Derivatives Firms Use Derivatives in Research Proposal

  • Length: 8 pages
  • Sources: 7
  • Subject: Business
  • Type: Research Proposal
  • Paper: #22488528

Excerpt from Research Proposal :

Thus, the company is not attempting to either "win" or "lose" with its transactions. Thus, either may occur over any given period. An example of a fuel hedging "loss" occurred in late 2008 and into 2009. During this period of high volatility, fuel prices shot up as high as $140 per barrel in mid-2008, only to quickly crash down to $40. This volatility is a tremendously challenging environment. The company's policies of hedging six months out would have helped as the fuel prices skyrocketed in the spring of 2008. Under that situation, the company would have been paying prices from January for fuel in June, delivering significant savings. On the way back down, however, the company would have been paying June prices in December. When the latter hit the annual income statement in FY 2009, it was recorded as a £330 million loss on fuel price hedging. During this period, the company also gained £120 million on U.S. dollar hedging (Osborne, 2009). For the observer of the company, it is important to remember that EasyJet would have profited on the upside and suffered losses on the downside. The key to evaluating the success of the hedging program is actually by analyzing the firm's operations to see if it was able to profit, and make the right tactical decisions in the marketplace by taking advantage of its cost certainty. For example, when the company lost money on its hedges in 2009, it saw a dramatic increase in revenue per seat.

As we near the end of March, 2012, it is possible to see where the company's hedging strategies as outlined in the 2011 Annual Report stand. With respect to fuel hedging, the IATA (2012) reports that the current price for jet fuel is $1,080.8 per metric tonne. Thus, the company's cost of fuel in dollars is lower than the current spot price, given that it is 80% hedged at $950 per metric tonne. Going along with the fuel hedging is the U.S. dollar hedge. Six months ago, the company was 80% hedged on its dollar requirements at $1.60. According to OANDA, the current spot rate for the £/$ pairing is 1.56693. This means that dollars are cheaper than what EasyJet is paying for them. The key now is to compare the hedge on fuel prices with the hedge on dollars to see whether or not EasyJet comes out ahead. On a metric tonne, the company is paying $950, at $1.60, which gives a total price per metric tonne of jet fuel as £593.75. At the spot rates, this would be $1,080.8, at $1.56693, which comes out to £689.75. Thus, it can be concluded that EasyJet's fuel and dollar hedging programs have a net success, and they are saving the company £96.01 per metric tonne on their fuel costs on its hedged exposure. While the rest of its fuel and dollar needs are unhedged, the weighted average cost of fuel will be lower in sterling terms than if the company had remained completely unhedged.

The euro hedging program has the company selling its surplus euros at 1.13, whereas the current rate is 1.19380 (Oanda, 2012). Thus, €1000 is equal to £836.67 on the spot market EasyJet is getting paid £884.96 for €1000. Again, this example shows that the company has gained through its hedging program, but this is simply because of the direction of the currency movements. More important is that the company knew six months ago how much that revenue was going to be worth, and that helped it to make better short-term tactical decisions and have better revenue certainty.

Conclusion

Almost all airlines utilize some form of derivative to hedge their fuel exposure, if not their currency exposure. Most use forward contracts, but many rely on imperfect hedges for their jet fuel exposure. The key to an effective hedging program using derivatives is that the objective of the program has to align with the company's strategy. Price volatility for currencies and commodities exists, so there will be a price movement one way or another. Any company that is simply hedging to gamble on a movement is doing just that -- gambling. The key to good derivatives use is to buy the company some cost certainty (and revenue certainty, for EasyJet's euro program). This certainty allows the company to do a number of things, which for EasyJet includes setting prices and routes in line with cost and revenue expectations.

Whether the company "wins" or "loses" on its hedging program might make for a good headline, but it is not the objective of the program to use company funds to gamble of derivatives markets. Companies use derivatives because the cash flow certainty helps the company to make better decisions. In the case of EasyJet, there is evidence that it does make better decisions with respect to routing and costs since it has hedging programs to deliver better certainty over the cost of its key inputs of fuel and revenue from Europe.

Works Cited:

CAPA. (2009). Jet fuel price volatility returns. Centre for Aviation. Retrieved March 12, 2012 from http://www.centreforaviation.com/analysis/jet-fuel-price-volatility-returns-6416

Cobb, R. (2004). Jet fuel hedging strategies: Options available for airlines and a survey of industry practices. Northwestern University. Retrieved March 12, 2012 from http://www.kellogg.northwestern.edu/research/fimrc/papers/jet_fuel.pdf

EasyJet 2011 Annual Report. Retrieved March 12, 2012 from http://corporate.easyJet.com/investors/~/media/Files/E/EasyJet-Plc-V2/pdf/investors/result-center-investor/annual-report-2011.pdf

EasyJet. (2003). EasyJet to commence hedging program. EasyJet.com. Retrieved March 12, 2012 from http://www.easyJet.com/en/Investor/20030528_01.html

IATA. (2012). Jet fuel price monitor. International Air Transport Association. Retrieved March 12, 2012 from http://www.iata.org/whatwedo/economics/fuel_monitor/Pages/index.aspx

Investopedia. (2012). Derivative. Investopedia. Retrieved March 12, 2012 from http://www.investopedia.com/terms/d/derivative.asp

Oanda.com. Retrieved March 12, 2012 from http://www.oanda.com/

Osborne, a. (2009). Fuel hedges hit EasyJet as revenue per seat rockets. The Telegraph. Retrieved March 12, 2012 from http://www.telegraph.co.uk/finance/newsbysector/transport/6590938/Fuel-hedges-hit-easyJet-as-revenue-per-seat-rockets.html

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