The Significance of Hedging in Aviation Fuel Pricing

A summary of the provided content is that hedging in aviation companies helps increase firm value by providing locked-in profits, reinforced profits, stable fair prices, access to debt financing, and reduced chances of bankruptcy. Hedging can also reduce complexity, opportunity costs, and behavioural biases associated with risk management strategies. Despite these benefits, there are downsides such as limiting gains but not losses, which may affect firm value. The conclusion is that hedging against volatility is an important risk management strategy to protect profits from fluctuating prices.

Hedging

Hedging
Table of Contents
Part 1.......................................................................................................................................................2
Question 1...........................................................................................................................................2
Question 2...........................................................................................................................................3
Part 2.......................................................................................................................................................4
Introduction........................................................................................................................................4
Advantages.........................................................................................................................................4
Disadvantages.....................................................................................................................................6
Conclusion..........................................................................................................................................8
References...............................................................................................................................................9
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Part 1
Question 1
The stock option should not be exercised because the current market price of £55 is less than
the strike price of £65 i.e. a price which is paid to convert option into a stock. It will be more
beneficial to purchase stock at market price rather than exercise the option at strike price.
The decision to exercise employee stock option depends upon the following determinants:
Intrinsic Value: It is the difference between market price of the underlying stock of a
company and strike price of the option. If the intrinsic value is greater than zero, the option
can be exercised by paying lower amount than the market rate. At any point of time, the
intrinsic value shows the financial advantage available to the option holder if he chooses to
exercise it immediately.
Vesting Period: A vesting period is a time after which an employee can exercise his option.
In our case, the vesting period is three years which means an option cannot be converted to a
stock before expiration of this period. The vesting period helps determine intrinsic value of a
stock after the time expires. The value thus obtained can be discounted back to the present to
know what would be the worth of an underlying stock if an option is vested. Longer vesting
period means higher intrinsic value because a forecast for market price on a longer horizon is
high.
Time Value: There is a component of time value in the intrinsic value obtained of an option.
The nominal value of a strike price is kept fixed though its real value may be different over
time. In our example, the strike price of £65 is applicable after three years till tenth year from
the time when stock option is offered. However, if time value of money is considered,
exercising option in 5th year at £65 will be less costly than doing it in 8th year at the same
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price. Thus, the time value component is included while calculating intrinsic value of an
option.
Volatility: The volatility in stock price causes the expected price of its option to increase in
near future (Black & Scholes 1973). The Black-Scholes model discuss that in the total value
of an option there is a minimum value along with the component of volatility. Higher
volatility causes the price of an option to rise.
Question 2
The minimum value of option can be derived when we expect a stock to give same return as
risk-free asset such as treasury notes.
Minimum Option Price = 40(1.034 )3 −65
(1.034)3 = £0 (Negative Value)
Where, the numerator represents premium three years from now on current market price and
the denominator discounts this premium back to the present value. The same equation to get
the price of the option at expiration period is applied to get option price of £3.70.
The maximum value can be assigned using the Black-Scholes model by taking 25% as annual
average standard deviation in stock price.
Maximum Option Pricing (3 years) = £2.137
Maximum Option Pricing (10 years) = £13.92
(Note: Keeping in mind the word limit, the demonstration of calculation would have
substantially increased the word count and decreased the content of central idea of this part.
The internet sources were used to calculate value using the Black-Scholes model)
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Part 2
Introduction
The companies in an airline industry bear fuel costs to run the operations. Since, the airline
fuel is extracted from the crude oil, the price of both commodities are aligned. Thus, the
airline companies face a major risk in terms of volatility in the crude oil price and hence in
the aviation fuel cost. In order to avoid channelizing this volatility in cost to the customer, the
airline companies enter into hedging contracts to lock in their fuel cost and turn it into a fixed
expense. In this context, I am discussing the advantages and disadvantages of aviation fuel
hedging exercised by the airline companies.
Advantages
Increasing Firm Value: The main reason why the companies do hedging for fuel costs is
because it acts as an insurance policy against fluctuating fuel prices and thus it forms a part of
risk management strategy of companies. It locks in a certain amount of profit irrespective of
what the jet fuel process will be in the future. This strategy is particularly very useful when
the fuel costs are already high and the price of fuel is expected to go even higher in the near
future. Thus, the locked in profits provide greater certainty in cash flow generations which
makes valuation of the airline company easier for investors. It leaves enough room for
retention of profits and expand the operations to increase firm value (Froot et al. 1993; Carter
et al. 2006).
Reinforced Profits: The profits are also strengthened when the higher fuel prices are caused
by economic growth and fuel supply constraints. When the aviation companies see increased
passenger traffic and improved revenue, the profit can be offset by increasing fuel price
caused by supply constraints (Morrell & Swan 2006). The hedging contracts can reinforce
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profits in such cases by fixated fuel costs. Besides, it also protects from a sudden rise in the
crude oil prices if not the gradual increase in costs. The abrupt rise in price caused by
consumer, political or any similar macroeconomic uncertainty is difficult to predict in
advance. Hence, the profits remain preserved in such cases.
Stable Fair Price: The customers of any aviation company would be thwarted for frequent
price changes in the aviation fairs. On an average, the fuel costs represent 27% of the revenue
for the airline service providers. It means that volatility in fuel prices can affect up to 27% of
the fair prices. If a company keeps its profit margin fixed, the increased costs have to be
channelled to fair costs for customers. The end users who utilize airline services frequently
would like stable fair price to ascertain their prospects. The hedge against volatility in oil
price can help a firm establish stability in fair prices and thus retain customers.
Access to Debt Financing: As discussed earlier that hedging helps increase the firm value, it
also forms a part of broader financing decisions of corporations (Smith & Stulz 2009). The
absence of hedging in fuel costs is also not acceptable to the financial institutions providing
credit to the airline companies. The hedging contracts is a strategic tool to stay protected
against market shocks, a move which is welcomed by banks who provide loans. The interest
on extended credit is applicable for longer periods. An increase in the fuel price reduces the
income left to pay interest on this debt. Hence, a bank would not lend for a longer term to a
firm who does not have a hedging exposure for the fuel costs. A volatility in fuel price and
the absence of proper risk management strategy impairs the ability of a firm to pay interest on
debt. Thus, hedging proves creditworthiness of the airline companies and shows how mature
the company managers are in debt management. It expands the access to debt finance for an
aviation company.
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Reduced Chances of Bankruptcy: A significant increase in aviation fuel prices can lead small
airline firms to bankruptcy. Their fuel bills become so high that their cash flows are not
enough to pay them all. The small airlines face solvency issues in such cases when they are
unable to pay other fixed costs as they come leading to closing down of operations only
because they have used everything in paying fuel bills. The hedging can protect such firms
from perishing by mitigating risks arising out of volatile oil prices.
Disadvantages
Cut in Potential Rewards: While creating a position in a hedge against volatility in oil prices,
the managers assume that the price will increase in the future. If the situation turns otherwise,
the derivative instrument offsets the gain available due to low price. A derivative instrument
is beneficial when the price rise and disadvantageous when it falls. Thus, if hedging reduces
the risk due to volatility in prices, it also cuts down the chances of potential rewards of
increased profitability due to decreased fuel cost. Also, if the position in a hedge is taken for
a longer period such as two or three years, the decreased price for a longer period of time can
make the airline company remain unprofitable for a prolonged period.
Complexity: The process of hedging implicates complex calculations and involves facing
difficult trade-offs. The complexity in calculations is due to the variables involved in it. Some
variables can be speculative in nature on which the management has little control. It simply
gambles on its position thinking that it will benefit in the near future. Thus, the management
discretion can sometimes be counterproductive with huge losses or it can be low yielding. For
example it may keep the hedge ratio too high or too low or can take a hedging position for a
term too short or too long.
Opportunity Cost: Taking positions in the derivatives market involves holding margin capital
in the balance sheet to pay for the potential obligations that can arise in future. This
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requirement can tie up large amount of capital of big firms taking large positions bearing an
opportunity cost. This capital can be used on other significant projects or capacity expansion
to maximize returns.
Selective Hedging: (Treanor et al. 2014) bring a view that the hedging is done to mitigate
volatility risks in fuel oil prices and not increase the firm value. It is done when oil price
levels are high and expected to rise further significantly and if the firm has a very high
exposure to fuel prices. Thus, the underlying assumption says that the hedging is avoided
when firms have low exposure and volatility will not significantly impact the cash flows. A
concept of firm value is tossed out by management when the fuel prices turn significantly
high. When the exposure is low the management does not bother to hedge (though in small
amount) in order to stabilize cash flows for longer-term and increase the firm value.
Behavioural Bias: The managers face a situation in which they have to consider choosing a
hedge against fuel prices which limits the losses but also limits the gains and a pure exposure
which can have exceptional benefits when fuel prices go down. The prospect theory says that
they make decision based on the value they assign to the gains and losses rather than final
outcome (Kahneman & Tversky 1979). The value assigned are based on certain heuristics
(behavioural shortcuts) which makes management focus on exposure gain even if the
probability of occurring that gain will be less. Thus, they avoid going for a hedge because
they are fixated on a profit they can reap by exposure. In this behavioural bias, they disregard
the high probability of occurrence of hike in fuel prices which will increase their losses if
they do not hedge properly. Such managers act purely on speculations with limited research
on risk mitigating measures against volatility in crude oil prices. The speculators fail to create
a stable business model.
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Conclusion
A hedge against volatility is an important risk management strategy to protect the profits
from the fluctuating prices. Though there are down side risks involved, it brings stability in
cash flows over longer term. The small airline companies can protect themselves by hedging
a part of exposure and remain solvent. Even the big aviation companies can include it as a
part of risk management strategies and decrease instability. The value maximizing firms have
avoided speculating in the market by maintaining a certain hedge ratio in their exposure.
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References
Carter, D. A., Rogers, D. A. and Simkins, B. J. (2006). ‘Does Hedging Affect Firm Value?
Evidence from the US Airline Industry’. Financial Management, 35 (1), pp 53–86. Available
at: http://onlinelibrary.wiley.com/doi/10.1111/j.1755-053X.2006.tb00131.x/abstract.
Morrell, P. and Swan, W., 2006. Airline jet fuel hedging: Theory and practice. Transport
Reviews, 26(6), pp.713-730. Available at:
http://www.tandfonline.com/doi/abs/10.1080/01441640600679524.
Froot, K.A., Scharfstein, D.S. and Stein, J.C., 1993. Risk management: Coordinating
corporate investment and financing policies. The Journal of Finance, 48(5), pp.1629-1658.
Available at: http://www.nber.org/papers/w4084.
Smith, C.W. and Stulz, R.M., 1985. The determinants of firms' hedging policies. Journal of
financial and quantitative analysis, 20(04), pp.391-405. Available at:
https://www.cambridge.org/core/journals/journal-of-financial-and-quantitative-analysis/
article/the-determinants-of-firms-hedging-policies/
8035EEB5F9B1A1E07EFFC2573D55A62B
Treanor, S.D., Rogers, D.A., Carter, D.A. and Simkins, B.J., 2014. Exposure, hedging, and
value: New evidence from the US airline industry. International Review of Financial
Analysis, 34, pp.200-211. Available at:
http://www.sciencedirect.com/science/article/pii/S1057521914000581
Black, F. and Scholes, M., 1973. The pricing of options and corporate liabilities. The journal
of political economy, pp.637-654.
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