Use of derivatives in a chosen company

Derivatives

Firms use derivatives in order to manage the financial risk associated with maintaining open positions in either currencies or commodities. As a result, firms that most commonly utilize derivatives are those who operate internationally or those who deal extensively with key commodities. EasyJet is one such company, since it uses crude oil hedges on the price of jet fuel, and it also uses currency hedges to manage its exposure to the euro and the U.S. dollar. This paper will discuss the use of derivatives as a risk management tool, using EasyJet as an example firm.

What are Derivatives?

Derivatives are instruments whose price is associated with the price of an underlying asset. Some of the more common derivatives in use are futures contracts, forward contracts, options and swaps (Investopedia, 2012). The choice of derivative used will depend on a number of different factors, including the needs of the firm, the availability of said derivative, the degree to which a specific derivative can hedge exposure, and the cost of the derivative. Thus, firms must be always aware of the different traits of the derivatives available in order to find the one that best meets the company's needs.

Purpose of the Activity

The first step in determining what if any derivative strategy needs to be adopted is to understand what the needs of the company are with its derivatives. In general, the value of derivatives to a company is to hedge exposure. When a company is exposed to a commodity or currency, that means that the fluctuations in that commodity can change the value of a transaction. This can be good or bad, but for many companies that uncertainty is something that they do not wish to be part of. This is a reasonable response -- if a CEO wants the success or failure of the company to depend on a gamble, then he or she should sell the assets and go to Las Vegas. Clearly, most firms do not wish their profits or losses to depend on the movement of a currency or commodity -- it is easier to derive long-term shareholder value by tying the firm's results to managerial actions. This is where hedging comes into play. With cost certainty, the company knows that its success or failure will not be the result of winning or losing a gamble, but rather will be the result of the company's own actions.

At EasyJet, the company has three major derivatives programs to hedge against its three major exposures. The first is fuel. For most airlines, fuel is one of the biggest costs, if not the biggest cost. Jet fuel prices are highly volatile in recent years (CAPA, 2009), and this represents a major risk for airlines. The most susceptible to fuel price fluctuations are discount airlines like EasyJet, because their business model relies on a high-volume, low-margin strategy. Those tight margins can easily erode with fuel price fluctuations. While all airlines undertake some fuel price hedging, discount airlines in particular seek cost certainty, as that allows them to set prices at levels that will allow the flight to be profitable. Without fuel price stability, the airline will much more trouble ensuring profitability, selecting routes and pricing competitively.

EasyJet also faces foreign exchange rate risk, as a UK company that does significant business in Europe and that purchases a major input (jet fuel) in U.S. dollars. As such, EasyJet has hedging programs for its exposure to these currencies. It has U.S. dollar requirements for jet fuel, but does not operate in the United States so the company does not have access to U.S. dollars from sales. Similarly, the country has a significant amount of euro-denominated sales, and these exceed EasyJet's euro-denominated expenses so that it must sell euros every year, or leave them on the balance sheet where they present a source of translation risk for the firm.

According to EasyJet's 2011 Annual Report, the company is hedged 73% of its fuel needs through the end of 2012. The annual report lists the hedge at $950 per metric tonne, and is hedge 49% through 2013 at $979 per metric tonne. The company hedges with the aim of "reducing short-term earnings volatility." This hedging policy reveals two things about the EasyJet hedging strategy. The first is that the company hedges long-term. This fits in with the company's business model. With longer-term hedges, the company has fuel price certainty far enough into the future to set routes and prices based on that information. There is a risk that prices could decline, which is why EasyJet does not fully hedge, but in gaining price certainty for this key input, EasyJet is in a better position to structure its operations in such a way as to ensure profit, raising rates on routes that would otherwise be unprofitable. The other thing worth noting with the fuel hedges is that they are in metric tonnes, a measure for jet fuel. Many airlines will hedge using crude, because the market for crude derivatives is more liquid. In the United States, airlines often use either crude or heating oil as imperfect hedges (Cobb, 2004). The market for hedging jet fuel directly may not be substantial, but if EasyJet is able to do that, the company will have better cost control.

Fuel prices represent just one element of hedging for fuel, since those prices are denominated globally in U.S. dollars. This means that EasyJet also needs dollar hedges to manage its currency exchange rate risk. Having its fuel hedges settled well in advance makes the dollar hedges easy, because the company then is in a better position to know the timing and amount of the dollar flows that it will have. It is believed that fuel and some aircraft costs are the only major inputs that EasyJet must purchase in dollars. According to the company's 2011 Annual Report, EasyJet is hedged 80% six months out, 69% for the full FY 2012 and 46% for the FY 2013. Having the cost certainty not only for dollars but for the fuel that they will buy is essential for cost control at EasyJet, and therefore there is a close match between the exposure to fuel prices that EasyJet has hedged and the exposure to dollars.

EasyJet also has euro exposure, because of the revenues that the company generates in Europe. The company sells its euros in advance. This is a slightly different hedge, because there is less certainty with respect to euro revenues than there is with fuel requirements. However, the six-month hedge is only 76%, the one year hedge is 71% and the FY 2013 hedge is 50%. This gives EasyJet some leeway with respect to revenue shortfalls, in that it would not have to buy euros on the open market to meet those shortfalls. However, there is a high degree of hedging for the euro even, as the company seems to feel that having revenue certainty is just as important as having cost certainty.

EasyJet hedges all three with forward contracts. The company has significant hedges six months forward, and generally conducts its hedging on the open market. There are other options available to EasyJet, especially with the foreign exchange hedging. There are very liquid markets for the £/€ pairing and the £/$ pairing, so these hedges could be conducted with interest rate swaps or with futures contracts. However, the use of forwards locks in prices for set quantities and times, both of which are useful for EasyJet, because of the control that the company wants to have over cash flow.

Changes Over Time

EasyJet began its hedging program in 2003 (EasyJet, 2003). The company initiated the program to hedge fuel costs and U.S. dollar exposures, which as noted typically go hand in hand because fuel prices are dollar-denominated. When the program was initiated, there was no euro hedging, and the dollar hedges were not used for aircraft purchase/leases. Both of those programs were added later, as EasyJet's operations grew larger. The company had initially felt that the small size of the company made hedging either impractical or unnecessary, but the company quickly became reliant on hedging as a means of managing short-term cash flow.

Monitoring and Governance

Hedging is a critical component of EasyJet's business, and therefore is a full-time job at the company. The finance department generally prefers to have full70-80% hedges out at least six months. This requires constant forecasting and monitoring of macroeconomic conditions. The company must estimate demand on key routes, must attempt to gauge fuel price demand and also must be aware of potential interest rate changes. However, in recent years the amount of hedging has remained relatively stable. This indicates that EasyJet is less concerned with the direction of movements, meaning it is not attempting to gamble on price movements with its hedges. The hedges instead are simply intended to give the company predictability of cash flows, allowing for other tactical decisions to be made.

Ex-Post Outcomes

EasyJet's hedging strategy seeks not to gamble on fuel price and exchange rate directions, but rather to provide certainty of cash flows for management. 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.