A derivative product is a financial tool to define an agreement between two parties to exchange on a future date. Derivatives are mainly used by the investors for the Speculation, hedging, arbitrage etc. Airlines use Jet fuel, crude and gas derivatives for the purpose of hedging. Hedging is a method used to avoid the risk of unexpected changes in the price. To protect the risk of instability in prices of fuel, airlines lock the future fuel price. Airlines use hedging to control the price of fuel which in turn controls the cost, cash flows and profits of the airline. With the control of cost the value of airline's stock also increases.
Airlines do not use derivatives for speculation purpose but to reduce the swings in profits. "The goal of a hedge transaction is to create a position that once added in investor's portfolio, will offset the price risk of another, more fundamental holding (Reilly and Brown, 2003)" Hedging protects airlines from the fluctuations of fuel price. Airlines enter into a hedging contract for six months mostly. In few cases it enters into contracts up to one year.Fuel hedging has become very common in airlines these days. Around 20 years ago, it was used only by selected airlines.
In the Annual shareholder meeting of Southwest Airlines on May 19, 2010 it was discussed that the biggest risk the airlines has to its long term and short term plans is the rise of jet fuel prices. The airline is expecting to cover this risk with the hedging of the jet fuel.
Types of Hedging:
Long term Hedging: Airline industry uses this type of hedging to avoid price fluctuations of fuel. They have to buy fuel to fulfill the contract.
Short Term Hedging: In this hedging sale of something is required. For example sale of foreign currency may be required to pay for another contract.
Over The Counter derivatives (OTC):
These are more customizable and are traded directly between airline and investment banks. The trading of these derivatives is off exchange. To diversify the risk involved most of the airline prefer to trade with two or more banks. Due to the counter party risk involved for both the parties some airlines shirk to take risk due to limited finances. These are illiquid and expensive derivatives. OTC derivatives are also not available in sufficient quantities. Due to these reasons these are not suitable for hedging by airlines. Future contracts for commodities are more suitable for the airlines as these are related with jet fuel like crude oil and heating oil.
Exchange Traded Futures:
The common exchange derivatives are futures and options. Crude or heating oil futures contracts are based on an underlying commodity. These future contracts are not perfectly correlated and thus introduce basis risk where basis is calculated by deducting future price of selected contract from the spot price of the hedged item.
BASIS = SPOT PRICE - FUTURE PRICE
The Exchange Traded Futures are regulated and standardized contracts. There is a transparency of price.
Exchange traded Futures include Interest Rate Derivatives, Foreign Exchange derivatives and Equity Exchange Derivatives and Commodity Derivatives. Interest Rate Derivative has an interest bearing instrument as an asset underlying it. This type of derivative is used to manage the risk of interest rate instability. Foreign Exchange (FX) derivative includes FX Future contracts, which involves purchasing one currency for another at a fixed price and specific time period. Equity Derivatives include futures and options either on individual stocks or on equity indices. Commodity Derivatives includes some commodity as an underlying asset. The commodity can include wheat, oil etc.
Example of a Hedge Transaction:
If an airline buys a future contract for oil at $ 20. Till the time of maturity of the contract the oil price goes up to $50 per barrel. Then the future contract will allow the airline to purchase it at $20 per barrel instead of $ 50 per barrel.
Why should Airlines Hedge:
According to classical investment theory, Oil can be hedged by portfolio investors to balance the risk of other investments. It considers the basic reason to avoid fluctuations in profit to be unjustified.
According to the Economic fundamentals, the inevitable reason for doing fuel hedging is the Zero Expected Value. Airlines can earn profits from hedging only in Long term hedging. The basic reason behind hedging in case airlines is to stabilize the profits and not to earn profits.
The main derivatives:
The increase in fuel price could lead to low profit margins. Airlines can earn more profits in such cases by increasing the efficiency of the fuel, increasing the fare of travelling or by using derivative products. Efficiency of fuel can be increased by using more efficient aircrafts. To replace the existing aircrafts needs more time and money. Airlines can pass the cost to customers by increasing the fare. This will affect the demand of the tickets. Therefore airlines use derivatives. The main derivatives used by airline industry are:
Future Contract
Forward Contract
Options
Collars
Swaps
Future Contract: These are binding contracts for exchange of fuel on a stated future date and time. The place and time of delivery, quantity and quality of fuel are standardized. The agreed price is known as 'Strike Price'. Instead of actual delivery these contracts are traded out using counter contracts. Future contracts are used for hedging and trading purposes. Future Contracts have guarantee of the clearing houses which are normally commercial banks.
Forward Contract: This is contract between two parties. In the agreement one party purchases fixed amount of fuel from the other party. This exchange takes place at a fixed price and fixed date. BP Air uses this type of contract to lock the fuel prices. In this case the counter party risk lies with the purchaser of the contract. This exchange is Over the Counter derivatives used for fuel hedging.
Both Forward and Future contracts helps to buy fuel at a specific time at a given price. But even then these contracts differ in many ways.
DIFFERENCE BETWEEN FUTURE CONTRACT AND FORWARD CONTRACT
BASIS
FUTURE CONTRACT
NATURE OF CONTRACT
STANDARDISED
FLEXIBILTY
FIXED
GUARANTEE
GUARANTEE OF CLEARING HOUSE
DETAILS CONCERNING SETTLEMENT AND DELIVERY
OCCURS DAILY, UNTILL THE END OF THE CONTRACT
SETTLEMENT DATE
OVER RANGE OF DATES
PURPOSE
SPECULATION
CLOSURE
BEFORE MATURITY
OPTIONS: It is a financial instrument that provides the airlines a right, but not an obligation to buy fuel at a pre determined price on or before a fixed date at a comparatively low cost. Options are more flexible than future contracts. Options are the most important and commonly used derivatives by the airlines. These can also be used with investment banks. There are two types of Options available:
CALL OPTION: Call option provides airlines the right to buy fuel at a fixed price within a specific time period. Cost of the call option is known as a premium.
PUT OPTION: Put option provides airlines the right to sell at a fixed price on or before a specific date. It does not leave any obligation but provides the right.
Zero Cost Option: As the name defines, in this kind of option, airlines do not have to pay the cost if the contract stays within the specific price range. For this the airlines have to buy a call option at a certain premium and sell the put option at the same premium value. If the price stays within the range of their call and put option, their cost of option becomes zero.
COLLAR: A combination of Call and Put option is known as Collar Contract. The Call option provides a protection cover against the price rise above the 'Strike Price' and the put option limits the price reduction below the 'Strike Price'. For this combination airlines pay extra option premium which is the difference between the call option premium and put option premium. I t is very popular and commonly used in airlines due to the least amount of risk involved. Buying 100 percent collars can also cause losses for the airlines. As in the first quarter of 2010, the Kathryn Mikells, chief financial officer of UAL Corp (UAUA.O) admitted that they have now added some straight call options in their portfolios instead of 100 percent collars.
SWAPS: Swaps are the customized future contracts. In this an airline makes payment as per the Strike Price. The airline pays the difference between the average price and Strike price, if it is more than the Strike Price.
Hedging by Airline Industry:
Passenger Airlines including AMR (American Airlines), British Airways, Singapore Airlines, Southwest Airlines etc hedge the fuel prices. Almost all the European Airlines use derivatives for hedging. Top US Airlines are being cautious for hedging after heavy losses in 2008." At the beginning of this year, American Airlines had hedged 24 percent of its full-year fuel requirements, down from 35 percent at the same time last year for the whole of 2009 (Reuters, 25th Feb, 2010)." United Airline suffered losses of $ 370 million on fuel hedging in the fourth quarter of 2008. US Airways group has not hedged since august 2008.
United Airlines have hedged around 70% of its demand for fuel for the first quarter of 2010. It has also reported a loss due to hedging in the fourth quarter of 2009 in January 2010. Delta Airlines has hedged around 47% of its fuel consumption for the first quarter of 2010. It has also reported a loss due to hedging. Southwest Airlines have hedged around 50% of its fuel consumption in 2010.
Asia's largest Airlines like Singapore Airlines, Cathay Pacific and Qantas hedge the fuel requirements.
Despite of 33 percent higher fuel rates Southwest Airlines earned a profit of $24 million dollars in the first quarter of 2010.
Risk of Using Derivatives:
The major risk in the Over the Counter derivative market is of transparency. Other important risk that has to be kept in mind is of counter party risk i.e the risk of the other party not able to fulfill the obligations of the contract. Operational risk occurring from human error can also affect the use of derivatives. Risk of credit is also involved with the use of derivatives, because only banks can have the access to specific credit information of the parties.
CONCLUSION:
Hedging can be effective and successful only if it is used properly, merely a use of derivative does not provide the guarantee of profitability. For Example Japan Airlines used derivatives to reduce risk but due to improper use of derivatives it led to its downfall (Gillani, 1996). Same is the case with Northwest and Delta Airlines (Adams and Reed, 2005). Use of derivatives may or may not be able to bring stability in the fuel prices and profits. Airlines should therefore use sophisticated programs for the hedging. Although there are risks and cost involved in hedging but the benefits of hedging are far more than that.
