Fuel Hedging in Airline Industry: Pros and Cons

This article discusses the application of fuel hedging in the airline industry, its advantages and disadvantages. It also explores the different ways airline companies practice fuel hedging.

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Coursework 1
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Coursework 2
Part 1
1. Suppose that in three years, company’s stock is trading at £55. At that time, should you
keep the options or exercise immediately? What are some of the important determinants in
making such a decision?
In such a situation, it is not clear whether to exercise the employee's stock or hold onto them
for longer. An employee is interested in making a profit. The employee might have three
situations. First, hold onto the stock if the current price is lower than the striking price.
Second, exercise the stock if the current price is higher than the striking price. And, three
hold onto the stock for longer even when the current price is higher than the strike price with
hopes of making more profit before the expiration date. Generally, it is advisable to exercise
stock towards the end of the expiration date (Cantrell, 2008, p. 312).
Factors such as financial needs, tax situation, market conditions, and expiration date can be
used in determining whether or not to exercise. Employees hold onto stocks with the hope of
gaining more in the future. If the stock option has value and an employee has urgent financial
needs, then the stocks should be exercised. The restaurant industry is risky and high price for
the stock is uncertain. Time value is also an important determinant. With seven years before
the expiration time, the stock options are likely to gain additional value (Pastore, 2005, p. 67).
However, if the risk is higher than returns, the stock option is likely to lose value and should
be exercised immediately. Likewise, the stock option should be exercised if the tax is
expected to increase in the future or held if the tax is expected to reduce. Lastly, market
conditions would also cause volatility of Ocean Cuisines' stock. If the market conditions are
unstable, the stock option should be exercised. On the other hand, if the market is stable, the
stock option should be held.
The strike price for Ocean Cuisines was £ 65. Likewise, the stock was trading at £40 when
they were offered to the customer. Three years later, the stock price stands at £40. Using the

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option pricing model, the stock would trade at £68.75 at the end of next one year although the
price might also drop to £41.25 using a standard deviation of 25%. The market is generally
stable and with the seven years before the expiration date, the stock price is expected to
increase in the future. Therefore the employee should hold onto the stock option (Barakat, et
al., 2015, p. 98).
2. You are trying to value your option. What minimum value would you assign? What is the
maximum value you would assign?
With the current market price of the stock as £ 55, the option pricing model has been used to
evaluate the minimum and maximum stock value based on the 25% standard deviation. The
minimum and maximum values of the stock would be £41.25 and £68.75 respectively. The
calculation can be summarised as shown in the table below.
Time 0
Call Value Put Value
S u 68.75 13.8 0.0
Stock Price 0 55 Interest Rate 3.4%
S d 41.25 0.0 13.8 FV 1.0346
PV 0.9666
Time Down State Up State
S d S u Stock 41.25 68.75
Call 0.0 13.8
Price Put 13.8 0.0
Units Cash Flow
Stock 55 Buy 1 -55.00 41.25 68.75 Cu - Cd 13.8
PV(Exercise) 0.9666 Borrow 55 53.16 -55 -55 Su - Sd 27.5
Call 15 Sell 1 15.00 0.0 -13.8 Pu - Pd -13.8
Put 8.40 Buy 1 -8.40 13.8 0.0
Hedge Ratio - Call 0.5000
Portfolio Cost 4.76 0.00 0.00 Hedge Ratio - Put -0.5000
Risk Neutral Prob, p 0.5692
(1 - p) 0.4308
Call Value 7.56
Put Value 5.73
Stock Price 1 Using CRR Binomial Formula
++++++++ 0 ++++++++ ********* 1 ********
Transaction
Value of Option******************** 1 *****************

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Part 2: Fuel hedging in Airline Industry
Introduction
Companies in the financial markets or those that deal with products which volatile prices use
the hedging technique to reduce risk exposure. Companies practice hedging through either
entering into future contracts or taking an offsetting position on a security. The three common
hedging derivatives used by companies are foreign exchange risks, interest rate risks and
product input (Romashova, 2015, p. 88).
Foreign exchange risks occur as a result of a fluctuating currency exchange rates. The risk
adversely impacts the performance of Multi-Corporations and are forced to use hedging to
mitigate/ reduce the impact of foreign exchange risks. Companies are exposed to Interest rate
risk when the rates in the finance market keep on fluctuating. For instance, companies engage
in future contracts as a mechanism of locking out the adverse impact from the reduction of
interest rates (Emrath, 2007, p. 8). Lastly, companies also use hedge derivatives to protect
themselves from increasing prices of raw materials. For example, airlines consume a high
volume of jet fuels and are highly affected by the increase in the price of crude oil. Most of
the airlines have employed hedging to protect themselves against frequent increases in the
prices of crude oil (Sensoy & Sobaci, 2014, p. 351). This section examines the application of
hedging against the increasing prices of jet fuels in the airline industry with specific attention
to the pros and cons.
Hedging against fuel costs in the Airlines industry
Fuel expenses form the largest portion of the operating cost for airlines. It is estimated that
the fuel cost range between 30% and 45% of the annual operating costs. The price of the
stocks owned by airlines decreases with an increase in the global price of crude oil which has

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a direct impact of the price of jet fuel. On the other hand, when the price of crude oil and
other related oil products decline, the stock price for airlines increase. Therefore, the
fluctuation of jet fuel and airline oil products largely impacts the financial performance and
value of airlines (Dafir & Gajjala, 2016, p. 111).
Airlines protect themselves from the volatility of fuel prices by taking advantage of the
arising situations in the market. For instance, airlines apply fuel hedging through selling or
buying the projected future fuel prices using different investment products. The main
objective of practicing fuel hedging is to protect airlines from volatile fuel prices
(Tangjitprom, 2012, p. 109).
There are four ways through which airline companies practice fuel hedging;
a) Buying oil contracts: The jet fuel market is influenced by the forces of demand and
supply. High demand followed by a low supply of crude oil causes the rise in the
price of jet fuel. If economic forces indicate that the price of jet fuel is likely to
increase further in the future, an airline firm can mitigate the situation by buying the
existing oil contracts at a large amount to protect itself from arising future prices
(Czaja, et al., 2010, p. 129).
b) Buying Call Options: Call options allows an airline company to continue purchasing
jet fuel using the current market price for a given time range even if the price
increases. In other words, can hedge against the expected future price of fuel by
purchasing the right to continue buying the product using the current price in the
future. For example, if the current price of a barrel is $ 90 but there are indications
that the price is likely to increase to $ 105 in the future. An airline company can enter
an agreement with the supplier to continue buying a barrel at $90 for a period of six
months irrespective of the increase in price (Harkin, 2012, p. 63).

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c) Implementation of Collar Hedge: The Collar hedge strategy comprises of both the call
and put options. While call option has already been discussed, allows an airline
company to buy fuel in future for a price that has been agreed upon today. Using the
above-mentioned example, an airline company would lose $15 per barrel if the price
increased from $ 90 to $105. Collar hedges would protect Airline Company from such
losses when the price of fuel increases (Huzam, 2011, p. 51).
d) Buying Swap Contracts: Airlines also use swap strategies to protect themselves
against the expected rise in the price of fuel. A swap contract is similar to a call option
strategy though it involves more strict guidelines. Call option strategy does not
compel airline companies to buy fuel even after a contract has been entered with the
supplier. On the other hand, swap contracts compel airlines to buy fuel on or before
specific dates within a given period. A company would suffer a loss by failing to buy
on or before the agreed date. One disadvantage of a swap strategy is that an airline
would also suffer a loss when the price of fuel decline instead of inclining (Fama &
French, 2012, p. 52).
Advantages of fuel hedging for Airlines
There are four advantages of fuel hedging in the airline industry;
First, hedging protect airlines companies from incurring losses when the fuel price goes up.
The point can be illustrated using an example which compares the impact an increase in the
price of fuel would bring to both hedged and unhedged airlines. Assumed the current fuel
price is $ 90 but is expected to rise to $100 in the future. A hedged company will have to pay
to continue paying the original $90 per barrel hence saving $10. On the other hand, the
unhedged company will have to pay an extra $10 to acquire a barrel of fuel. The comparison
shows that hedging helped the hedged company not to incur extra expenditure on fuel. At the

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end of a fiscal year, the hedges company would be profitable compared to the unhedged
company (Vasigh, 2014, p. 321).
Second, hedging contributes to increased profitability and value growth for airline
companies. The main objective of airline companies is to maximise the wealth of its
shareholders. Increase in fuel prices causes a reduction of profit earned per annum which
would lead to little or no dividend paid to investors. Subsequently, investors would lose
confident on the airline's stock hence withdraw their money from the stock market. Leading
to loss of future profitability and growth opportunity. Hedging of fuel price help to mitigate
the adverse impact on the company (Kothari Et Al., 1995, p. 193). For example, if the price
of fuel increased from $ 90 to $ 100 per barrel, a hedged company would save $ 10 of
additional cost per barrel. The company's profitability level would be higher than that of the
unhedged company when all factors remain constant. Besides paying more dividends to its
current shareholders, the company would restore the confidence of more investors who would
return invest more money. Lastly, the company would have extra retained earnings to finance
more investment opportunities (Romashova, 2015, p. 183).
Third, hedging offer airlines a competitive advantage in the market. It is common practice in
the airline companies to pass the additional operational cost to the customers by increasing
airfare. On the other hand, customers are price sensitive and would switch to less costly
airlines. Hedged airlines would use hedging as an opportunity to expand their market share
by snatching more customers from their competitors (Emrath, 2007, p. 11).
Fourth, hedging helps companies to improve their liquidity level. Airline companies might be
forced to seek financial short-term loans to cater for the extra cost of fuel when the global
price increases. A short-term loan is an element of current liability which reduces the ability

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of a company to meet its short-term financial obligations. Fuel hedging takes care of the extra
cost of fuel which helps to maintain an airline's current liquidity level (Vasigh, 2014, p. 193).
Disadvantages of fuel hedging for Airlines
First, hedging would only work to the advantage of airline companies when the price of fuel
increase. Airlines do not fully enjoy a reduction in the fuel price. If the fuel price reduces, as
it happened between 2014 and 2015, hedged companies would not take advantage of the
reduction due to hedge restriction. For example, when the price of fuel drops from $ 90 to $
80. Hedged companies will continue purchasing at $ 90 while unhedged companies will be
purchasing at $ 80 (Lechner, 2010, p. 73)..
Second, an airline company incurs several costs when seeking to enter into hedging
agreement with fuel suppliers. In some cases, the hedging cost might be too expensive to
afford. Therefore, an airline company should evaluate whether or not it would necessary to
take such costs (Dafir & Gajjala, 2016, p. 209).
Three, in some cases hedging, limit the ability of a company to make more profit. It would be
hard to hedged companies to compete in the same market as the unhedged ones when the
price of fuel drops. Unhedged companies would incur an extra operating cost which is likely
to be passed to the customer. Such a scenario would give unhedged airline companies and
competitive edge over the edged ones (Lechner, 2010, p. 75).
Conclusion
Airline companies engage in fuel hedging as a mechanism of locking out the adverse impact
from increasing prices of fuel. Some of the advantages of fuel hedging include reducing the
risks associated with investing in the airline industry, increase profitability level and firm's

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value, enhanced the competitive level and improved liquidity ability. On the other hand, the
disadvantages include; losing when the price of fuel drops, hedging is associated with extra
cost, and reduced prices of fuel reduce the profitability level of a company. Irrespective of the
advantages and disadvantages, airlines companies should consider their situations as well as
the market conditions before making a decision on whether or not to hedge against the
expected future increase in fuel price.
References List

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Barakat, M. R., Elgazzar, S. H. & Hanafy, K. M., 2015. Impact of Macroeconomic Variables
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