Southwest Airlines Derivatives and Fuel Hedging Strategy

Introduction to Derivatives and Their Role at Southwest Airlines

Southwest Airlines is one of the most successful airlines in the United States, remaining profitable in many years when other airlines suffered losses, including in the aftermath of September 11, 2001. The low-cost carrier achieves this with a range of strategies, including a very active hedging strategy using derivatives. To appreciate the role that derivatives have played in Southwest Airlines' financial performance, it is useful to examine what is meant by the term "derivative," how derivatives are used in Southwest's hedging strategy, the reasons the firm may have adopted this strategy, and the results it has achieved.

Derivatives are financial tools designed to create a price exposure based on the valuation of an underlying asset, commodity, or event, capturing market price changes and fluctuations (Dodd, 2002). The term "derivative" reflects the structure of the financial tool, as these instruments derive their value with reference to the underlying asset or security (Dodd, 2002). This is usually achieved without the transfer of any title (Dodd, 2002). There are different types of derivatives that may be utilized, including forwards, futures, options, and swaps. A brief consideration of these categories will help illustrate the way in which they may be used by firms such as Southwest, typically with the aim of reducing some form of risk as part of a wider risk management strategy.

Types of Derivative Instruments

A forward is one of the oldest types of derivative, with records demonstrating its use as long ago as 2000 BCE in India (Markham, 1987). A forward is a contract in which there is an agreement to buy, borrow, sell, or lend a specific amount of a commodity at a specific time in the future for a specific price. Forward contracts are individually negotiated, so their terms and conditions vary from contract to contract (Howells and Bain, 2007).

Futures are similar to forwards in that they are agreements for a transaction to take place in the future for a set amount of a commodity or asset at a set price. Unlike forwards, however, futures are standardized contracts that are fungible and easily traded on secondary markets (Sundaram, 2010). This ease of trading increases their potential use as a speculative tool (Sundaram, 2010). While these are useful instruments, Southwest Airlines does not currently use futures or forwards in its hedging program, as the airline now requires a higher level of flexibility following losses incurred through the use of futures in the past. Instead, the hedging program currently utilizes only options and swaps.

An option is similar to a future, but rather than entering into a binding commitment to undertake a transaction, the contract gives the purchaser the right—but not the obligation—to undertake that transaction. Two types of option exist: a call option, which confers the right to buy, and a put option, which confers the right to sell. After purchasing the option, the contract owner decides whether to exercise it by comparing the price of the underlying asset specified in the contract with the current spot price. If the owner does not exercise the option by the specified date, it simply expires. It is notable that there are differences between options sold in the US and those sold in European markets: US options can be exercised at any time during the life of the contract, whereas European options can only be exercised on the specified expiration date (Sundaram, 2010). Southwest purchases US options to protect its exposure as part of its fuel hedging strategy (Southwest Airlines, 2012).

The last of the main derivative types is the swap. Swaps are more recent instruments than the derivatives discussed above, having been developed in 1981 (Sundaram, 2010). A swap is a contract in which two parties agree to exchange two different types of payment. Several varieties of swaps exist, including interest rate swaps and exchange rate swaps. Southwest utilizes swaps in both its fuel hedging program and its interest rate hedging strategy (Southwest Airlines, 2012).

Different types of derivatives may therefore be used to create contractual arrangements that increase certainty—or, more precisely, reduce uncertainty—in transactions that a business must undertake. One of the primary uses of derivatives is in the practice of hedging. Hedging is utilized by firms to protect an "open" position. An open position exists where an organization has exposure to potential losses depending on how market prices of commodities or underlying assets move, yet regardless of those price movements the organization will still need to make a purchase or complete the relevant transaction.

Hedging: Definition, Mechanics, and Basis Risk

Hedging is a financial tool that can help reduce an organization's exposure to market price movements. Giddy (2002) defines hedging as a financial tool that facilitates the transformation of "unacceptable risks into an acceptable form… The goal of any hedging program should be to help the corporation achieve the optimal risk profile that balances the benefits of protection against the costs of hedging." The practice of hedging may be carried out using a range of financial tools, with derivatives being the most commonly utilized (Cusatis and Thomas, 2005).

There are two potential forms of hedging: short hedging and long hedging. Short hedging involves purchasing a contract for the sale of a commodity, while long hedging involves acquiring a contract for the purchase of—or the right to purchase—a commodity at a future date (Howells and Bain, 2007). Because Southwest Airlines' open position relates to the acquisition of fuel, the strategy it follows is long hedging, utilizing options and swaps.

At face value, Southwest Airlines undertakes this strategy as a method of reducing risk exposure. However, it is notable that a number of airlines do not pursue similar strategies, and in some countries—such as China—companies were not permitted to use derivatives for hedging until 2008.

Gibbons (2011) argues that undertaking hedging can be viewed as a conservative approach, effectively equivalent to purchasing an insurance policy that limits the maximum price the firm will pay for a commodity in the future. However, it must also be recognized that while this insurance policy may help reduce exposure to commodity price volatility, it simultaneously creates a different form of risk exposure known as basis risk.

Basis risk arises from the potential difference between the spot price of a commodity and the agreed price for the underlying commodity in the derivative contract. The derivative price reflects market expectations of future influences on the commodity, whereas the spot price is the current market price (Sundaram, 2010). In an ideal scenario, the difference between the derivative contract price and the spot price would converge toward zero as the contract approaches maturity (Chorafas, 2008). However, this convergence does not always occur due to the asymmetrical nature of the marketplace (Chorafas, 2008). In addition to information asymmetries, unexpected intervening events can also affect spot prices (Chorafas, 2008). The greater the difference between the contract price and the spot price, the greater the potential basis risk. It may be argued that using options rather than futures or forwards reduces the level of basis risk, since the company is not necessarily committed to making a purchase if the spot price falls below the contract price. Nevertheless, this does not eliminate risk entirely, as the company will still have incurred the cost of purchasing the option contract in the first place. The firm is therefore swapping one type of risk for another.