International Finance the Use of Term Paper

  • Length: 7 pages
  • Sources: 7
  • Subject: Economics
  • Type: Term Paper
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Excerpt from Term Paper :

DeMarzo and Duffie, (1995), also argue that the presence of hedging may be utilized by shareholders as a way of interpreting the quality of management, with hedging generally deemed to be a beneficial strategy. The perceived lower risk profile may also aid in other areas, such as increasing the ease with which capital raising may take place.

It is also speculated that large organizations may be able to benefit from the tax impact of hedging. A number of theorists argue that tax structures of western countries encourage companies to provide a smooth performance, avoiding peaks and troughs (Ross, 1996). Therefore, there will also be some tax advantages to utilizing hedging resulting from hedging potentially delaying losses and smoothing financial performance (Ross, 1996).

Morrell and Swan, (2006) argue that whatever the motivations, when the performance of a firm is assessed in the long-term the impact will be null, as the hedging merely facilitates a delay in the changes of market prices impacting on the firm. This also aligns with the idea of smoothing financial results, as it allows increasing planning.

Therefore, although the main motivation for hedging using derivatives is as a risk management strategy, there are a number of additional benefits which may be achieved and support the operations of the organization. When assessing the way in which Southwest Airlines undertakes hedging all these elements may be considered.

Southwest Airlines has a highly active strategy of hedging utilizing options and swaps. The main heading strategy is focused on fuel prices. Interestingly, the hedging strategy does not always involve the purchase of derivatives where the underlying commodity is aviation fuel. Instead, the airline may purchase derivatives where the underlying commodity highly aligned with aviation fuel. In the past the company has utilized West Texas intermediate crude derivatives, but is found that despite the commonality with aviation fuel, the prices have not been that highly aligned. The recent strategy includes utilizing derivatives where the underlying commodity is heating oil and kerosene. These commodities are highly viable as they are aligned with aviation fuel, utilizing the same inputs, and Southwest Airlines may benefit from the greater degree of liquidity facilitated by the larger trading market for these commodities, both traded on the New York Mercantile Exchange (NYMEX) (Sadrinna, 2010). By hedging in these derivatives the organization has the potential to limit its exposure to movements in aviation fuel as the jewel price movements are likely to be reflected in the kerosene and heating oil market resulting from the similar characteristics of the commodities (Sadrinna, 2010).

When looking at the underlying strategy of Southwest and their use of derivatives Scott Topping, the director of corporate finance states that the main motivation was based on the strict control of cost (Carter et al., 2006). Within the aviation industry, and Southwest Airlines in particular, the cost of fuel was the second largest business expense following the cost of labor (Carter et al., 2006). However, it is one of the cost inputs it is demonstrated the greatest level of potential volatility. For example, between 1998 and 2000 the cost of aviation fuel increased by 255%, rising from a spot price for Gulf coast jet fuel of 28.5 cents per gallon, seen in December of 1998, up to 201.25 cents in September 2000 (Carter et al., 2006). The level of volatility in the pricing of aviation fuel can be further appreciated when it is realized the following year the price in June 2001 reduced 79.45 cents per gallon (Carter et al., 2006). Therefore, the cost is one that has the potential to impact significantly on Southwest, as well as impact on overall returns creating increased financial volatility in the firm's results. The organization undertook a statistical analysis in order to determine the risk they face, in order to assess whether or not hedging should take place. In the year 2000 it was estimated that there was a 68% probability level that volatility would continue, and based on the previous 10 weeks, it was extrapolated that the volatility could result in increased costs amounting to as much $147.8 million (Carter et al., 2006).

The hedging strategy at Southwest appears to have been extremely beneficial, with many years allowing the firm to make significant savings. In financial year 1999 it was estimated that the direct benefit of the hedging programs $40.8 million, in financial year 2000 the benefit of hedging program increased to $113.5 million (Carter et al., 2006). This pattern of beneficial gains continues until financial year 2007, when a total of benefit of $2.4 billion was realized (Brooks, 2008).

However, the utilization of derivatives is risky, and just as gains can be made, as seen with the concept of basis risk, there is the potential for losses to occur if the spot price falls. This occurred in 2008, where Southwest Airlines that hedged utilizing futures contracts. The price of aviation fuel in the future contract turned out to be much higher than the spot price at the time of purchase, and resulted in the airline making a loss of $992 million (Brooks, 2008). This resulted in the airline posting a loss in the third quarter of that year (Pae, 2008). This indicates the risk associated with hedging. However, without hedging Southwest Airlines would have faced losses at a much earlier date, in 2004 (Gimbel, 2008).

Therefore, Southwest Airlines may be used as a good example of the effective use of derivatives, but even the careful use and management may result in losses as they have suffered from basis risk. It is also interesting to note that over this period there has been an overall general increase in the price of aviation fuel. With this in mind the argument of Morrell and Swan, (2006) that the issue is not only of avoiding costs, but controlling when they occur, by delaying the impact of market changes. The increases were delayed for many years, but losses were incurred when the prices fell. Therefore, Southwest has benefited, but the benefit is in the increased control that the use of derivatives by swapping unacceptable risk for acceptable risk.

References

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Brooks, R. (2008), a life cycle view of enterprise risk management: The case of Southwest Airlines jet fuel hedging, Working Paper No. 10-02-01, University of Alabama.

Carter, David a.; Rogers Daniel a; Simkins, Betty J. (2006, Fall), Hedging and Value in the U.S. Airline Industry, Journal of Applied Corporate Finance 18(4), 21

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DeMarzo, Peter M; Duffie Darrell, (1995), Corporate Incentives for Hedging and Hedge Accounting, Stanford University Working Paper

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Gimbel, B., (2005), Southwest's new flight plan, Fortune, 15(10), 93

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Markham, Jerry W. (1987), the History of Commodity Futures Trading and Its Regulation. New York, Praeger Press.

Morrell, P; Swan, W. (2006, Nov), Airline jet fuel hedging: Theory and practice, Transport Reviews, 26(6), 713-730

Pae, P., (2008), Southwest Airlines posts first loss in 17 years, Los Angeles Times, retrieved from http://www.latimes.com/business/la-fi-southwest17-2008oct17,0,6167330.story.

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