detail below, transportation options would be quite similar in many ways to stock options and other financial derivatives. A primary function of financial derivatives is for one party to pay another participant to assume some risk. Transportation options would work similarly to stock options in this regard. For example, if a shipper bought an option to ship an item at a future date for a given price, they have eliminated the risk of needing to pay a higher price for that transportation at the time of the transaction. In exchange for the payment they receive, the option seller agrees to accept the risk of price increases, because the seller believes that the price will not rise to the extent that the purchaser of the option believes is likely. Given the sources of uncertainty companies face (access to capacity, fuel prices, driver shortages, etc., etc.), and the possibility for options to reduce these risks, we believe using options to hedge transportation costs could provide significant opportunities for parties at all stages of the supply chain: shippers, carriers, and 3PLs. Although we will refer to the provider of the transportation service as a “carrier,” we believe that transportation options could potentially be written for any transportation modes such as truck, ocean, air, rail, pipeline, or power line. Additionally, the transportation provider could be a non-asset-based third party such as an NVOCC. In fact, some forms of options have been traded on ocean shipping capacity since 1985 (Gray, 1987, Alizadeh and Nomikos, 2009), when the Baltic International Freight Futures Exchange (BIFFEX) futures contracts were created, trading on the 13 routes defined in the Baltic Freight Index (BFI). Multiple sizes of ships and types of cargoes are now included. The statistical relationships between the lanes and cargo types have been widely studied (Haigh et al..,2004, Nomikos and Alizadeh, 2002). These indices have allowed shippers and carriers to manage their risks and have found acceptance in the ocean shipping world. We believe that a method for hedging and managing other types of transportation risk could provide similar benefits. Below, we address many of the issues that must