Derivatives Market

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HOW MUCH SHOULD WE USE DERIVATIVES HEDGES?
A Study in Airline Industry

Changgull Song
Fordham University, Deming Scholars MBA, changgull@gmail.com

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



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