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An airline is a company that provides air transport services for traveling passengers
and freight. Airlines lease or own their aircraft with which to supply these services and
may form partnerships or alliances with other airlines for mutual benefit. Generally,
airline companies are recognized with an air operating certificate or license issued by
a governmental aviation body.
Airlines vary from those with a single aircraft carrying mail or cargo, through fullservice international airlines operating hundreds of aircraft. Airline services can be
categorized as being intercontinental, domestic, regional, or international, and may be
operated as scheduled services or charters.
Finance theory does not provide a comprehensive framework for explaining risk
management within the imperfect financial environment in which firms operate.
Corporate managers, however, rank risk management as one of their most important
objectives. Therefore, it is not surprising that papers on the question why firms hedge
are mushrooming. This paper critically reviews this literature and analyses the
implications for risk management practice. It is distinguished between two competing
approaches to corporate hedging: equity value maximising strategies and strategies
determined by managerial risk aversion. The first category suggests that managers act
in the best interest of shareholders. They hedge to reduce real costs like taxes, costs of
financial distress and costs of external finance or to replace home-made hedging by
shareholders. The second category considers that managers maximise their personal
utility rather than the market value of equity. Their hedging strategy, therefore, is
determined by their compensation plan and reputational concerns. There is ambiguous
empirical evidence on the dominant hedging motive. It depends on the environment in
which firms operate (e.g. tax schedule) and on firm characteristics (e.g. capital
intensity). In general, one can observe that (i) hedging taxable income is of minor
importance, (ii) firms with a high probability of financial distress hedge more, (iii)
companies with greater growth opportunities hedge more, (iv) managers with common
stockholdings hedge more than managers with option holdings and (v) high ability
managers hedge more than low ability managers. The total benefits of hedging are not
the sum across the various motives. Therefore, a manager has to concentrate on a
primary motive to implement an effective risk management programme: If his primary
motive is to minimise corporate taxes, he will hedge taxable income. If his primary
concern is to reduce the costs of financial distress and if he can faithfully
communicate the firm?s true probability of default, his hedging strategy will focus on
the market value of debt and equity. If hedging is prompted to reduce the demand for
costly external finance, he will hedge cash flows. If the manager is concerned with his
reputation, he will focus on accounting earnings. Once he has focused on a certain
exposure, the manager has to decide whether he wants to minimise the volatility of
this exposure or simply avoid large losses.
Southwest Airlines
Southwest Airlines Co. is a major U.S. airline and the world's largest low-cost carrier,
headquartered in Dallas, Texas. The airline was established in 1967 and adopted its
current name in 1971. The airline has nearly 46,000 employees as of December 2014
and operates more than 3,400 flights per day.[6] As of June 5, 2011, it carries the most
domestic passengers of any U.S. airline. As of November 2014, Southwest Airlines
has scheduled service to 93 destinations in 41 states, Puerto Rico and abroad.
Southwest Airlines has used only Boeing 737s, except for a few years in the 1970s and
1980s, when it leased a few Boeing 727s. As of August 2012, southwest is the largest
operator of the 737 worldwide with over 650 in service, each averaging six flights per
day.
Early history
Southwest Airlines began with the March 15, 1967 incorporation of Air Southwest Co.
by Rollin King and Herb Kelleher to fly within the state of Texas.
Kelleher believed that by staying within Texas, the airline could avoid federal
regulation. Three airlines (Braniff, Trans-Texas and Continental Airlines) started legal
action which was not resolved for three years. Air Southwest prevailed in 1970 when
the Texas Supreme Court upheld Air Southwests right to fly within Texas. [9] The
Texas decision became final on December 7, 1970 when the U.S. Supreme Court
declined to review the case, without comment.
The story of Southwests legal fight was turned into a childrens book, Gumwrappers
and Goggles by Winifred Barnum in 1983. In the story, TJ Love, a small jet, is taken
to court by two larger jets to keep him from their hangar and to stop him from flying.
In court, TJ Loves right to fly is upheld after an impassioned plea from a character
referred to as "The Lawyer". While no company names are mentioned in the book, TJ
Loves colors were those of Southwest Airlines, and the two other jets are colored in
Braniff and Continental colors. The Lawyer resembles Herb Kelleher. The book was
adapted into a stage musical, Show Your Spirit, sponsored by Southwest Airlines and
played only in cities served by the airline.
On March 29, 1971 Air Southwest Co. changed its name to Southwest Airlines Co.
with headquarters in Dallas. Southwest began scheduled flights on June 18, 1971,
Dallas to Houston and Dallas to San Antonio with three 737-200s. The OAG for 15
October 1972 shows 61 flights a week each way between Dallas and Houston Hobby,
23 each way between Dallas and San Antonio and 16 each way between San Antonio
and Houston; no flights were scheduled on Saturdays.
A company that does not hedge its fuel costs generally believes one, if not both, of the
following: 1. The company has the ability to pass on any and all increases in fuel
prices to their customers, without a negative impact on their profit margins. 2. The
company is confident that fuel prices are going to fall and is comfortable paying a
higher price for fuel if, in fact, their analysis proves to be incorrect.
Typically, airlines will hedge only a certain portion of their fuel requirements for a
certain period. Often, contracts for portions of an airline's jet fuel needs will overlap,
with different levels of hedging expiring over time.
During the 2009-2010 period, the studies for the airline industry have shown the
average hedging ratio to be 64%. Especially during the peak stress periods, the ratio
tends to increase.
Southwest Airlines has tended to hedge a greater portion of its fuel needs than other
major U.S. domestic carriers.[3] Southwest's aggressive fuel hedging has helped the
airline avoid some of the pain of the recent airline industry downturn resulting from
high fuel costs. Between 1999 and 2008, Southwest saved approximately $3.5 billion
through fuel hedging.
Jet fuel represents a critical expense category for any airline that bears its own fuel
costs and most airlines bear at least 80% of its fuel costs. Fuel has consistently been
one of the largest expense categories for domestic airlines. During 2003, fuel costs
represented, on average, over 16% of the total operating expenses for all U.S.
domestic airlines. Moreover, airlines are generally unable to increase fares to offset
any significant increase in fuel costs. From 2001 to2003, these same airlines
experienced a 25.9% compound annual increase in jet fuel costs while average airline
pricing decreased by 0.1%, as measured by revenue per available seat mile. Jet fuel
costs have gone up over the past several years laying a constant pressure on airlines to
maintain a profitable operation. Savings in the lines of operation and fuel cost turn out
to be the profit earned.
In a fuel driven industry like Commercial Aviation, sudden hikes and fluctuations in
fuel prices can have an immense effect on the business plan, not to mention adding to
the difficult task of budgeting of Future fuel expenditures. If fuel costs are not actively
managed, they can lead a company into losses. Airlines can mitigate their exposure to
volatility and sudden hike in fuel costs, as well as natural gas and electricity costs,
through hedging. Hedging allows the fuel market participants to fix prices in advance,
while reducing the potential impact of volatile fuel prices.
Hedging items is a standard practice in almost every field that involves finance,
including Market players in precious metals like Gold, Silver and Platinum. While
fuel costs may be hedged, there is no perfect hedge available in either over-thecounter or exchange traded derivatives markets. Over-the-counter derivatives on jet
fuel are very illiquid which makes them rather expensive and not available in
Scot thought that might be the prices of fuel would decrease next year, he cannot be
sure energy prices are hard to predict. If the cost of jet fuel continued to rise, the cost
of fuel Southwest would rise according to without hedging.On the other hand if the
price of fuel is droped, the Southwest would un-hedged.
By viewing all these things ,Scott identifies the five alternatives, which are
Do nothing
Hedge using a plain vanilla jet fuel or heating oil swap
. Hedging using options
Hedge using a zero-cost collar strategy
Hedge using a crude oil or heating oil futures contract.
Southwest Airlines have to choose the best option among the following alternatives
based on two possible scenarios:
1) Fuel price decline
2) Fuel price rise.
1) Hedging using a Plain Vanilla Jet Fuel Swap : This alternative is simple and basic
form of swap. A certain amount of floating price is exchanged for a fixed price
over a certain period of time. The airline pays a fixed price and receives a floating
price both indexed to expected jet fuel use during each monthly settlement period.
Based on the amount of fuel hedged, and the possible scenario, the airline can either
make a profit from the swap or a loss from its swap. The two fuel hedging ratios
analyzed in this case are the full hedge and 50% fuel hedge. The airline fuel usage is
estimated to be 1100 million gallons
2) Hedging Using a Plain Vanilla Heating Oil Swap- This is similar to the jet fuel
swap in its operation The swap is in Heating Oil futures prices and the rise or
decline of these prices would act as an offset to the Fuel price volatility since the
correlation between Jet fuel prices and heating oil prices are high, as both are
byproducts of crude oil and assuming the basis has not changed. The loss or gain
in the futures contract will be offset by the lower cash price of jet fuel or by higher
cash price of jet fuel respectively. As a result, the airline effectively pays a fixed
price for jet fuel.
3) Hedging using a Crude Oil Call option- The call option gives the right to buy a
particular asset at a predetermined fixed price (strike price) at a time up until the
maturity date. In case of price rise, the call option can be exercised and the option
would make a profit, and would offset the loss from the actual price rise of the
commodity. In the case of a price decline, the call option may not be exercised,
giving it an advantage over other hedging strategies and hence would benefit
considerably from the price decline.
Conclusion
After carefully considering all the hedging strategies, in the primary and the
sensitivity analysis, it can be recommended that the best strategy, which can be used to
maintain constant and minimum fuel costs, is the Full Hedge Heating Oil Futures
Contract. This strategy also has a very low basis risk compared to the other strategies
using Crude Oil. It is therefore advised that Scott Topping utilizes this strategy for
Southwest Airlines.