HOW MUCH SHOULD WE USE DERIVATIVES HEDGES?
A Study in Airline Industry
Fordham University, Deming Scholars MBA, firstname.lastname@example.org
For managers of airlines, it is not always easy to predict the jet fuel costs, which affect the profitability of the firm. As a solution, some airlines aggressively hedge against the variability, but some others don’t. Here, we are trying to find an answer to a question, “How much should they hedge?”
Variability in Earnings: Is it Bad?
In a management world, it is a common knowledge that variability harms the efficiency. For example, a combination of variability in lead-time of raw materials will make the firm harder to meet the manufacturing lead-time, and eventually harm the …show more content…
In Figure 1, jet fuel costs reflect adjustment of gain or loss from using derivatives for hedging purpose. Among the six airlines studied, Southwest was the only airline that maintained aggressive long-term fuel hedging plan. Figure 2 shows Southwest’s jet fuel costs to operation expenses ratio before and after adjustment of its fuel hedges.
Figure 2. Southwest Airline 's Jet Fuel Costs to Operation Expenses Before and After Hedge Gain
(EDGAR SEC Filngs, 2006)
Southwest’s gain from hedges is large enough to compare with its operation income. As shown in Table 1, from 2004 to 2006, it will not be an exaggeration to say the most (or even more) of its operating income came from hedge gain. How was it possible? Or, why other airlines that hedged part of their jet fuel costs could not result in similar results?
Table 1. Airline 's Operating Income [Hedge Gains] (USD, million) (EDGAR SEC Filngs, 2006) (* 2006 Q1, Q2, and Q3)
| |1999 |2000 |2001 |2002 |
|Southwest |70% @ $36/barrel |55% @ $37/barrel |35% @ $37/ barrel |30% @ $39/barrel |
|AirTran |25% @ $56/barrel |16% @ $59/barrel |0% |0% |
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