Good Finance Derivatives Project: A Case Of Fuel Hedging Report Example
There are numerous ways how the financial markets work. Perhaps the most popular option for someone who wants to get both of his feet wet in the world of trading in the financial markets is to be familiar with how common shares of well-established companies get bought and sold in the stock exchange. Some people who fear even slight amounts of investment risks would prefer to engage in fixed income security investing. These people are known to choose to buy corporate and government bonds and even preferred shares of well-established and high dividend paying companies over the more risky choice which are common shares. But then again, there is more to the financial markets than just these plain choices of securities. Derivatives, just like other any other security, are traded in stock markets. Derivatives are often considered as high risk securities. This is mainly because of the often high leverage associated with derivatives trading. Additionally, derivatives trading are one of the areas of the financial market where investor speculation levels are high.
Basically, a derivative is just like any security that is traded on the exchange with one distinct characteristic: its price is not dependent on the performance of a corporation or on the supply and demand curves of a commodity but on the price of an underlying asset . The next ordeal now would be to define what underlying assets can be used as an anchor by these derivatives. Stocks, bonds, and commodities are some of the assets that are being used as the anchor for most derivatives. It is also important to note that unlike most securities whose price can only be anchored on one factor or variable, the price of most derivatives is not often anchored to the price of one security only. Because of the numerous connections that it has with other securities and or assets, it is generally deemed as a risky choice of investment security.
One of the most common uses of derivatives is for hedging . Hedging is synonymous to the term to protect. That is, hedging is done mostly by investors and businessmen who are uncertain about the future of their business. In order to explain how derivatives are used in hedging by businesses and investors, an example scenario wherein a derivative has been used as a form of hedge against uncertainty in the market and the overall economy. Suppose we have American Airlines, one of the largest airline companies in the United States. Airline companies generate revenue by transporting passengers, cargoes, and shipments from one point to another via their airplanes. These airline companies generate profit by making sure that the revenue they generate from passenger ticket sales and sales of cargo and shipment spaces outweigh the total cost of operating the entire business.
Some of the major expenses of airline companies include but may not be limited to rental fees, utility fees, employee salary, maintenance of the infrastructures and the aircrafts used in daily operations, and jet fuel fees . Among the ones that have been mentioned, jet fuel fees account for the biggest share in the total operating costs of the business. According to estimates, jet fuel fees account for roughly 50 percent of the total operating costs of an airline company . This means that an increase in the price of jet fuel would have a negative effect on the company’s net income because it constitutes a large percentage of its operating expenses and that a sharp decrease in its price would be substantially good for the business for the same reason.
The ideal situation for airline companies, of course, is a situation where the price of the largest component of the expenses portion of its balance sheet is on a sharp decline, which is what is actually happening today. Since last year, oil prices have dropped by approximately 50 percent or by half of its price over a year ago; and experts are signaling that the prices have not yet reached a bottom . The dominance of the bear in the oil market is one of the major reasons why most hedge fund managers and administrators of airline companies have started to shift towards a different direction when it comes to investing in future contracts.
Futures contracts are the most common forms of derivatives. This group of derivatives is the most commonly used means by financial institutions and businesses to hedge their investment and business against any untoward fluctuations in the market. In this case, we are talking about airline companies and one of the most important considerations for airlines companies is the price of jet fuel because after all it constitutes roughly fifty percent of their total operating expenses. The manager of any airline company would want for their company to enjoy the benefits of low and stable fuel prices and one way to do that is to predict any possible movement of fuel prices in the market. In today’s situation, for example, most airline company managers have been shocked by how low the prices of oil dropped. From a high of $115 per barrel a couple of years ago, the price per barrel of oil now sits at around $40 to $50. One way how airline managers can take advantage of this huge dive in oil prices is by securing futures contracts in the market. Futures contracts are, from the name itself, a contractual agreement that is generally made on the trading floor of futures and derivatives exchange signaling the buying and or selling of a particular commodity (i.e. oil) at a set or fixed price in the future.
So, if airline companies are expecting the price of oil (i.e. jet fuel) to rebound soon, then they could take advantage of the current dip by locking the price of all their future oil purchases to the current spot market price. This can be done via futures contract investing. It is important to note that the price of oil is a major determinant in knowing the price of jet fuels and that they have a directly proportional relationship.
Suppose American Airlines was able to secure a futures contract that enables them to purchase jet fuel at a fixed price of $50 per barrel for the next two years. Now, let us assume that after the first year, the price of jet fuel has returned to a new high of $100 per barrel and that that price stayed at that level for the remainder half of the duration of the futures contract (i.e. for another one year). This means that because American Airlines was able to secure a futures contract with a two year duration when the spot price of jet fuel was at $50 per barrel, they would still be able to buy their jet fuels at that price even though the spot market price of jet fuel now stands at $100 per barrel. In order to compute for American Airlines’ savings (which we can also compute using the formula for computing profits) for every barrel of jet fuel they would purchase, we simply have to use this equation: (Price Sold – Purchase Price) / (Purchase Price) with the answer multiplied by 100 to give us a percentage point as the answer. This would give us ((100-50)/(50)) x 100. The answer is 100%. This means that for every barrel of jet fuel American Airlines would purchase, they were able to hedge a total of $50 which is 100% of their original purchase price when jet fuel was trading at $50. Of course, this is how the ideal scenario should work and in order for this idea scenario to work, the company’s purchasing analysts should be able to predict the movement of the prices correctly or else, they would be on the losing side of the equation.
Suppose American Airlines was able to lock in a two year contract of jet fuel purchase at as set price of $50 per barrel via a futures contract derivative sale in the market. But instead of going higher, the price of jet fuel went down further to $25 per barrel, then that would only mean that American Airlines would have to pay twice the price of the spot market price of jet fuel for every barrel of jet fuel that they would purchase. That is equivalent to a 100 percent loss for every jet fuel purchase initiated.
The hedging strategy using derivatives can be turned upside down. The rationale behind the use of the downward trend in jet fuel prices as the underlying scenario is to make the paper more relevant to what is presently happening to the prices of oil and jet fuels. Hedges can be used both in a bear and bull market. In order to fully take advantage of the large changes in prices of derivatives, the company or the financial analyst should be able to predict the price movements correctly. Otherwise, instead of being able to hedge against a downward or an upward price trend and converting such hedges to gains, the company would suffer from losses.
Carter, D., Rogers, D., & Simkins, B. (2004). Does Fuel Hedging Make Economic Sense? The Case of the US Airline Industry. AFA.
Carter, D., Rogers, D., & Simkins, B. (2006). Heding and Value in the U.S. Airline Industry Abstract. Journal of Applied Corporate Finance, 21-33.
Cobbs, R., & Wolf, A. (2004). Jet Fuel Hedging Strategies: Options Available for Airlines and a Survey of Industry Practices. Unpublished Manuscript.
Gulliver, N. (2015). Fuel hedging and airlines: Gambles that haven't paid off. The Economist.
Mulla, H. (2014). Why are Oil Prices Dropping. Forbes.
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