Fine-Tuning a Corporate Hedging Portfolio: the Case of an Airline

JOURNAL OF APPLIED CORPORATE FINANCE JOURNAL OF APPLIED CORPORATE VOLUME 25 | NUMBER 4 | FALL 2013 Journal of APPLIED CORPORATE FINANCE Journal of Applied Corporate Finance c/o Wiley-Blackwell 350 Main Street Malden, MA 02148-5018 In This Issue: Risk Management Risk Management Navigating the Changing Landscape of Finance 8 James Gorman, Chairman and CEO, Morgan Stanley Reforming Banks Without Destroying Their Productivity and Value 14 Charles W. Calomiris, Columbia University How Companies Can Use Hedging to Create Shareholder Value 21 René Stulz, Ohio State University Do Trading and Power Operations Mix? 30 John E. Parsons, MIT Sloan School of Management Aligning Incentives at Systemically Important Financial Institutions: 37 The Squam Lake Group A Proposal by the Squam Lake Group Managing Pension Risks: A Corporate Finance Perspective 41 Gabriel Kimyagarov, Citigroup Global Markets, and Anil Shivdasani, University of North Carolina at Chapel Hill Synthetic Floating-Rate Debt: An Example of an Asset-Driven Liability Structure 50 James Adams, J.P. Morgan Securities, and Donald J. Smith, Boston University Hedge Fund Involvement in Convertible Securities 60 Stephen J. Brown, New York University; Bruce D. Grundy Uni- VOLUME 25 VOLUME versity of Melbourne; Craig M. Lewis, Vanderbilt University; and Patrick Verwijmeren, Erasmus University Rotterdam Fine-Tuning a Corporate Hedging Portfolio: The Case of an Airline 74 Mathias Gerner, European Business School and Ehud I. Ronn, University of Texas at Austin | NUMBER 4 A Primer on the Economics of Shale Gas Production 87 Larry W. Lake, University of Texas; John Martin, Baylor The Simon Business School is ranked #7 in the world Just How Cheap is Shale Gas? University; J. Douglas Ramsey, EXCO Resources, Inc.; and for finance and #8 for accounting by the Financial Times. Sheridan Titman, University of Texas In addition to the flagship two-year MBA program and several | Evidence from German Companies of Effects of Corporate 97 Julita M. Bock, Otto von Guericke University one-year master’s degree programs at its main campus FALL in Rochester, New York, Simon offers one-year, part-time Risk Management on Capital Structure Decisions master’s degree programs in finance and management at its 2013 New York City location. Designed for working professionals, with alternate weekend classes in midtown Manhattan and residency weeks to further complement the classroom instruction, these programs feature senior Simon faculty, small class sizes, and personalized program support. For additional details, please visit www.simon.rochester.edu. Fine-Tuning a Corporate Hedging Portfolio: The Case of an Airline by Mathias Gerner, European Business School* and Ehud I. Ronn, University of Texas at Austin* here is now a large body of academic research The Airline’s Hedging Strategy that attempts to explain why companies hedge Airlines are heavily exposed to fluctuations in jet fuel prices. T the risks arising from volatility in commodity Moreover, there are several factors that complicate strategies prices, foreign exchange, interest rates, and other for hedging such exposures. Although major commodity such “financial prices.” In recent years, there has also been a exchanges such as ICE and NYMEX have listed futures and number of academic papers on how companies should hedge, options on crude oil and various refined products, these do including discussions of optimal corporate hedging practices not include futures on jet fuel. As a result, many airlines, involving the use of linear futures-like contracts as well as including the one in this case study, use derivatives based nonlinear option-like contracts. But because actual corporate on crude oil or heating oil.4 There may also be a discrepancy hedging practices are typically confidential, these theoretical between a firm’s desired hedging horizon and the maturi- studies have generally been of limited use to practitioners.1 ties available for standardized derivative contracts. Finally, Studies of airline industry hedging activities, for example, exchanges require hedgers to post cash-variation margin for have been forced to rely on information from publicly avail- futures and short options positions, and this requirement can able sources, such as 10-K reports. And most academic studies be onerous for cash-strapped airlines. of corporate hedging have focused primarily on the question For all those reasons, airlines often find over-the-counter of whether there is a discernible relationship between the (“OTC”) derivatives offered by financial institutions prefer- firm’s hedging activities and its value.2 able to standard exchange-traded contracts. The high degree In this paper, we provide a case study involving in-depth of flexibility inherent in OTC derivatives—especially those analysis of an international air carrier’s actual jet-fuel price that provide payoffs based on average prices during a specific hedging strategy and compare it with an optimized mix delivery month—allows airlines to match their financing of derivatives. We also explain how the airline’s financial requirements and hedging objectives. strength, fuel price-and-quantity correlations, and risk We found that four major considerations influence the profile relate to that optimal mix of derivatives. With this airline’s hedging decision: air carrier’s specific objectives in mind, we recommend a 1. The firm’s financial strength and current credit rating; hedging strategy that proposes the use of a specific custom- 2. The correlations between the volumes of fuel it ized derivative: annually-settled Asian options. We show consumes and the prices it pays; how this derivative can be used to protect the airline against 3. Its fixed and variable transaction costs; and jet-fuel price fluctuations at reasonable cost while also 4. Its internal risk profile. preserving the corporate liquidity that can be jeopardized While these four considerations cannot easily be trans- by some hedging instruments.3 lated into quantitatively measurable rules, the overall hedging * The authors acknowledge with thanks the financial support of the European Busi- conclude jet-fuel hedging is positively related to market values. Results show U.S. air- ness School Endowed Chair of Corporate Finance and Capital Markets for its support of lines engaging in hedging activities increase their firm value by roughly 14%. See “Fuel Mathias’ doctoral studies. They also thank the Department of Finance at the McCombs Hedging in the Airline Industry: The Case Study of Southwest Airlines,” Working Paper, School of Business, University of Texas at Austin for support of a summer visiting re- Oklahoma State University and Portland State University, 2004; “Does Hedging Affect search assistantship extended to Mathias. Previous drafts of this paper were presented Firm Value: Evidence from the U.S. Airline Industry,” in Financial Management, 35(1), at the March 2012 22nd Annual Derivatives Securities and Risk Management Confer- 53–86, 2006; and “Hedging and value in the U.S. Airline Industry” in this Journal of ence, Case Western Reserve University, Tulane University and the University of Alberta. Applied Corporate Finance, 18(4), 21–33, 2006. The comments and feedback of Ulrich Hommel, the executives of the airline whose jet- 3. Our analysis and recommendations are consistent with, and serve to confirm, the fuel hedging portfolio is examined here and the editors of this Journal are readily ac- theoretical findings of a 2001 study by University of North Carolina professor Greg knowledged. The authors are solely responsible for any errors in the paper. Brown and Goldman Sachs’ Klaus Toft that demonstrated how non-financial companies 1. For example of such papers, see “On the Optimal Mix of Corporate Hedging Instru- can optimize their hedging portfolios by using customized options. See Gregory Brown ments: Linear Versus Nonlinear Derivatives,” by Gerald Gay, Jouahn Nam and Marian and Klaus Toft, “How Firms Should Hedge,” Review of Financial Studies, 15(4), 1283- Turac in the Journal of Futures Markets, 23(3), 217–239, 2003; and “Managing Long 1324; 2001. and Short Price-and-Quantity Exposure at the Corporate Level,” a Working Paper at the 4. Jet-fuel is a kerosene-like middle distillate. The prices of crude oil, home heating University of Texas at Austin by Sergey Kolos and Ehud Ronn. oil and jet-kerosene are highly correlated as the latter two are derived physically from the 2. The balance of evidence suggests that hedging does create value. Most notable are former in the refining process. papers by David Carter and Betty Simkins of Oklahoma State and Daniel Rogers of Port- land State. Studying the hedging behavior of U.S. airlines between 1992 and 2003, they 74 Journal of Applied Corporate Finance • Volume 25 Number 4 Fall 2013 Figure 1 Continuous Hedging Approach (Expressed as a Percentage of the Expected Crude Oil Consumption at Time t) 100% 80% 60% 40% Hedging Ratio 20% 0% t-1 t-5 t-9 t-13 t-17 t-21 Time strategy recognizes these factors. And since management does time and cash flow to make the necessary operating changes. not have a specific quantitative optimization framework, it Such a gradual approach, which is illustrated in Figure relies instead on experience and rules of thumb. 1, begins with the airline hedging volumes equal to 5% An airline’s credit rating heavily influences the kinds of of its expected fuel consumption 24 months in the future. hedges it can obtain in the OTC market as well as the cost of With each passing month, the airline hedges another 5% those hedges. A high credit rating allows the firm to choose of expected volumes until the hedged position amounts to from a broad range of hedging instruments,5 some of which— approximately 85%-90% of the total six months prior to for example, a “collar” involving the purchase of a call and the actual consumption. This 24-month time horizon corre- sale of a put—are likely to involve the financial institution sponds to the airline’s confidence in its ability to forecast accepting some credit exposure to the airline.

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