Showing papers on "Fixed price published in 1970"

Does Hedging Reduce Risk? Analysis of Large Domestic Airlines

Abstract: In this paper two approaches are applied to understand the hedging behavior of companies which compete in the American airline industry (2007-2014) as they seek to cope with the uncertain, future costs of jet fuel The first measures the risk that jet fuel prices will fall, a matter of concern to airlines that hedge against rising jet fuel prices, for when jet fuel prices fall, those airlines that have hedged lose money on their hedges The second describes the risk of hedging or not by using some of the tools of game theory Two different cases are investigated In the first case airlines compete against one another in a market structure where it is assumed that whether one airline hedges is of no immediate concern to its rivals In this first case hedging decisions of one airline produce no effects upon other airlines In the second case airlines compete against one another in the context of an oligopoly Hedging decisions of one airline are connected to the hedging decisions of other airlines If some airlines hedge jet fuel costs while at the same time others do not, winners and losers are created among the competing airlines The problem here is that while hedging can fix the price of jet fuel, it cannot guarantee that this fixed price will be lower than the price paid by a rival that did not hedge The last part of this paper is an empirical data analysis of the differences in jet fuel costs, net of hedging results, is conducted The null hypothesis that all airlines have equal jet fuel costs after hedge results are accounted for could not be rejected at any reasonable level of confidence INTRODUCTION The only purpose of a hedge is to reduce risk There are different hedge strategies available Some fix the price of an input Other strategies locate the input price below an upper bound or within a range defined by upper and lower bounds Consider the case of an airline wishing to mitigate the effects of an increase in jet fuel prices This airline may agree to purchase some portion of its future jet fuel usage at a fixed price known today by way of either a forward pricing contract or a swap contract, thus shifting the risk that jet fuel prices might increase to the speculator who takes the other side of the forward contract or the swap contract (Futures contracts are often used as substitutes for forward contracts) Or an airline may construct a collar around current jet fuel prices A collar could be constructed by purchasing call options on jet fuel with the exercise price of these calls somewhat above the current level jet fuel prices and by selling put options on jet fuel with the exercise price of these puts somewhat below current jet fuel prices The effect of this collar would be to fix jet fuel costs within a known range of jet fuel prices There are other hedging strategies Perhaps the simplest is to buy calls with exercise prices well above the current level of jet fuel prices to insure against a large price increase in jet fuel Readers interested in the nuts and bolts of creating hedges using call options, put options, forward contracts, futures contracts, and swap contracts may consult Hull (2009) There are real-world problems with every hedge There are often problems of basis risk: in some markets jet fuel derivatives are not available, not available in sufficient quantity, or too expensive relative to contracts that are highly correlated with jet fuel price movements A solution to these difficulties might be to use derivative contracts on heating oil instead of contracts on jet fuel But heating oil is not the same thing as jet fuel, so the price movements of heating oil and those of jet fuel may be highly correlated, but these changes are not identical A perfect hedge is impossible in these instances There are also financial problems that must be addressed Creating hedges requires collateral (margin) to secure performance and/ or cash to make hedge investments …