Derivatives Market

Topics: Southwest Airlines, Airline, Price of petroleum Pages: 9 (2540 words) Published: April 24, 2013
A Study in Airline Industry

Changgull Song
Fordham University, Deming Scholars MBA,

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 profitability. Variability in quality of raw material will affect the quality of end product, and the firm will suffer from the cost of resolving customer dissatisfaction. Therefore, managers are trained to cope with the variability in production or supply chain management, where they can relatively easily trace the sources of the variability, and often can find solutions to improve the process. Here, we can find a great help from statistics and continuous improvement (Deming, 2000).

Unfortunately, for airlines, fluctuation of jet fuel is not easy to predict or to control, where the earnings are hugely affected at the rise or fall of the jet fuel. One may argue that average profitability over years will be the same whether the variability in the cost is large or small. It is true when there is no other systemic influence such as tax liabilities to the earnings. When corporate tax liabilities draw a convex function to the earnings, the value of the firm will draw a concave function. So, the more the variability in earnings, the less the average value of the firm (Smith & Stulz, Dec., 1985). Therefore, corporate tax liability can be one of the motives of a manager who choose to hedge against the variability of the costs. It is beneficial to use hedges when the cost of hedges is smaller than the benefit. From a study of 422 non-financial firms, Grahm and Rogers (2002) found that the hedging costs were smaller than the tax benefits for four out of five of the case studies.

Other Incentives to Reduce the Firm’s Volatility
As an another aspect, increase in debt capacity by using derivatives hedges can reduce tax liabilities (Stulz (1996) and (Ross, 1997)). Reducing the volatility of income or reducing the probability of financial distress, hedging increases debt capacity. Since the cost of debt decreases by the decrease in the risk premium, the firm can increase debt/equity ratio maintaining the cost of capital at the same or at a lower level. If firms add leverage in response to the greater debt capacity, the associated increase in interest deductions reduces tax liabilities and increases the firm value. Thus the ability to increase debt capacity provides an additional tax incentive to hedge (Graham & Rogers, April, 2002).

Hedging can reduce the underinvestment problem (Myers & Majluf, 1984). By reducing the sensitivity of the investment decisions to the volatility of the firms, hedging allows a firm to shift internal funds into states where they would otherwise be scarce. If internal funds are cheaper than external funds, hedging permits the company to finance valuable investment projects and increase the firm value (Froot, Scharfstein, & Stein, 1993).

Fuel Costs and Operation of Airlines
In an airline’s operation, fuel costs contribute a large portion to the operation expense. Figure 1 show six airlines’ jet fuel costs to operation expenses ratio from 1999 to 2006. Since Q4 of 2006 has not been disclosed to SEC filings, data of Q1-Q3 of 2006 was used for the calculation. Here, we can observe Southwest does not follow the sudden rise and fall of the jet fuel costs burden. [pic]

Figure 1. Fuel Costs to Operation Expense of Airlines (EDGAR SEC Filngs, 2006)

Figure 1 also shows an...
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