Fuel Hedging in the Airline Industry

1Fuel Hedging in the Airline Industry: The Case of Southwest Airlines “If we don’t hedge jet fuel price risk, we are speculating. It is our fiduciary duty to try and hedge this risk.” Scott Topping, Director of Corporate Finance for Southwest Airlines June 12, 2001: Scott Topping, the Director of Corporate Finance for Southwest Airlines (hereafter referred to as “Southwest”), was concerned about the cost of fuel for Southwest. High jet fuel prices over the past 18 months had caused havoc in the airline industry. Scott knew that since the industry was deregulated in 1978, airline profitability and survival depended on controlling costs. 1 After labor, jet fuel is the second largest operating expense for airlines. If airlines can control the cost of fuel, they can more accurately estimate budgets and forecast earnings. It was Scott’s job to hedge fuel costs, however, he knows that jet fuel prices are largely unpredictable. As shown in Figure 1, jet fuel spot prices (Gulf Coast) have been on an overall upward trend since reaching a low of 28.50 cents per gallon on December 21, 1998. On September 11, 2000, the Gulf Coast jet fuel spot price was 101.25 cents/gallon – a whopping increase of 255 % in the spot price since the low in 1998. The prior day’s (June 11, 2001) spot price for Gulf Coast jet fuel closed at a price of 79.45 cents/gallon. While this price was lower than the highest level, Scott knew that future jet fuel prices would be uncertain. Figure 2 illustrates the high volatility of jet fuel prices. As shown, historical daily volatility over a recent 25-day period for Gulf Coast has averaged 58.7 percent. 2 Clearly, fuel price risk is an important concern for airlines. 1 One of the most important events in the history of the airline industry was the Deregulation Act passed by U.S. Congress in 1978. This act removed all government controls over fares and domestic routes for the first time and gave airlines the opportunity to operate as true businesses. 2 For example, at the price of 79.45 cents/gallon for jet fuel, there is a 68% probability that the price will change by as much as +/-46.63 cents/gallon (i.e. 79.45 x 0.587). This means that there is a 68 percent probability that the price will range from 32.8 to 126.0 cents/gallon. Using a recent 10-week average volatility of 30.5% (data not shown), Paper #9100933 2 As a result of fuel price increases during the later half of 1999 and throughout 2000, Southwest’s fuel and oil expense per available seat-mile (ASM) for the year 2000 increased 44.1 percent over that for 1999. 3 As shown in Table 1, Southwest’s average price per gallon of jet fuel in 2000 was $0.7869 compared to $0.5271 in 1999. 4 About Southwest Airlines Southwest was formed in 1971 by Rollin King and Herb Kelleher and the airline began with three Boeing 737 aircraft serving the Texas cities -- Dallas, Houston, and San Antonio. The airline began with one simple strategy: “If you get your passengers to their destinations when they want to get there, on time, at the lowest possible fares, and make darn sure they have a good time doing it, people will fly your airline.” 5 This strategy has been the key to Southwest’s success. The airline realized early on that air travel would become a commodity business. In May 1988, Southwest became the first airline to win the coveted Triple Crown for a month – Best On-time Record, Best Baggage Handling, and Fewest Customer Complaints. Since then, the airline has won five annual Triple Crowns: 1992, 1993, 1994, 1995, and 1996. In addition to being a top quality airline, Southwest was also innovative. They were the first airline with a frequent flyer program to give credit for the number of trips taken and not the number of miles flown. Additionally, they pioneered senior discounts, same-day airfreight delivery service, ticketless travel, and many other unique programs. By the year 2000, the small Texas airline had evolved to become the 4 th largest U.S. carrier based on domestic passengers boarded and the largest U.S. carrier based on scheduled domestic departures. At year-end 2000, Southwest operated 344 Boeing 737 aircraft and provided service to 58 airports in 57 cities in 29 states throughout the U.S. In 2000, Southwest commenced service to Albany and Buffalo, New York, and in January 2001, to West Palm Beach, Florida. Tables 2 and 3 provide Southwest Airlines’ consolidated statement of income and consolidated balance sheet, respectively, for the years 1999 and 2000. Historically, Southwest has experienced some seasonality in their business. For example, quarterly operating income and, to a lesser extent, revenues tend to be lower in the first quarter. In 2000, quarterly operating income represented 22 percent of annual operating income. Fuel Hedging in the Airline Industry there is a 68% probability that the price will change by as much as 24.23 cents/gallon. Given that Southwest spent $484.7 million on jet fuel in the year 2000, there is a 68 % change that jet fuel can fluctuate by as much as $ 147.8 million using the 10 week volatility average (i.e. 0.303 x $484.7 million). 3 See the appendix for a glossary of airline terms. 4 These prices are net of the following gains from hedging -- approximately $113.5 million in 2000 and $14.8 million in 1999. 5 Refer to “We Weren’t Just Airborne Yesterday”, Southwest Airlines – A Brief History, http://www.southwest.com/. Paper #9100933 3 Airlines executives know that it is often impossible to pass higher fuel prices on to passengers by raising ticket prices due to the highly competitive nature of the industry. Because large airlines compete with one another on most of the routes they serve, they have little power to raise prices in response to higher fuel costs. For example, Continental Airlines rescinded a fare hike after trying a number of times to boost overall fares. The airline said the airfare increases were due to high fuel costs, but intense airline competition has left the firm unable to pass along fuel costs to customers. 6 Table 4 provides information on competition in the airline industry for both passenger airlines (Panel A) and airfreight carriers (Panel B). As shown in Panel A, Southwest Airlines holds a 5.51% market share based on total available seat miles flown over the period 1994-2000. Over the same period, Southwest holds a much smaller share of the freight market (see Panel B). By 2000, Southwest was the fourth largest carrier in the US based on passengers flown and the largest based on departures (see previous section). Obviously, competition is a top concern for Southwest. With air travel becoming a commodity business, being competitive on price is the key to survival and success. As Warren Buffett states: “You cannot be the high-cost producer in a commodity business. Sometimes it’s not even any good to be the low-cost producer.” (McCartney, Michaels, and Rogers, 2002). Airlines that want to prevent huge swings in operating expenses and bottom line profitability choose to hedge fuel prices. In fact, Raymond Neidl (see Neidl and Chiprich, 2001) points out that “the carriers that produced an adequate return, especially in the second half of 2000, tended to be those that had good fuel hedge positions in place.” Airlines without hedges in place had disappointing earnings or losses. For example, in the fourth quarter 2000, US Airways, which was unhedged, estimated that its $88 million net loss would have been a profit of $38 million if their fuel costs had not increased. Airlines are different from most commodity users or producers in that it usually the airline company’s treasury department (rather than the fuel purchasers) that handles fuel hedging. Fuel price risk management techniques were adopted by airlines around 1989 (Clubley, 1999). Airlines use derivative instruments based on crude oil, heating oil, or jet fuel to hedge their fuel cost risk. The majority of airlines rely on plain vanilla instruments to hedge their jet fuel costs, including swaps, futures, call options (including average price options which are a type of call option), and collars (including zero-cost collars). There are two main reasons why several fuels other than jet fuel are used in jet fuel hedging by airlines. The first reason requires a brief explanation of refining. When refiners process crude oil, the main products are gasoline, middle distillates (heating oil, diesel fuel, and jet kerosene) and residual fuel oil. Refiners often refer to these products as top, middle, or bottom of the barrel, respectively. Products from the same part of the barrel share similar characteristics, and as a result, the prices are highly correlated. 7 Hence, heating oil, which shares similar 6 See “Continental Raises Domestic Fares, Cites Fuel Costs” (Reuters, February 27, 2004) and “Continental Airlines Resends Latest Fare Hike” (Reuters, June 7, 2004). 7 Jet fuel is a essentially pure kerosene with some additives. Two products from the barrel not mentioned above are the gas liquids like butane at the very top and asphalt at the very bottom. Paper #9100933 4 characteristics to jet fuel, is frequently used in hedging by airlines. Also, since jet fuel is refined from crude oil, crude oil is also used in hedging by airlines due to high price correlation. The second reason why airlines use several fuels in hedging is because jet fuel is not a sufficiently liquid market to warrant a futures contract or other type of exchanged-traded contract. As a result, derivative contracts for jet fuel must be arranged on the over-the-counter (OTC) markets. However, there are active and liquid markets for exchange-traded contracts on crude oil and heating oil in New York (the New York Mercantile Exchange, NYMEX) and for gasoil in London (the International Petroleum Exchange, IPE). 8 While exchange-traded products offer high liquidity and low credit risk, typically these contracts are standardized and inflexible, meaning that users often face large basis risk. The term “basis risk” is used to describe the risk that the value of the commodity being hedged may not change in tandem with the value of the derivative contract used to hedge the price risk. While crude oil, heating oil, and jet fuel prices are highly correlated, significant basis risk can emerge if the relationship between the commodities breaks down. In an ideal hedge, the hedge would match the underlying position in every respect, removing any change of basis risk. However, in actuality, basis risk is a high concern, even if the derivatives contract is for the exact same commodity being hedge. More specifically, in the futures markets, basis is defined as the differential between the cash price of a given commodity and the price of the nearest futures contract for the same, or a related commodity. 9 Hence, basis risk when hedging using futures contracts refers to the risk of the differential changing over the life of the hedge. Why does basis risk occur? The following three basis risks occur frequently in hedging: product basis risk, time basis risk, and locational basis risk. Product basis risk occurs when there is a mismatch in the quality, consistency, weight, or underlying product. For example, airlines frequently use crude oil contacts to hedge jet fuel, but obviously crude oil and jet fuel are two different commodities and hence have large product basis risk. Even within the same commodity category, such as crude oil, product basis risk occurs because there are many types of crude oil varying in viscosity (such as heavy versus light crude) and sulfur content (sweet versus sour crude). Time basis risk occurs when there is a mismatch in the time of the hedge. For example, if a hedger wishes to hedge long-term but only has short dated contracts available, time basis risk is very significant. 10 Locational basis risk, one of the most common types of basis risk, 8 Gas oil is the European designation for No. 2 heating oil and diesel fuel. 9 Refer to “A Guide to Energy Hedging” published by the New York Mercantile Exchange. 10 For one of the most famous examples of time basis risk, refer to Metallgesellschaft Refining and Marketing (MGRM), which was an American subsidiary of Metallgesellschaft (MG), an international trading, engineering, and chemicals conglomerate. In 1992, MGRM implemented what it believed to be a profitable marketing strategy. The company agreed to sell specified amounts of petroleum products every month, for up to ten years, at fixed prices that were higher than the current market price. MGRM then purchased short-term energy futures to hedge the long-term commitments - a "stack" hedging strategy. This timing mismatch caused MGRM to go bankrupt. The MGRM hedge also illustrates another type of hedging risk: "funding risk" - the risk that positions which may be profitable in the long run can bankrupt a company in the short run if negative cash flows are mismatched with positive cash flows. For a short summary of the MGRM hedging disaster, refer to http://www.erisk.com/Learning/CaseStudies/ref_case_mg.asp. Paper #9100933 5 occurs when there is a mismatch in the price of the product from one location to another, a mismatch in the delivery point for the derivatives contract, among others. While such extreme breakdowns in correlations are rare, hedgers should be aware of basis risk. Julian Barrowcliffe, director of global commodity swaps at Merrill Lynch (Schap, 1993) stated: “Some of the largest hedging losses have resulted from the assumption that heating oil and jet kerosene were essentially the same product and heating oil futures could hedge jet. At times, they haven’t tracked each other at all.” For example, in late 1990 when Iraq invaded Kuwait (which precipitated the first Gulf War), the differential between European jet fuel and heating oil quickly increased to more than five times the usual margin. As shown in Figure 3, the spread between jet fuel and heating oil for the Gulf Coast location increased to 28.5 cents per gallon. This is 8.1 times the average spread of 3.5 cents per gallon and represents a 714% increase relative to the average spread (i.e. (28.5 – 3.5)/ 3.5). It is important to note that since this period of time, basis risk fundamentals between jet fuel and heating oil or crude oil have improved. This is due primarily to the fact that there is significantly more storage of jet fuel in the Middle East now, which places less price pressure on jet fuel in periods of higher demand due to military conflict. Frequently Used Fuel Hedging Instruments by Airlines This section describes the most commonly used hedging contracts by airlines: swap contracts (including plain vanilla, differential, and basis swaps), call options (including caps), collars (including zero-cost and premium collars), futures contracts and forwards contracts. Plain Vanilla Swap The plain vanilla energy swap (called this because it is simple and basic when compared to more exotic swap contracts) is an agreement whereby a floating price is exchanged for a fixed price over a certain period of time. It is an off-balance-sheet financial arrangement, which involves no transfer of the physical item. Both parties settle their contractual obligations by means of a transfer of cash. In a fuel swap, the swap contract specifies the volume of fuel, the duration (i.e., the maturity of the swap), and the fixed and floating prices for fuel. The differences between fixed and floating prices are settled in cash for specific periods (usually monthly, but sometimes quarterly, semi-annually, or annually). Figure 4 illustrates fuel hedging using two types of swap contracts. Example 1 in the figure describes how a plain vanilla jet fuel swap arranged in the OTC market is used. Example 2 illustrates fuel hedging on the organized exchanges using a highly liquid contract -- the NYMEX New York Heating Oil Calendar Swap contract. In all swap contracts, the airline is usually the fixed-price payer, thus allowing the airline to hedge fuel price risk. For more information on these contracts, refer to the NYMEX website at http://www.NYMEX.com. Differential Swaps and Basis Risk Paper #9100933 6 While a plain vanilla swap is based on the difference between the fixed and floating prices for the same commodity, a differential swap is based on the difference between a fixed differential for two different commodities and their actual differential over time. Differential swaps can be used by companies to manage the basis risk from other hedging activities. For instance, assume an airline prefers to hedge its jet fuel exposure using a heating oil plain vanilla swap. The airline can used an additional swap contract, the differential swap for jet fuel versus heating oil, to hedge basis risk assumed from the heating oil swap. The net result is that the airline can eliminate the risk that jet fuel prices will increase more than heating oil prices. Basis risk can be an important concern for cross-hedges of this type. For more information on differential swaps, refer to Chapter 1 of Falloon and Turner (1999). Call Options (Caps) A call option is the right to buy a particular asset at a predetermined fixed price (the strike) at a time up until the maturity date. OTC options in the oil industry are usually cash settled while exchange-traded oil options on the NYMEX are exercised into futures contracts. OTC option settlement is normally based on the average price for a period, commonly a calendar month. Airlines like settlement against average prices because an airline usually refuels its aircraft several times a day. Since the airline is effectively paying an average price over the month, they typically prefer to settle hedges against an average price (called average price options). In the energy industry, options are often used to hedge cross-market risks, especially when market liquidity is a concern. For example, an airline might buy an option on heating oil as a cross-market hedge against a rise in the price of jet fuel. Of course, cross-market hedges should only be used if the prices are highly correlated. Airlines such as Southwest value the flexibility that energy options provide, but energy options can be seen as expensive relative to other options. The reason is the high volatility of energy commodities, which causes the option to have a higher premium. For this reason, zero-cost collars (discussed next) are often used. Figure 5 provides a conceptual illustration for hedging gains or losses using swaps, call options, and premium collars when locking into a 60-cent/gallon price of jet fuel. Collars, Including Zero-Cost and Premium Collars A collar is a combination of a put option and a call option. For a hedger planning to purchase a commodity, a collar is created by selling a put option with a strike price below the current commodity price and purchasing a call option with a strike price above the current commodity price. The purchase of a call option provides protection during the life of the option against upward commodity price movements above the call strike price. The premium received from selling the put option helps offset the cost of the call option. By establishing a collar strategy, a minimum and maximum commodity price is created around a hedger’s position until the expiration of the options. Figure 6 provides an example of the net cost of jet fuel in $/gallon using a collar where a call option is purchased with a $0.80 strike price and a put option is sold with $0.60 strike price. As shown, the airline will never pay more than $0.80 for jet fuel no matter how high prices rise, yet will never pay less than $0.60 regardless of how low jet fuel Paper #9100933 7 prices drop. A collar can be structured so that the premium received from the sale of the put option completely offsets the purchase price of the call option. This type of collar is called a “zero cost collar.” If more protection against upward price movements is desired (i.e., having a lower call option strike price) or more benefit from declining prices is desired (i.e., selling a put with a lower strike price), a premium collar is used. With a premium collar, the cost of the call option is only partially offset by the premium received from selling a put option. Refer to Figure 5 for a conceptual illustration of the premium collar strategy. Using a zero-cost collar or premium collar may appear to be a reasonable hedging strategy for an airline since it involves no upfront cost (or low upfront cost) and involves no speculative return. However, if jet fuel prices fall significantly, as illustrated in Figure 6, the airline may pay more for jet fuel than its competitors who did not employ the collar strategy. Competitors may lower their airfares aggressively as a result. Accordingly, the zero-cost collar should be more accurately called a “zero-upfront cost” collar. Futures and Forward Contracts A futures contract is an agreement to buy or sell a specified quantity and quality of a commodity for a certain price at a designated time in the future. The buyer has a long position, which means he/she agrees to make delivery of the commodity (i.e., purchase the commodity). The seller has a short position, which means he/she agrees to make delivery of the commodity (i.e., sell the commodity). Futures contracts are traded on an exchange, which specifies standard terms for the contracts (e.g., quantity, quality, delivery, etc.) and guarantees their performance (removing counterparty risk). Only a small percentage of futures contracts traded result in delivery of the commodity (less than one percent in the case of energy contract). Instead, buyers and sellers of futures contracts generally offset their position. A forward contract is the same as a futures contract except for two important distinctions: (1) Futures contracts are standardized and traded on organized exchanges, whereas forward contracts are typically customized and not traded on an exchange; and (2) Futures contracts are marked to market daily, whereas forward contracts are settled at maturity only. For the futures contract, this means that each day during the life of the contract, there is a daily cash settlement depending on the current value of the commodity being hedged. The NYMEX exchange trades futures on crude oil, heating oil, and gasoline (among other commodities). Table 5 illustrates how a fuel hedger can use the NYMEX heating oil futures contract to hedge jet fuel price risk. As shown, the hedger purchases a futures contract at 66.28 cents per gallon (futures contract size is 42,000 gallons) in January. On the same day, the New York jet fuel spot price is 80.28 cents per gallon. If the hedger closes out this futures contract for 42,000 gallons on August 29, 2000 at 98.59 cents per gallon, he/she has made a profit of 32.31 cents per gallon (98.59 minus 66.28). The spot price of NY jet fuel on August 29th is 103.6 cents per gallon. (Note: If the hedger had not hedged, he would have paid 23.32 cents/gallon more for the fuel.) However, by using the futures contract and purchasing jet fuel in the spot market, the gain of 32.31 on the futures more than offsets the 23.32 increase in jet fuel prices. In essence, the Paper #9100933 8 hedger’s net cost of jet fuel is 71.29 cents per gallon (i.e., 103.6 spot price in August minus the futures hedging gain of 32.31 cents/gallon). Accounting for Derivatives According to SFAS 133 The Financial Accounting Standards Board (FASB) issued Statement 133 to make a company’s exposure to its derivative positions more transparent. Prior to SFAS 133, most derivatives were carried off-balance sheet and reported only in footnotes to the financial statements. Under SFAS 133, depending on the reason for holding the derivative position and the derivative’s effectiveness in hedging, changes in the derivatives’ fair value is recorded either in the income statement or in a component of equity known as other comprehensive income. Table 6 summarizes the balance sheet and income statement impacts of cash flow hedges, fair value hedges, and speculative transactions under SFAS 133. Under SFAS 133, managers such as Scott Topping that want their hedge to receive hedge accounting treatment, must be certain their hedge will pass the effectiveness measure. To qualify, the manager must measure the effectiveness of the hedge at least each reporting period for the entire duration of the hedge. Any ineffective portion or excluded portion of the change in derivative value must be reported directly to earnings. According to the FASB, hedge effectiveness should take into account both historical performance (retrospective test) and anticipated future performance (prospective test). The FASB has provided only broad guidelines for testing hedge effectiveness. The FASB has two suggested approaches to measure historical performance: the “80-125 rule” and the correlation method. According to the “80-125 rule” (also referred to as the dollar-value-offset method), a hedge is deemed effective if the ratio of the change in value of the derivative to the change in value of the hedged item falls between 80 % and 125%. Shown in equation form: Effectiveness measure = Σ n i=2 (∆P H ) i ⁄ Σ n i=2 (∆P D ) i Where: (∆P H ) i = (P H ) i - (P H ) i-1 (∆P D ) i = (P D ) i - (P D ) i-1 P H = the daily price of the hedged item P D = the daily price of the derivative i = trading day i n = total number of trading days in the period According to the correlation measure, a hedge is deemed effective if the correlation between the changes in the value of the hedged item and the derivative is high. In other words, a hedge should be considered effective if the R-squared of the regression of this relation is around 80 percent. Furthermore, the slope of the regression line should be close to 1.0 (but this is not explicitly referred to in SFAS 133). For more information on measuring hedge effectiveness, refer to Kalotay and Abreo (2001), Risk Books (1999), and Energy Information Administration (2002), among others. Paper #9100933 9 June 12, 2001 Senior management asked Scott to propose Southwest’s hedging strategy for the next one to three years. Because of the current high price of jet fuel, Scott was unsure of the best hedging strategy to employ. Table 7 provides Southwest’s hedging practices at year-end 2000 as discussed in their annual report. Because Southwest adopted SFAS 133 in 2001, Scott needed to consider this in his hedging strategy. Southwest’s average fuel cost per gallon in 2000 was $0.7869, which was the highest annual average fuel cost per gallon experienced by the company since 1984. As discussed previously, fuel and oil expense per ASM increased 44.1 percent in 2000, primarily due to the 49.3 percent increase in the average jet fuel cost per gallon. (Refer to Table 1: The average price per gallon of jet fuel in 2000 was $0.7869 compared to $0.5271 in 1999.) Although Scott thought the price of jet fuel would decrease over the next year, he cannot be sure – energy prices are notoriously hard to predict. Scott knew that: “Predicting is very difficult, especially as it concerns the future” (Chinese Proverb). Any political instability in the Middle East could cause energy prices to rise dramatically without much warning. If the cost of jet fuel continued to rise, the cost of fuel for Southwest would rise accordingly without hedging. On the other hand, if the cost of jet fuel declines, the cost of fuel would drop if Southwest were unhedged. To deal with these risks, Scott identified the following 5 alternatives. Scott estimated Southwest’s jet fuel usage to be approximately 1,100 million gallons for next year. 1. Do nothing. 2. Hedge using a plain vanilla jet fuel or heating oil swap. 3. Hedging using options. 4. Hedge using a zero-cost collar strategy. 5. Hedge using a crude oil or heating oil futures contract. Appendix 2 contains information on NYMEX futures contracts and futures options contracts, both for crude oil and heating oil. For alternative 2 above (i.e. hedging using a plain vanilla crude oil or heating oil swap), there were two different possibilities: 11 (1) Enron offered Scott an over-the-counter plain vanilla jet fuel swap with a 1-year maturity. The offer stipulated a fixed rate for Southwest Airlines of 76 cents/gallon. The variable rate was based on the monthly average price for Gulf Coast jet fuel. Contract payments would be made monthly during the life of the contract. The size of the swap contract was one million gallons and for simplicity, assume that Enron was willing to 11 For the swap contract, use 1/12 th of the hedge volume since the contracts are settled monthly over the one-year period. In other words, for the 100% hedging, use swap contracts for a total of 1,100 million gallons divided by 12 = 91.67 swap contracts (or round to 92 contracts). Paper #9100933 10 enter into as many of these swap contracts as Southwest Airlines wanted. This swap was similar to that explained in Example 1 of Figure 4. (2) Scott also considered a NYMEX New York Heating Oil Calendar Swap (1-year duration). The contract size was 42,000 gallons. The contract guaranteed a fixed rate for Southwest Airlines of 73 cents/gallon for heating oil. The variable rate was based (per NYMEX regulations) on the arithmetic average of the NYMEX New York Harbor heating oil futures nearby month settle price for each business day during the month. Contract payments would be made monthly during the life of the contract. This is similar to Figure 4 (see Example 2). Appendix 3 (see the first figure) contains information on the relation between jet fuel costs and airline stock prices (11 major airlines). Note the negative correlation between the two lines. Appendix 4 illustrates monthly load factors for U.S. domestic flights. As shown, demand varies significantly by month and demand is highest in the summer months. The Excel file (Jet Fuel Hedging Case Excel Data for Students.xls) contains historical prices for jet fuel (spot), heating oil (spot and futures), and crude oil (spot and futures). Paper #9100933 11 Case Questions 1. Why do firms like Southwest hedge? What are the benefits of hedging? (Suggestion: refer to Carter, Rogers, and Simkins (2004) for assistance in answering this question.) 2. Does heating oil or crude oil more closely follow the price of jet fuel? To answer this question, use the information in the Excel spreadsheet. 3. (a) Evaluate each of the five proposed hedging strategies. What are the benefits of each hedge based on two fuel price scenarios in one year? In other words, assume in June 2002 that one of these scenarios occurs. Calculate your net cost of jet fuel under each scenario incorporating the hedging strategies used. (Note: you can analyze the hedges under as many price scenarios as you wish, but be certain to include the following two scenarios.) For both scenarios, consider full hedging and a 50% hedge strategy. SCENARIO 1: 39.3 cents/gallon spot price for jet fuel; 38.8 cents/gallon spot price for heating oil, or $14.10 per barrel spot price for crude oil, and SCENARIO 2: 119.6 cents/gallon spot price for jet fuel; 118.6 cents/gallon spot price for heating oil, and $40,00 per barrel spot price for crude oil. (b) Discuss the pros and cons of each hedging strategy. (c) Describe how a combination of the hedging strategies can be used. 4. What are the risks of being unhedged? Totally hedged? (Note: the February 24, 2004 Wall Street Journal article titled “Outside Audit: Jet-Fuel Bets Are Risky Business” by Melanie Trottman may be useful.) 5. (a) What is basis risk and how is it different from price risk? (b) What are the implications of a changing basis? (c) Does basis risk exist for Southwest Airlines in their fuel hedging program? 6. (a) What is FAS 133 and how does it impact a firm’s hedging strategy? (b) Using the effectiveness measure on page 6, calculate the effectiveness of hedges using heating oil futures and crude oil futures for the period 2000-2001 (up until the time of the case). How does the effectiveness measure impact a firm’s hedging decision. 7. Describe how a market in backwardation or contango (i.e. shape of the forward curve) might impact hedging strategies. Are current crude oil markets in backwardation or contango? (Note: Backwardation is the market situation when futures prices are progressively lower in the distant delivery months when compared to the nearest (prompt) month. Contango, the opposite of backwardation, is a market situation in which prices in later delivery months are progressively higher than in the nearest delivery (prompt) month.) 8. What do you recommend to Scott Topping? Why? Paper #9100933 12 References Clubley, Sally, 1999, “An Early Take Off”, Risk (May), (see pg. 7 of Commodity Risk Special Report in the issue). Carter, David A., Dan Rogers, and Betty J. Simkins, 2004, “Does Fuel Hedging Make Economic Sense? The Case of the U.S. Airline Industry”, Oklahoma State University working paper. Energy Information Administration, 2002, Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity Industries (October), U.S. Department of Energy. Falloon, William and David Turner, editors, 1999, Managing Energy Price Risk, Risk Publications (London). Kalotay, Andrew and Leslie Abreo, 2001, “Testing Hedge Effectiveness for FAS 133: The Volatility Reduction Measure”, Journal of Applied Corporate Finance Vol. 13 (No. 4), 93-99. McCartney, Scott, Daniel Michaels, and David Rogers, 2002, “Airlines Seek More Government Aid”, The Wall Street Journal, September 23, 2002, (pages A1, A10). Neidl, Raymond E. and Erik C. Chiprich, 2001, Major U.S. Carriers 2000 Results and 2001 Outlook, Global Research, Ing-Barings. Reuters, 2004, “Soaring Jet Fuel Prices Threaten Airlines’ Bottom Lines”, March 10. Schap, Keith, 1993, “Jet Fuel Swaps Ground Risk”, Futures (February), 44-46. Trottman, Melanie, 2004, “Outside Audit: Jet-Fuel Bets Are Risky Business”, Wall Street Journal, February 24, page C3. Paper #9100933 13 Table 1 Fuel Usage and Hedging Data for Southwest Airlines Exposure variables Hedging variables Fiscal year ends Year Hedge Fuel? Fuel Used (Million Gallons) Fuel Cost ($million) Cost of Fuel ($ per gallon) Available Seat Miles (ASM) (millions) Cost/ ASM Total Expenses ($ Millions) Fuel as a % of Expenses Total Revenue ($ Millions) Fuel Cost (% of Revenue) Gallons Hedged (millions) % of Next Year Hedged Longest Maturity of Hedges (yrs) 31-Dec 2000 Yes 1022.2 $ 804.4 $ 0.7869 59,910 $ 0.0081 $ 4,628 10.5% $ 5,649 8.6% N/A 80.00% 3.00 31-Dec 1999 Yes 939.1 $ 495.0 $ 0.5271 52,855 $ 0.0094 $ 3,954 12.5% $ 4,736 10.5% 126.10 86.00% >1 31-Dec 1998 Yes 850.3 $ 388.3 $ 0.4567 47,544 $ 0.0082 $ 3,480 11.2% $ 4,164 9.3% 290.00 33.00% 0.50 31-Dec 1997 Yes 792.4 $ 495.0 $ 0.6246 44,487 $ 0.0111 $ 3,293 15.0% $ 3,817 13.0% not material not material N/A 31-Dec 1996 Yes 740.3 $ 484.7 $ 0.6547 40,727 $ 0.0119 $ 3,055 15.9% $ 3,406 14.2% not material not material N/A 31-Dec 1995 Yes 662.2 $ 365.7 $ 0.5522 36,180 $ 0.0101 $ 2,559 14.3% $ 2,873 12.7% 1.05 2.00% <1 31-Dec 1994 Yes 592.6 $ 319.6 $ 0.5392 32,124 $ 0.0099 $ 2,275 14.0% $ 2,592 12.3% 2.10 5.00% <1 Paper #9100933 14 Table 2 SOUTHWEST AIRLINES CO. CONSOLIDATED STATEMENTS OF INCOME YEARS ENDED DECEMBER 31, (In thousands, except per share amounts) 2000 1999 1998 ----------- ----------- ----------- OPERATING REVENUES: Passenger $ 5,467,965 $ 4,562,616 $ 4,010,029 Freight 110,742 102,990 98,500 Other 70,853 69,981 55,451 ----------- ----------- ----------- Total operating revenues 5,649,560 4,735,587 4,163,980 OPERATING EXPENSES: Salaries, wages, and benefits (Note 10) 1,683,689 1,455,237 1,285,942 Fuel and oil 804,426 492,415 388,348 Maintenance materials and repairs 378,470 367,606 302,431 Agency commissions 159,309 156,419 157,766 Aircraft rentals 196,328 199,740 202,160 Landing fees and other rentals 265,106 242,002 214,907 Depreciation (Note 2) 281,276 248,660 225,212 Other operating expenses 859,811 791,932 703,603 ----------- ----------- ----------- Total operating expenses 4,628,415 3,954,011 3,480,369 ----------- ----------- ----------- OPERATING INCOME 1,021,145 781,576 683,611 OTHER EXPENSES (INCOME): Interest expense 69,889 54,145 56,276 Capitalized interest (27,551) (31,262) (25,588) Interest income (40,072) (25,200) (31,083) Other (gains) losses, net 1,515 10,282 (21,106) ----------- ----------- ----------- Total other expenses (income) 3,781 7,965 (21,501) ----------- ----------- ----------- INCOME BEFORE TAXES AND CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE 1,017,364 773,611 705,112 PROVISION FOR INCOME TAXES (NOTE 11) 392,140 299,233 271,681 ----------- ----------- ----------- INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE 625,224 474,378 433,431 CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE, NET OF INCOME TAXES (NOTE 2) (22,131) -- -- ----------- ----------- ----------- NET INCOME $ 603,093 $ 474,378 $ 433,431 =========== =========== =========== NET INCOME PER SHARE, BASIC BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE $ 1.25 $ .94 $ .87 CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE (.04) -- -- ----------- ----------- ----------- NET INCOME PER SHARE, BASIC $ 1.21 $ .94 $ .87 =========== =========== =========== Paper #9100933 15 Table 3 SOUTHWEST AIRLINES CO. CONSOLIDATED BALANCE SHEETS (In thousands, except per share amounts) DECEMBER 31, 2000 1999 ------------ ------------ ASSETS Current assets: Cash and cash equivalents $ 522,995 $ 418,819 Accounts and other receivables (Note 7) 138,070 75,038 Inventories of parts and supplies, at cost 80,564 65,152 Deferred income taxes (Note 11) 28,005 20,929 Prepaid expenses and other current assets 61,902 52,657 ----------- ----------- Total current assets 831,536 632,595 Property and equipment, at cost (Notes 3, 5, and 6): Flight equipment 6,831,913 5,768,506 Ground property and equipment 800,718 742,230 Deposits on flight equipment purchase contracts 335,164 338,229 ----------- ----------- 7,967,795 6,848,965 Less allowance for depreciation 2,148,070 1,840,799 ----------- ----------- 5,819,725 5,008,166 Other assets 18,311 12,942 ----------- ----------- $ 6,669,572 $ 5,653,703 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 312,716 $ 266,735 Accrued liabilities (Note 4) 499,874 430,506 Air traffic liability 377,061 256,942 Current maturities of long-term debt (Note 5) 108,752 7,873 ----------- ----------- Total current liabilities 1,298,403 962,056 Long-term debt less current maturities (Note 5) 760,992 871,717 Deferred income taxes (Note 11) 852,865 692,342 Deferred gains from sale and leaseback of aircraft 207,522 222,700 Other deferred liabilities 98,470 69,100 Stockholders' equity (Notes 8 and 9): Common stock, $1.00 par value: 1,300,000 shares authorized; 507,897 and 505,005 shares issued in 2000 and 1999, respectively 507,897 505,005 Capital in excess of par value 103,780 35,436 Retained earnings 2,902,007 2,385,854 Treasury stock, at cost: 3,735 and 5,579 shares in 2000 and 1999, respectively (62,364) (90,507) ----------- ----------- Total stockholders' equity 3,451,320 2,835,788 ----------- ----------- $ 6,669,572 $ 5,653,703 =========== =========== Paper #9100933 16 Table 4 Market Share of US Airlines This table presents the market share of passenger-only or combined passenger and cargo carriers (designated as passenger airlines) in Panel A and cargo-only carriers (designated as airfreight carriers) in Panel B. Major airlines are defined as airlines with annual revenues of more than $1 billion, and regional airlines are those carriers with annual revenues less than $1 billion. ASM stands for available seat miles and represents one seat flown one mile. Average revenues are calculated as the average over 1994-2000 and market share in Panel A is calculated as the percentage of total ASM for the period 1994-2000. Panel A: Market Share of Passenger Carriers Based on Available Seat Miles. Airline Average Revenue ($ Millions) Total Available Seat Miles (1994-2000) Market Share Based on ASM Major Airlines United Airlines 16,796 1,168,894.0 20.52% American Airlines 16,913 1,126,177.0 19.77% Delta Air Lines 13,528 966,188.0 16.96% Northwest Airlines 9,750 657,477.6 11.54% Continental Airlines 7,356 498,731.0 8.75% US Airways Group 8,240 418,607.0 7.35% Southwest Airlines 3,891 313,827.9 5.51% America West Holdings 1,879 160,005.0 2.81% Alaska Air Group 1,746 119,565.0 2.10% Regional Airlines Amtran 880 94,232.6 1.65% Hawaiian Airlines 423 38,455.1 0.67% Airtran Holdings 360 27,787.1 0.49% Midwest Express Holdings 347 17,603.5 0.31% Mesa Air Group 452 16,966.4 0.30% Comair Holdings 517 15,113.9 0.27% Frontier Airlines 151 14,992.8 0.26% SkyWest 291 12,147.6 0.21% Mesaba Holdings 235 12,054.7 0.21% Midway Airlines 200 9,775.3 0.17% Atlantic Coast Airlines 253 8,642.7 0.15% Total 5,697,244.20 100.00% Paper #9100933 17 Table 4. Continued Panel B: Market Share of Cargo Carriers based on Freight Ton-miles (in Millions) Airfreight Carrier Freight Ton-miles (in Millions) Market Share Based on Freight Ton-miles FedEx 7,401.9 31.71% United Parcel Service 4,339.1 18.59% United Airlines 2,529.9 10.84% Northwest Airlines 2,205.1 9.45% American Airlines 1,916.7 8.21% Delta Airlines 1,435.0 6.15% Atlas Air 1,048.3 4.49% Continental Airlines 995.1 4.26% Airborne Express 887.0 3.80% US Airways 277.7 1.19% TransWorld Airlines 129.6 0.56% Southwest Airlines 69.1 0.30% Alaska Air 57.4 0.25% Hawaiian Airlines 53.7 0.23% Total 23,345.60 100.00% Note: FedEx, United Parcel Service, Atlas Air, and Airborne Express are cargo-only carriers. The other firms listed are primarily passenger airlines. Paper #9100933 18 Table 5 Example of a Jet Fuel Cross-hedge Using the NYMEX Heating Oil Futures Contract On January 6, 2000, a fuel purchasing director wants to hedge his September jet fuel consumption at current prices. He buys a September New York Harbor heating oil futures contract on the NYMEX at 66.28 cents per gallon (contract size is for 42,000 gallons). On the same day, the New York jet fuel spot price is 80.28 cents per gallon. The director closes out this futures contract on August 29, 2000 at 98.59 cents per gallon. As shown below, the director has made a profit of 32.31 cents per gallon (98.59 minus 66.28) on the futures contract. In essence, the hedger bought a futures contract (a long hedge) in January and then sold back the futures contract in August. The spot price of NY jet fuel on August 29th is 103.6 cents per gallon. Without the futures hedge, the director would have paid 23.32 cents/gallon more for the fuel. However, by using the futures contract and purchasing jet fuel in the spot market, the gain of 32.31 on the futures offsets the 23.32 increase in the jet fuel spot price. As a result, the director’s net cost of jet fuel is 71.29 cents per gallon (i.e. 103.6 spot price in August minus the futures hedging gain of 32.31 cents/gallon). Cash Price (i.e. Spot Price) Futures Price Basis (Cash price minus futures price) January 6 cash price 80.28 cents/gallon 66.28 cents/gallon 14.00 cents/gallon August 29 cash price 103.6 cents/gallon 98.59 5.01 32.31 cents/gallon gain 8.99 cents/gallon basis loss Result: Cash purchase price of jet fuel 103.6 cents/gallon Minus heating oil futures gain - 32.31 cents/gallon Net purchase price of jet fuel 71.29 cents/gallon Paper #9100933 19 Table 6 Statement of Financial Accounting Standards 133 (SFAS 133) Balance Sheet and Income Statement Impacts of Cash Flow and Fair Value Hedges This table summarizes the balance sheet and income statement impacts of hedging according to SFAS 133. Type of Derivative Balance Sheet Impact Income Statement Impact Cash Flow Hedge Derivative (asset or liability) is reported at fair value. Changes in fair value of derivative are reported as components of Other Comprehensive Income (balance sheet) No immediate income statement impact. Changes in fair value of derivatives are reclassified into the income statement (from Other Comprehensive Income in the balance sheet) when the expected (hedged) transaction affects the net income. Derivative must qualify for hedge accounting treatment. Fair Value Hedge Derivative (asset or liability) is reported at fair value. Hedged item is also reported at fair value. Changes in fair value are reported as income/loss in the income statement. Offsetting changes in fair value of the hedged item are also reported as an income/loss in the income statement Speculative Transaction Derivative (asset or liability) is reported at fair value Changes in the fair value are reported as income/loss in the income statement. Paper #9100933 20 Table 7 Disclosures on Hedging From Southwest Airlines’ 2000 Annual Report FINANCIAL DERIVATIVE INSTRUMENTS The Company utilizes a variety of derivative instruments, including both crude oil and heating oil based derivatives, to hedge a portion of its exposure to jet fuel price increases. These instruments consist primarily of purchased call options, collar structures, and fixed price swap agreements. The net cost paid for option premiums and gains and losses on fixed price swap agreements, including those terminated or settled early, are deferred and charged or credited to fuel expense in the same month that the underlying jet fuel being hedged is used. Hedging gains and losses are recorded as a reduction of fuel and oil expense. Beginning January 1, 2001, the Company will adopt Statement of Financial Accounting Standards No. 133 (SFAS 133), Accounting for Derivative Instruments and Hedging Activities which will change the way it accounts for financial derivative instruments. See Recent Accounting Developments. RECENT ACCOUNTING DEVELOPMENTS In 1998, the Financial Accounting Standards Board (FASB) issued SFAS 133. SFAS 133, as amended, is required to be adopted in fiscal years beginning after June 15, 2000. The Company will adopt SFAS 133 effective January 1, 2001. SFAS 133 will require the Company to record all derivatives on its balance sheet at fair value. Derivatives that are not designated as hedges must be adjusted to fair value through income. If the derivative is designated as a hedge, depending on the nature of the hedge, changes in the fair value of derivatives that are considered to be effective, as defined, will either offset the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or will be recorded in other comprehensive income until the hedged item is recorded in earnings. Any portion of a change in a derivative's fair value that is considered to be ineffective, as defined, may have to be immediately recorded in earnings. Any portion of a change in a derivative's fair value that the Company has elected to exclude from its measurement of effectiveness, such as the change in time value of option contracts, will be recorded in earnings. The Company will account for its fuel hedge derivative instruments as cash flow hedges, as defined. Although the fair value of the Company's derivative instruments fluctuates daily, as of January 1, 2001, the fair value of the Company's fuel hedge derivative instruments was approximately $98.3 million, of which approximately $75.8 million was not recorded in the Consolidated Balance Sheet. The $75.8 million will be recorded as an asset on the Company's balance sheet as part of the transition adjustment related to the Company's adoption of SFAS 133. The offset to this balance sheet adjustment will be an increase to "Accumulated other comprehensive income", a component of stockholders' equity. The portion of the transition adjustment in "Accumulated other comprehensive income" that relates to 2001 hedge positions, based on fair value as of January 1, 2001, is approximately $73.9 million and will be reclassified into earnings during 2001. The remainder of the transition amount will be reclassified to earnings in periods subsequent to 2001. The Company believes the adoption of SFAS 133 will result in more volatility in its financial statements than in the past. Paper #9100933 21 Figure 1 OPIS Regional Jet Fuel Prices 25 45 65 85 105 125 1 / 3 / 1 9 9 4 4 / 3 / 1 9 9 4 7 / 3 / 1 9 9 4 1 0 / 3 / 1 9 9 4 1 / 3 / 1 9 9 5 4 / 3 / 1 9 9 5 7 / 3 / 1 9 9 5 1 0 / 3 / 1 9 9 5 1 / 3 / 1 9 9 6 4 / 3 / 1 9 9 6 7 / 3 / 1 9 9 6 1 0 / 3 / 1 9 9 6 1 / 3 / 1 9 9 7 4 / 3 / 1 9 9 7 7 / 3 / 1 9 9 7 1 0 / 3 / 1 9 9 7 1 / 3 / 1 9 9 8 4 / 3 / 1 9 9 8 7 / 3 / 1 9 9 8 1 0 / 3 / 1 9 9 8 1 / 3 / 1 9 9 9 4 / 3 / 1 9 9 9 7 / 3 / 1 9 9 9 1 0 / 3 / 1 9 9 9 1 / 3 / 2 0 0 0 4 / 3 / 2 0 0 0 7 / 3 / 2 0 0 0 1 0 / 3 / 2 0 0 0 1 / 3 / 2 0 0 1 4 / 3 / 2 0 0 1 Date U . S . C e n t s / G a l l o n OPIS Chicago Jet 54 OPIS Gulf Coast Jet 54 OPIS Los Angeles Jet 54 OPIS N.Y. Harbor Jet 54 OPIS San Francisco Jet 54 Paper #9100933 22 Figure 2 Historical Gulf Coast Spot Jet Fuel Price Volatility COMPUTING VOLATILITY (Standard Deviation) Results: Periodic Annualized Variance 0.001378 0.344570998 Standard Deviation (i.e. VOLATILITY) 3.71% 58.70% Mean -0.06% N/A Obs. Date Jet Fuel Price Simple Rate of Return Continuously Compounded Rate of Return Squared Deviation 1 1/2/2001 86.8 NA NA NA 2 1/3/2001 81.65 -5.93% -6.12% 0.003741 3 1/4/2001 82.8 1.41% 1.40% 0.000196 4 1/5/2001 85.83 3.66% 3.59% 0.001292 5 1/8/2001 82.13 -4.31% -4.41% 0.001942 6 1/9/2001 79.98 -2.62% -2.65% 0.000704 7 1/10/2001 86 7.53% 7.26% 0.005267 8 1/11/2001 84.43 -1.83% -1.84% 0.000339 9 1/12/2001 85.4 1.15% 1.14% 0.000130 10 1/16/2001 87.75 2.75% 2.71% 0.000737 11 1/17/2001 87.25 -0.57% -0.57% 0.000033 12 1/18/2001 90.15 3.32% 3.27% 0.001069 13 1/19/2001 91.47 1.46% 1.45% 0.000211 14 1/22/2001 92.4 1.02% 1.01% 0.000102 15 1/23/2001 91.82 -0.63% -0.63% 0.000040 16 1/24/2001 85.88 -6.47% -6.69% 0.004473 17 1/25/2001 89 3.63% 3.57% 0.001273 18 1/26/2001 93.25 4.78% 4.66% 0.002176 19 1/29/2001 90.13 -3.35% -3.40% 0.001158 20 1/30/2001 85.83 -4.77% -4.89% 0.002390 21 1/31/2001 86.78 1.11% 1.10% 0.000121 22 2/1/2001 82.84 -4.54% -4.65% 0.002159 23 2/2/2001 87.83 6.02% 5.85% 0.003421 24 2/5/2001 87.3 -0.60% -0.61% 0.000037 25 2/6/2001 87.95 0.74% 0.74% 0.000055 26 2/7/2001 87.63 -0.36% -0.36% 0.000013 Totals Count= 25 0.033079 Paper #9100933 23 Figure 3 Price Spread Between Jet Fuel and Heating Oil for Gulf Coast Prompt 0 5 10 15 20 25 30 M a r - 9 0 J u l - 9 0 N o v - 9 0 M a r - 9 1 J u l - 9 1 N o v - 9 1 M a r - 9 2 J u l - 9 2 N o v - 9 2 M a r - 9 3 J u l - 9 3 N o v - 9 3 M a r - 9 4 J u l - 9 4 N o v - 9 4 M a r - 9 5 J u l - 9 5 N o v - 9 5 M a r - 9 6 J u l - 9 6 N o v - 9 6 M a r - 9 7 J u l - 9 7 N o v - 9 7 M a r - 9 8 J u l - 9 8 N o v - 9 8 M a r - 9 9 J u l - 9 9 N o v - 9 9 M a r - 0 0 J u l - 0 0 N o v - 0 0 Date S p r e a d ( J e t F u e l - H e a t i n g O i l ) i n C e n t s / G a l l o n Source: Bloomberg Paper #9100933 24 Figure 4 Fuel Hedging Using Swap Contracts Example 1 using a Plain Vanilla Jet Fuel Swap Arranged in the OTC Market Typically, the airline pays a fixed price and receives a floating price, both indexed to expected jet fuel use during each monthly settlement period. The volume of fuel hedged is negotiated because this is a customized contract. During the life of the swap contract, the airline buys jet fuel in the cash market, as usual, but the swap contract makes up the difference when prices rise and removes the difference when prices decline. The result for the airline is a fixed price for the period covered. The fixed rate payment is set based on market conditions when the swap contract is initiated. The floating price of jet fuel is commonly based on Platt’s New York Harbor jet fuel price and is calculated monthly using daily prices for the month. The net monthly payment (or cost) to the fixed-rate payer is the floating rate minus the fixed rate. For example, if the floating rate for a month averages 80 cents per gallon and the fixed rate is 70 cents per gallon, then the floating rate payer makes a 10 cents per gallon payment that month to the airline. If the size of the contract is 100,000 gallons, a payment of $10,000 is made to the airline (i.e. $0.10 x 100,000). Example 2 using the NYMEX New York Harbor Heating Oil Calendar Swap The NYMEX New York Heating Oil Calendar Swap lets hedgers arrange positions in the heating oil market as far forward as 36 months. The price settlement of the contract is based on the arithmetic average of the NYMEX New York Harbor heating oil futures nearby month settlement price for each business day during the contract month. The swap contract is for 42,000-gallons – the same size as the NYMEX heating oil futures contract. Consider an 18- month swap currently trading with a fixed-price of 0.6841 cents/gallon. Suppose the futures average daily price for the month was 0.5900. The hedger who is long the futures contract (such as the airline) will make a payment to the counterparty of $3952.20 [i.e. (0.6841 – 0.5900) x 42,000]. The airline would purchase jet fuel in the spot market. Assuming the basis has not changed between jet fuel and heating oil (i.e. the high correlation between heating oil and jet fuel remains unchanged), the loss on the futures contract will be offset by the lower cash price of jet fuel. As a result, the airline effectively pays a fixed price for jet fuel. Counterparty is Floating-rate payer Pay fixed rate of $X per gallon per the swap contract Airline receives floating rate based on monthly average jet fuel price Airline is Fixed-rate payer Paper #9100933 25 Figure 5 Swap, Call Option, and Premium Collar Illustration Paper #9100933 26 Figure 6 Net Cost of Jet Fuel Using a Collar Strategy (Buy 80 Cent/Gallon Call and Sell 60 Cent/Gallon Put) 0 10 20 30 40 50 60 70 80 90 3 0 3 3 3 6 3 9 4 2 4 5 4 8 5 1 5 4 5 7 6 0 6 3 6 6 6 9 7 2 7 5 7 8 8 1 8 4 8 7 9 0 9 3 9 6 9 9 1 0 2 1 0 5 1 0 8 1 1 1 1 1 4 1 1 7 1 2 0 1 2 3 1 2 6 1 2 9 1 3 2 1 3 5 1 3 8 Price of Jet Fuel in Cents per Gallon N e t C o s t o f J e t F u e l U s i n g a C o l l a r S t r a t e g y Paper #9100933 27 Appendix 1 Glossary of Airline Terms Aircraft (average during period): The average number of aircraft operated during the period. Aircraft utilization: The average number of block hours operated in scheduled service per day per aircraft for the total fleet of aircraft. Available seat miles (ASMs): The number of seats available for scheduled passengers multiplied by the number of miles those seats were flown. Average fare: The average fare paid by a revenue passenger. Average seats per departure: The average number of available seats per departing aircraft. Average stage length: The average number of miles flown per flight. Block hour: The total time an aircraft is in motion from brake release at the origination to brake application at the destination. Break-even load factor: The load factor at which scheduled passenger revenues would have been equal to operating plus non-operating expenses/(income) (holding yield constant). Cost per available seat mile (CASM): Operating expenses plus non-operating expenses/(income) divided by ASMs. Departure: A scheduled aircraft flight. Fuel price per gallon: The average price per gallon of jet fuel for the fleet (excluding into plane fees) Load factor: RPMs divided by ASMs. Onboard passengers: The number of revenue passengers carried. Revenue passenger miles (RPMs): The number of miles flown by revenue passengers. Passenger revenue per available seat mile (PRASM): Passenger revenues divided by ASMs. Yield: The average scheduled passenger fare paid for each mile a scheduled revenue passenger is carried. Paper #9100933 28 Appendix 2 Futures Options Data as per Barrons on 6-11-01 (NYMEX) CRUDE OIL CALLS CRUDE OIL PUTS Month Strike Volume Premium Month Strike Volume Premium Jul-01 $27.50 706 $1.05 Jul-01 $24.00 1,792 $0.01 Jul-01 $28.00 3,610 $0.71 Jul-01 $25.00 1,274 $0.02 Jul-01 $28.50 3,085 $0.47 Jul-01 $25.50 881 $0.03 Jul-01 $29.00 5,122 $0.29 Jul-01 $26.00 2,145 $0.04 Jul-01 $29.50 2,659 $0.18 Jul-01 $26.50 750 $0.07 Jul-01 $30.00 8,575 $0.10 Jul-01 $27.00 4,005 $0.12 Jul-01 $30.50 708 $0.06 Jul-01 $27.50 1,583 $0.22 Jul-01 $31.00 2,463 $0.04 Jul-01 $28.00 5,128 $0.38 Jul-01 $32.00 4,086 $0.02 Jul-01 $36.00 506 $0.01 Aug-01 $28.00 1,966 $1.43 Aug-01 $23.00 535 $0.05 Aug-01 $28.50 4,054 $1.16 Aug-01 $24.00 761 $0.07 Aug-01 $29.00 2,930 $0.91 Aug-01 $25.00 1,022 $0.12 Aug-01 $29.50 4,892 $0.73 Aug-01 $26.00 2,957 $0.24 Aug-01 $30.00 6,127 $0.58 Aug-01 $26.50 1,003 $0.33 Aug-01 $31.00 1,726 $0.34 Aug-01 $27.00 2,026 $0.46 Aug-01 $31.50 1,012 $0.26 Aug-01 $27.50 1,017 $0.62 Aug-01 $32.00 7,880 $0.19 Aug-01 $28.00 5,064 $0.80 Aug-01 $33.00 1,880 $0.13 Aug-01 $35.00 2,309 $0.09 Aug-01 $40.00 1,161 $0.02 Aug-01 $45.00 1,000 $0.01 Sep-01 $28.00 750 $1.75 Sep-01 $24.00 733 $0.16 Sep-01 $28.50 921 $1.48 Sep-01 $25.00 921 $0.28 Sep-01 $29.00 900 $1.22 Sep-01 $26.50 810 $0.59 Sep-01 $30.50 700 $0.71 Sep-01 $27.50 1,200 $0.92 Sep-01 $33.00 1,371 $0.26 Sep-01 $28.00 1,708 $1.12 Sep-01 $34.00 4,305 $0.18 Sep-01 $31.00 500 $2.93 Oct-01 $28.00 675 $1.92 Oct-01 $20.00 815 $0.06 Oct-01 $33.00 945 $0.39 Oct-01 $24.00 520 $0.27 Oct-01 $34.00 2,430 $0.29 Oct-01 $27.00 655 $1.02 Oct-01 $28.00 525 $1.42 Nov-01 $32.00 2,700 $0.63 Nov-01 $20.00 1,250 $0.10 Nov-01 $24.00 3,325 $0.40 Dec-01 $27.50 568 $2.24 Dec-01 $22.00 1,055 $0.22 Dec-01 $28.00 602 $1.89 Dec-01 $23.00 5,850 $0.34 Dec-01 $29.00 500 $1.46 Dec-01 $25.00 2,750 $0.77 Dec-01 $30.00 579 $1.14 Dec-01 $26.00 3,151 $1.08 Dec-01 $34.00 600 $0.42 Dec-01 $27.50 650 $1.67 Apr-02 $26.50 525 $2.50 Jun-02 $22.50 900 $1.80 Jun-02 $26.00 1,287 $2.61 Jun-02 $20.50 950 $0.56 Jun-02 $28.00 600 $1.80 Dec-03 $23.00 700 $2.91 Dec-03 $23.00 700 $2.65 Paper #9100933 29 Futures Data as per Barrons on 6-11-01 Heating Oil (NYMEX HO) 42,000 gallons per contract (cents/gallon) Month Week’s High Week’s Low Week’s Settle Open Interest Jul 01 78.40 75.00 76.65 29,709 Aug 01 78.35 75.70 77.12 19,087 Sep 01 78.90 76.30 77.77 12,679 Oct 01 79.55 77.50 78.52 7,415 Nov 01 80.35 78.10 79.27 9,606 Dec 01 80.90 78.80 79.82 21,185 Jan 02 80.90 79.00 80.02 8,576 Feb 02 80.40 78.00 78.87 7,055 Mar 02 77.80 75.60 76.17 9,774 Apr 02 74.90 73.18 73.62 1,981 May 02 71.90 70.95 71.27 1,584 Jun 02 70.75 69.75 70.02 1,795 Jul 02 70.02 69.62 69.62 474 Aug 02 … … 69.77 289 Sep 02 … … 70.12 289 Oct 02 … … 70.52 207 Nov 02 71.9 70.38 70.92 382 Dec 02 71.73 71.65 71.42 103 Light Sweet Crude (NYMEX CL) 1,000 barrels per contract (dollars/barrel) Jul 01 28.74 27.25 28.33 93,423 Aug 01 28.90 27.71 28.63 95,499 Sep 01 28.85 27.90 28.63 46,117 Oct 01 28.61 27.90 28.50 23,347 Nov 01 28.33 27.81 28.32 21,390 Dec 01 28.20 27.55 28.07 35,792 Feb 02 27.65 27.20 27.51 9,215 Mar 02 27.21 26.87 27.23 5,214 May 02 … … 26.67 4,616 Jun 02 26.42 26.10 26.39 19,331 Jul 02 … … 26.13 4,822 Aug 02 25.74 25.60 25.87 2,687 Sep 02 … … 25.62 8,269 Oct 02 … … 25.38 4,494 Nov 02 … … 25.16 3,246 Dec 02 24.99 24.71 24.96 18,953 Jan 03 … … 24.77 3,976 Feb 03 … … 24.59 819 Mar 03 … … 24.43 904 Paper #9100933 30 Apr 03 … … 24.28 267 May 03 … … 24.14 217 Jun 03 24.10 23.79 24.01 6,504 Jul 03 … … 23.88 169 Aug 03 … … 23.75 230 Sep 03 … … 23.62 415 Oct 03 … … 23.49 … Nov 03 … … 23.37 … Dec 03 … … 23.26 9,995 Jun 04 22.88 22.67 22.88 200 Dec 04 22.69 22.65 22.57 5,999 Dec 05 … … 22.17 5,302 Dec 06 … … 21.82 1,996 Dec 07 … … 21.77 375 Paper #9100933 31 Appendix 3 Monthly Stock Returns of 11 Major Airlines Versus the Montly Percentage Change in Jet Fuel Costs Over the Period 1994-1999 -25.00% -20.00% -15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% J a n - 9 4 M a y - 9 4 S e p - 9 4 J a n - 9 5 M a y - 9 5 S e p - 9 5 J a n - 9 6 M a y - 9 6 S e p - 9 6 J a n - 9 7 M a y - 9 7 S e p - 9 7 J a n - 9 8 M a y - 9 8 S e p - 9 8 J a n - 9 9 M a y - 9 9 S e p - 9 9 Date R e t u r n Airline Portfolio Return Change in Jet Fuel Costs Paper #9100933 32 Appendix 4 50 55 60 65 70 75 80 L o a d F a c t o r ( R P M / A S M ) % J a n - 0 0 F e b - 0 0 M a r - 0 0 A p r - 0 0 M a y - 0 0 J u n - 0 0 J u l - 0 0 A u g - 0 0 S e p - 0 0 O c t - 0 0 N o v - 0 0 D e c - 0 0 J a n - 0 1 F e b - 0 1 M a r - 0 1 A p r - 0 1 M a y - 0 1 Date Monthly Load Factors for U.S. Airline Domestic Flights Source: Bloomberg Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 1 TEACHING NOTE Fuel Hedging in the Airline Industry: The Case of Southwest Airlines Synopsis and Objectives Set in J une 2001, the case places the student in the role of Scott Topping, Director of Corporate Finance at Southwest Airlines. Scott is responsible for the airline’s fuel hedging program. The case describes the importance of jet fuel hedging in the airline industry, the volatility of jet fuel prices, hedging strategies available to manage jet fuel price risk, and related issues. [Note: The time period of the case allows the instructor to discuss additional issues not specifically addressed in the case such as the impact of September 11 th , 2001 terror attacks on the airline’s hedging strategy and the collapse of Enron (e.g., counterparty credit risk in hedging).] Southwest Airlines has a business model based on being a low cost provider and has been very successful at offering the lowest airfares in the industry. This business strategy has effectively resulted in a consistently increasing market share over the years. A dominant factor on the expense side of its business is the cost of fuel. Fuel is the second largest expense behind labor. Most recently, fuel costs have reached the highest annual average over the six-year period from 1994 to 2000 at $0.7869 per gallon in 2000. This fact has led to the increased importance of minimizing fuel cost for 2001 and beyond. To mitigate the sensitivity to fuel prices, Southwest has consistently hedged its fuel usage but wants to reevaluate the strategies it employs. As listed in the case, the student is asked to evaluate the following hedging strategies: (1) doing nothing, (2) hedge using plain vanilla swaps, (3) hedge using options, (4) hedge using zero cost collars, and (5) hedge using futures contracts. The case is intended for use in an advanced corporate finance course or risk management at the graduate level. However, the case can also be used in an undergraduate risk management course. Specific learning objectives are to: Introduce students to the topic of corporate risk management and reasons why firms should hedge. Understand the importance of price volatility for an input price in an industry that is highly competitive. Teach about different derivatives instruments used in hedging. While the case deals with the commodity jet fuel, these hedging strategies are Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 2 commonly used in other areas of the energy industry and in hedging agricultural commodities, metals, currencies, interest rates, etc. Cover more advanced risk management topics such as basis risk, backwardated markets, contango markets, and accounting issues (i.e., SFAS 133). Available Computer Spreadsheets Student spreadsheet: “J et fuel hedging case Excel data for students.xls”. This spreadsheet should be provided to students before analyzing the case. Solution spreadsheet: “J et Fuel Hedging Solution Spreadsheet.xls” contains detailed calculations and provides assumptions used. Description of Case Research Development In developing the case, numerous interviews were conducted with Scott Topping, Director of Corporate Finance at Southwest Airlines, over the period 2002 through Spring 2004. Scott Topping visited Oklahoma State University to speak to an MBA class about fuel hedging at Southwest Airlines during the Spring, 2002 when the case was first used. At this time, two of the case authors interviewed Scott in person. In addition, one of the authors went to Southwest Airlines’ headquarters in Dallas, Texas during September 2003 to conduct additional field interviews. Scott Topping also participated in a phone interview with MBA students during the Spring, 2004 semester when the case was used in a graduate level corporate finance course. At this time, Scott provided an update on their view of fuel hedging and related issues. Scott Topping reviewed an early draft of the case during the Spring semester of 2002 and provided extensive comments and corrections at that time. This was very helpful in focusing the case on relevant issues and clarification of hedging strategies. Most of the data on Southwest Airlines presented in the case is based on publicly available financial information obtained from annual and quarterly financial statements and from Bloomberg. Useful Reference Articles for Students: Carter, David A., Daniel A. Rogers, and Betty J . Simkins, 2004, “Does Fuel Hedging Make Economic Sense? The Case of the U.S. Airline Industry”, Oklahoma State University working paper. “Energy Derivatives and the Transformation of the U.S. Corporate Energy Sector”, 2001, Journal of Applied Corporate Finance, Vol. 13 (No. 4), 50-75. Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 3 Energy Information Administration, 2002, Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity Industries (October), U.S. Department of Energy. Haushalter, David, 2001, “Why Hedge? Some Evidence From Oil and Gas Producers”, Journal of Applied Corporate Finance, Vol. 13 (No. 4), 87-92. NYMEX, “A Guide to Energy Hedging”, (available at http://www.nymex.com/media/energyhedge.pdf). Stulz, R.M., 1996, “Rethinking Risk Management,” Journal of Applied Corporate Finance, Vol. 9, 8-24. Trottman, Melanie, 2004, “Outside Audit: J et-Fuel Bets Are Risky Business”, The Wall Street Journal Online, February 24. Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 4 DISCUSSION AND ANALYSIS Case Questions and Answers 1. Why do firms like Southwest hedge? What are the benefits of hedging? Answer: The instructor might want to open the discussion by stating Scott Topping’s quote at the beginning of the case: “If we don’t hedge jet fuel price risk, we are speculating. It is our fiduciary duty to try and hedge this risk.” Then, the instructor should ask the class: “Why would someone like Scott Topping say this? What does he mean?” More generally, the following discussion summarizes the answer. Southwest realizes that jet fuel prices are highly unpredictable. Most airlines realize it is often impossible to pass on higher fuel prices to its customers, because this would require raising ticket prices in a highly competitive industry. An example would be one airline that is not hedged for higher fuel prices, having to raise its ticket prices to remain profitable. However, its competitors (who have a fuel hedging strategy) do not raise ticket prices, thus having a lower price in what has become a commodity service. As a result, the un-hedged airline is forced to go back to its original prices in order not to lose sales and to remain competitive. This happened to Continental Airlines as described on page 3 of the case: “For example, Continental Airlines rescinded a fare hike after trying a number of times to boost overall fares. The airline said the air fare increases were due to high fuel costs, but intense airline competition has left the firm unable to pass along fuel costs to customers” . 1 The instructor may want to start a more in-depth discussion by first discussing the theoretical academic perspective on risk management: The starting point is typically the seminal work of Modigliani and Miller (1958) (M&M) on corporate finance and optimal capital structure. M&M find that under perfect capital markets assumptions (e.g., no taxation, no bankruptcy costs, and well-diversified investors, etc.), the value of a firm does not depend on how the firm is financed. A corollary to the M&M conclusion is that there is no value to risk management because shareholders can do it for themselves (by simply holding a well-diversified portfolio and make the necessary asset allocation decisions themselves if they seek to bear more risk). However, when relaxing the M&M assumptions to more “real world” assumptions, the conclusion is that risk management can add value. How? This is described next. 1 See “Continental Raises Domestic Fares, Cites Fuel Costs” (Reuters, February 27, 2004) and “Continental Airlines Resends Latest Fare Hike” (Reuters, J une 7, 2004). Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 5 At this point, the instructor may want to summarize theoretical motivations and evidence for hedging from the academic literature: Most theoretical research in corporate risk management identifies value- maximizing rationales for hedging. Empirical research in this area has found the following: Many published articles conclude that firms hedge to reduce expected costs of distress. 2 Other papers deduce that firms hedge because of high investment opportunities. 3 Carter, Rogers, and Simkins (2004) present evidence that hedging airlines are more highly valued in the market place (based on Tobin’s Q). Such hedging provides firms with the opportunity to buy underpriced assets from distressed airlines during periods of high jet fuel prices and/or protects the ability to meet previously contracted purchase commitments. They point out that large airlines (such as Southwest Airlines) are typically in the best position to buy distressed airlines (or desirable parts). Hedging future jet fuel purchases allows these firms a means to manage a significant source of variation in cash flows. Given that jet fuel price increases often coincide with distress in the airline industry, hedging provides an additional source of cash for making acquisitions during these periods. Allayannis and Weston (2001) examine the effect of currency derivatives usage on relative market value and find a positive relation between currency hedging and Tobin’s Q. Graham and Rogers (2002) test the effect of derivatives hedging on debt in a capital structure model and find that hedging has a positive effect on debt ratios. The more astute student may also point out the following reasons cited in the suggested readings: The article from the Journal of Applied Corporate Finance titled “Why hedge: Some evidence from Oil and Gas producers”, states firms hedge for two reasons. The first being that management is risk averse, meaning that management wants to reduce the likelihood that they may lose their jobs if the price of a major input/output changes unfavorably. The second reason stated is that hedging can reduce the likelihood that a company will incur financial distress and therefore increase the ability to fund profitable capital projects. In the article “Energy Derivatives and the Transformation of the U.S. Corporate Energy Sector” from the Journal of Applied Corporate Finance it states “. . . derivative markets help enable companies to take the risks that they want to take in part by getting rid of the risks that they don’t want to take . . . allowing them to concentrate more on their core competence. So, if they can reduce or eliminate that price risk, then shareholders should feel better about that.” By transferring the risk of business processes that firms do not have any insight into or control over, a firm is able to concentrate its 2 Berkman and Bradbury (1996), Dolde (1995), Gay and Nam (1998), Graham and Rogers (2002), Haushalter (2000), and Howton and Perfect (1998) are examples of papers reaching this conclusion. 3 Allayannis and Ofek (2001), Dolde (1995), Gay and Nam (1998), Géczy et al. (1997), and Nance et al. (1993) find that hedging increases with the level of R&D expenditures. Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 6 efforts on those “competencies” which they are best at, increasing the overall effectiveness and efficiency of the firm. To summarize, the benefits of hedging are: • Reduce risk of financial distress • Increase ability to make profitable investment opportunities • Minimizes price risk • Improves firm value • Manages the volatility of earnings • Reduce the firm’s cost of capital 2. Does heating oil or crude oil more closely follow the price of jet fuel? To answer this question, use the information in the Excel spreadsheet. Answer: [Note: The main purpose of this question is to have the student understand the relationship between prices for related commodities in hedging and realize why cross- hedges are sometimes used. Question 5 further analyzes this issue by covering basis risk.] Refer to the solution spreadsheet. Using daily prices from J an. 2, 1991 through J une 12, 2001, the correlation is 97.9% for jet fuel and heating oil and 95.3% for jet fuel and. crude oil. This is a correlation using prices, not returns. As shown, both commodities have a high correlation to jet fuel, but heating oil has the highest correlation. Students will calculate different correlations depending on the period and interval used (i.e., daily versus monthly or weekly). The instructor may have the students calculate the correlation based on returns instead of price levels. The main purpose of this question is for the student to understand why cross-hedges are sometimes used. The following figure (also included in the solution spreadsheet – see Tab “Q2&Q5 Basis & Corr. Coeff.”) illustrates the relationship between heating oil futures and crude oil futures and the spot price of jet fuel. Note the high correlation and similar prices for jet fuel and heating oil. The futures contracts are for the nearby contract. Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 7 3. (a) Evaluate the 5 proposed hedging strategies. Evaluate each hedge under two fuel price scenarios. (Note: You can evaluate the hedges under as many price scenarios as you wish, but be certain to analyze the following two scenarios.) SCENARIO 1: 39.3 cents/gallon spot price for jet fuel; 38.8 cents/gallon spot price for heating oil, or $14.10 per barrel spot price for crude oil, and SCENARIO 2: 119.6 cents/gallon spot price for jet fuel; 118.6 cents/gallon spot price for heating oil, and $40,00 per barrel spot price for crude oil. For both scenarios, consider full hedging and a 50% hedge strategy. The 5 proposed hedging strategies are: 1. Do nothing. 2. Hedge using a plain vanilla jet fuel or heating oil swap. 3. Hedging using options. 4. Hedge using a zero-cost collar strategy. 5. Hedge using a crude oil or heating oil futures contract. Answer: This question is by far the most difficult one in the case because it requires lengthy calculations. Based on our experience using the case, the instructor should provide students with simple examples of how to analyze some of the hedging strategy in class lectures when the case is assigned. The answers students calculate will depend on the assumptions they make. In our analysis, we have made the following assumptions: 0 20 40 60 80 100 120 1 / 2 / 1 9 9 1 1 / 2 / 1 9 9 2 1 / 2 / 1 9 9 3 1 / 2 / 1 9 9 4 1 / 2 / 1 9 9 5 1 / 2 / 1 9 9 6 1 / 2 / 1 9 9 7 1 / 2 / 1 9 9 8 1 / 2 / 1 9 9 9 1 / 2 / 2 0 0 0 1 / 2 / 2 0 0 1 New York, NY Crude Oil Future Contract 1 ($/bbl) New York, NY No 2 Fuel Oil / Heating Oil Future Contract 1 (C/gal) Gulf Coast J et Fuel Kero Spot Price FOB (C/gal) Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 8 For calculating the cost of jet fuel using the swap contracts for the one-year period, we assumed the monthly floating prices either increased (Scenario 2) or decreased (Scenario 1) linearly to the spot price in one year (see prices given in the case). The same instructions were given to the students before analyzing the case. For example, for the jet fuel swap, we assumed that prices declined at a linear rate from 79.45 cents/gallon in J une 2001 to 39.3 cents per gallon in J une 2002. The solution spreadsheet shows the detailed calculations. (Note: Of course, actual numbers can be used when conducting “ex-post” analysis.) The solution for the crude oil option strategy is based on buying a $28.00 call option with a premium of $1.80. The solution for the costless collar strategy assumes the purchase of a $28.00 call option ($1.80 premium paid) and the sale of a $22.50 put ($1.80 premium received). The solutions for the crude oil and heating oil futures strategy (5a and 5b) are based on selecting the futures contract maturing in J une 2002. For simplicity, calculations are summarized over the time period (see solution file). Futures contracts are offset before maturity and futures contract prices are assumed to converge on the future spot price (using the spot prices provided in the case scenarios). In other words, the futures hedge is treated as a static hedge for the entire annual jet fuel usage using a one-year futures contract. This assumption is used to simplify calculations but in reality, the assumption is unrealistic. Please refer to the response to part C of this question for a more realistic futures strategy. The following table provides a summary of the answers (in millions of $) for the total cost of jet fuel including the hedging gains or losses. As shown, under Scenario 1, the lowest cost would be strategy #1 “do nothing”, and the next best strategy is #3 using crude oil options. Under Scenario 2, the futures contracts using heating oil provides the minimum cost of fuel. Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 9 Scenario 1 Scenario 2 Full Hedge 50% Hedge Full Hedge 50% Hedge 1 Do nothing 432.3 N/A 1315.6 N/A 2a J et Fuel Swap 633.6 532.9 1038.4 1177.0 2b Heating Oil Swap 651.1 541.7 1058.9 1187.3 3 Crude Oil Options 479.4 455.9 1037.5 1182.0 4 Zero-cost Collar 652.3 542.3 1001.3 1158.5 5a Crude Oil Futures 754.2 593.2 959.2 1137.4 5b Heating Oil Futures 775.7 604.0 781.2 1048.4 Total Costs - Scenario 1 0 200 400 600 800 1000 1200 1400 1 2a 2b 3 4 5a 5b C o s t s ( $ M M ) Full Hedge 50% Hedge Total Costs - Scenario 2 0 200 400 600 800 1000 1200 1400 1 2a 2b 3 4 5a 5b C o s t s ( $ M M ) Full Hedge 50% Hedge Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 10 Refer to “J et Fuel Hedging Solution Spreadsheet.xls” for the detailed calculations and assumptions. To illustrate solutions provided in the spreadsheet – the following is the solution for strategy #2 using the jet fuel swap and prices under Scenario 1: Scenario 1-JET FUEL Assume: Floating prices chg linearly to end spot. So avg monthly floating price chg = (0.0335) Time Fixed Floating SWA Net Payment $/gal 0 J un-01 0.76 0.7945 1 J ul-01 0.76 0.7610 (0.0010) 2 Aug-01 0.76 0.7276 0.0324 3 Sep-01 0.76 0.6941 0.0659 4 Oct-01 0.76 0.6607 0.0993 5 Nov-01 0.76 0.6272 0.1328 6 Dec-01 0.76 0.5938 0.1663 7 J an-02 0.76 0.5603 0.1997 8 Feb-02 0.76 0.5268 0.2332 9 Mar-02 0.76 0.4934 0.2666 10 Apr-02 0.76 0.4599 0.3001 11 May-02 0.76 0.4265 0.3335 12 J un-02 0.76 0.3930 0.3670 Avg PMT= 0.1830 Total Cost=Spot * Gal +Paid to Enron Fuel Cost Swap Cost 432.3 201.3 Total Cost= 633.6 50% Hedge Fuel Cost Swap Cost 432.30 100.6385 Total Cost= 532.94 Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 11 (b) Discuss the pros and cons of each hedging strategy. Answer: To fully address this question, the student should discuss the pros (advantages) and cons (disadvantages) of each strategy separately. Strategy #1: Do Nothing Pros No upfront cash costs Cons Unlimited market risk If prices increase dramatically, it can impact the firm’s profitability and cause financial distress. Strategy #2: Hedge using a plain vanilla jet fuel or heating oil swap Pros Cash flows occur monthly which more closely matches actual fuel expenditures No upfront cash costs Cons Counterparty credit risk with Enron swap Heating oil swap has basis risk Liquidity may be a concern if Southwest wants to unwind the position early Limited ability to benefit financially if jet fuel prices decline Strategy #3: Hedge using options Pros Greatest flexibility of all alternatives No counterparty credit risk since traded on NYMEX Upside price protection and firm still benefits from declining prices Cons High upfront cash costs in form of option premiums Basis risk Strategy #4: Hedge using a zero-cost collar strategy Pros High flexibility No counterparty credit risk if hedger utilizes crude oil or jet fuel traded on NYMEX Upside price protection and firm still benefits from declining prices until the put strike price is reached Low or zero upfront cash costs Cons If prices drop below the put strike price, the firm loses the benefit of lower prices Basis risk Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 12 Strategy #5: Hedge using crude oil or heating oil futures contract strategy Pros No counterparty credit risk if hedger utilizes crude oil or jet fuel traded on NYMEX Low upfront cash costs (just margin that needs to be posted but can be substantial) Cons The firm does not benefit from lower prices Basis risk Contracts are marked-to-market daily, which may require additional cash payments over the life of the contract (c) Describe how a combination of the hedging strategies can be used. Answer: Answers will vary and it is difficult to say with certainty that one strategy clearly dominates. Nevertheless, students should not select #1: Do Nothing – Southwest’s strategy of providing air travel at the lowest possible fares demands strict cost management. By not hedging its fuel costs, Southwest might place its entire business strategy at risk. The more astute student will suggest, for example, a futures strip to more closely match actual fuel needs for each month. In Appendix 3 of the case, monthly load factors for U.S. domestic flights are provided. The student could use this information to obtain a rough estimate of monthly jet fuel requirements. A futures strip is a series of futures contracts that expire monthly. For this case, a one-year strip (futures contracts expiring over the next 12 months) is appropriate. 4. What are the risks of being unhedged? Totally hedged? Answer: After labor, jet fuel is the second largest cost for airlines. The price paid for this commodity can significantly impact earnings, the viability of an airline, the ability of the airline to remain competitive with other airlines. The typical airline customer is very sensitive to ticket prices. In other words, most customers do not exhibit product loyalty and will switch airlines based on prices. If an airline was to raise the costs of their tickets to offset the rise in fuel costs, they may lose business. Hedging protects companies from the price fluctuations that can occur with commodities like jet fuel. The volatility of prices can cause operating costs to increase dramatically. Hedging allows an firm to set a fixed price for the commodity in the future. Hedging reduces the risk associated with price fluctuations. Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 13 If a company is unhedged, it assumes all risk associated with price volatility. With the price of jet fuel rising and uncertainty in prices, companies can be assume major financial risk if they do not hedge. For Southwest, a 25 cents gallon jet fuel increase will raise the fuel price by $275 million. Not hedging has caused airlines to file bankruptcy in the past. However, if an airline is completely hedged, they will not benefit from declining prices (depending on the derivative contract used). This is clear from the analysis in Question 3. The more thorough student might talk about price elasticity of demand of air travel, and the extent to which oil prices may be related to important macroeconomic conditions affecting business and leisure travel (i.e., GDP growth, interest rate levels, etc.). To expand the discussion to the transportation industry, the instructor may want to point out that unlike the airline industry, large firms in the trucking industry are more able to pass on the extra cost of fuel to their customers. Why? Airlines compete with one another on almost all of the markets they serve. Price competition is extremely high in the airline industry. The trucking industry is structured differently and their service can be viewed as more customized. For this reason, long-haul trucking firms often have formalized fuel surcharges. This allows these firms to add a fuel surcharge that varies with the price of fuel. The biggest fuel-related risk for large trucking firms, such as J B Hunt Transport Services, among others, is that the price of fuel may increase significantly before the firm is able to pass extra costs to customers (causing a short-term decrease in earnings). Smaller trucking firms and independent contractors often receive a flat fee for shipping, and as a result, increased fuel costs directly impact earnings. It is interesting to note that, similar to airlines, long-haul trucking firms have fuel costs comprising 10 to 15 percent of total expenses. Meanwhile, for firms such as UPS and FedEx, fuel costs represent approximately 4 to 6 percent of expenses. 5. (a) What is basis risk and how is it different from price risk? Answer: As discussed in the case, quoting directly: “The term “basis risk” is used to describe the risk that the value of the commodity being hedged may not change in tandem with the value of the derivative contract used to hedge the price risk. While crude oil, heating oil, and jet fuel prices are highly correlated, significant basis risk can emerge if the relationship between the commodities breaks down. In an ideal hedge, the hedge would match the underlying position in every respect. However, in actuality, basis risk is a high concern, even if the derivatives contract is for the exact same commodity being hedged.” …. “Why does basis risk occur? The following Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 14 three basis risks occur frequently in hedging: product basis risk, time basis risk, and locational basis risk.” The student may also use the following definition of basis (see, for example, “A Guide to Energy Hedging” by NYMEX): basis is the differential that exists between the cash price of a given commodity and the price of the nearest futures contract for the same, or a related commodity. Most of the hedging strategies evaluated involve basis risk since in many cases, the hedging instrument is a different commodity than the needed commodity product (i.e. jet fuel.) Basis risk is not the same as price risk. Price risk is the magnitude of the volatility associated with any particular commodity product whereas basis risk involves the differential between prices. 4 A change in the differential between prices over time leads to a change in the effectiveness of the hedge as it no longer accurately tracks the price movements of the hedged commodity. This could lead to either more protection or less protection but either way, it introduces additional uncertainty into a strategy whose purpose is to reduce uncertainty. Basis risk will affect Southwest’s hedging strategies since most of the hedge strategies do not use a jet fuel based derivative but rather related commodities such as heating oil and crude oil. Refer to the figure below (also included in the solution spreadsheet – see Tab “Q2&Q5 Basis & Corr. Coeff.”) for an illustration of the basis between jet fuel and heating oil/crude oil. As shown, the basis can dramatically change from time to time. 4 The instructor can refer the student to their spreadsheet (see tab Volatility) to see how it is calculated for jet fuel. -30 -20 -10 0 10 20 30 40 1 / 2 / 1 9 9 1 1 / 2 / 1 9 9 2 1 / 2 / 1 9 9 3 1 / 2 / 1 9 9 4 1 / 2 / 1 9 9 5 1 / 2 / 1 9 9 6 1 / 2 / 1 9 9 7 1 / 2 / 1 9 9 8 1 / 2 / 1 9 9 9 1 / 2 / 2 0 0 0 1 / 2 / 2 0 0 1 C e n t s / g a l l o n Basis Heating Oil Basis Crude Oil Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 15 (b) What are the implications of a changing basis? Answer: The change in basis impacts hedge performance and can cause either a loss or gain to occur as a result of hedging. For example, employing the following definition of basis: Basis = cash price – futures price One can readily see that a party entering into a long hedge (such as Southwest) will earn a profit from the hedged position if the futures price increases more than does the cash price (or decreases less). On the other, a loss will result if cash price increases relative to the futures price. A perfect hedge (ex post) results only if the basis does not change when measured between the inception date of the hedge and its liquidation. (c) Does basis risk exist for Southwest Airlines in their fuel hedging program? Answer: The answer to this question is “yes” but the degree of basis risk depends on the hedging instruments used. The greatest basis risk is for strategies involving a cross hedge (i.e., heating oil or crude oil). The reason is that the price of the cash commodity (jet fuel) and the price of the futures contract may not always move in tandem. 6. (a) What is SFAS 133 and how does it impact a firm’s hedging strategy? Answer: A recent development related to hedging is SFAS 133, which is a requirement by the Financial Accounting Standards Board for the disclosure of any derivative transaction entered into by a corporation. From a strictly theoretical point of view, the change in the accounting disclosure requirements should have no effect on a firm’s hedging strategy. Nevertheless, one can find many examples of situations in which changes in accounting policy has caused firms to change business behaviors. A concern voiced by heavy users of derivatives is that, by introducing unrealized gains and losses from derivative instruments that fail to qualify for hedge accounting, SFAS 133 would cause more volatility in reported earnings. In such cases, firms may be discouraged from entering into cross-hedges that may be subject to significant levels of basis risk. Smaller users of derivatives suggested that the added costs from complying with SFAS 133 would negate the benefits associated with hedging. (b) Using the effectiveness measure on page 6, calculate the effectiveness of hedges using heating oil futures and crude oil futures for the period 2000-2001 (up until the time of the case). How does the effectiveness measure impact a firm’s hedging decision. Answer: Hedge effectiveness is determined by reviewing historical performance of a hedge instrument and the hedged item along with an evaluation of anticipated future Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 16 performance. FASB has two suggested methods of measuring the historical performance – the 80-125 Rule and the Correlation Method. Under the 80-125 Rule, a hedge is considered effective if there is a high degree of confidence that the dollar offset ratio will remain within a range of 0.80 to 1.25 over the hedge horizon . In other words, this means that the change in value of the derivative will be between 80% and 125% of the change in value of the hedged item. 5 Both of these methods were applied to the daily period from J anuary 4, 2000 through J une 12, 2001 using jet fuel as the hedged item and crude oil and heating oil as the hedge instrument. Refer to the Excel tab “Q5 Effectiveness Test Results” in the solution spreadsheet for complete details. RETROSPECTIVE TEST FAS 133 Requirement Heating Oil Futures Contract Crude Oil Futures Contract 80-125 Rule 80%-125% 70.22% 100.66% Correlation Measure >80% 76.74% 57.58% As shown, the crude oil futures passes the hedge effectiveness test based on the 80-125 Rule but not under the Correlation Method. On the other hand, the heating oil futures contract almost passes the correlation measure (77% versus the minimum of 80%). This suggests that under SFAS 133, some hedges involving either heating oil or crude oil may not be classified as cash flow hedges and the results would be sensitive to the retrospective test used. If a hedge does not pass the hedge effectiveness test, changes in the fair value of the derivative would have to be reported as income/loss in the income statement. However, this is not a certainty as there is plenty of gray area in SFAS 133. For example, the time period for performing the retrospective test is not specified with any detail so more (or less) data could be used in performing this test. Also, a prospective test is supposed to be used to take into account anticipated future performance. Since this particular test involves estimates of future prices, much leeway could be used. Hedging effectiveness under SFAS 133 is a advanced subject in the area of risk management and can quickly come very complex. This question in the case is meant to be an introduction to the topic – so that the student is at least aware of these issues. For additional articles on SFAS 133, refer to Canabarro (1999), Charnes, Koch, and Berkman (2003), Kalotay and Abreo (2001), and Kawaller and Koch (2000). Refer to the reference list at the end of this teaching note for publication details on these articles. This effectiveness measure puts strain on management’s decision making process when entering into hedges. Overall, management should educate investors and analysts about why hedging is important for the firm to effectively manage its expenses. 5 The dollar offset ratio has been criticized because it can give false signals about hedge effectiveness. For example, the ratio can frequently fall outside the 80-125 band even when the prices of the hedged item and the derivative are highly correlation. See Charnes, Koch, and Berkman (2003) and Canabarro (1999). Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 17 It is important to note the following: Scott Topping states that while SFAS 133 is an important concern, generally speaking, their strategy is chosen based on the economics -- not the accounting issues. 7. Describe how a backwardated market or contango market (i.e. shape of the forward curve) might impact hedging strategies. Are current crude oil markets in backwardation or contango? Answer: Contango is a market situation where prices are progressively higher in the distant delivery months. Backwardation is a market situation where prices are progressively lower in distant delivery months. If the jet fuel markets were in contango, there would be a financial incentive to purchase fuel in an earlier period for use in later periods if the storage costs were less than the price increases. Southwest might choose to lease additional fuel tanks as its hedging strategy rather than hedge in the commodity markets (only if the carrying costs of this storage is less than the time basis between months.) According to Scott Topping, such a strategy is too expensive because storage is typically expensive relative to the time basis. When markets are in backwardation, a hedging strategy using futures contracts may be useful. This lack of storability is one reason that crude oil markets tend to exhibit backwardation. Therefore, Southwest must rely on financial instruments to protect itself against rising fuel costs. Appendix 2 in the case demonstrates the backwardation in the crude oil and heating oil futures market. For example, notice that the heating oil futures prices are progressively lower for futures contracts with longer maturities. The same trend is evident in crude oil futures prices, as shown in the following graph: Crude Oil (NYMEX CL) Futures (6-11-01) 22 23 24 25 26 27 28 29 J u l - 0 1 S e p - 0 1 N o v - 0 1 J a n - 0 2 M a r - 0 2 M a y - 0 2 J u l - 0 2 S e p - 0 2 N o v - 0 2 J a n - 0 3 $ / b a r r e l Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 18 To challenge students, the instructor can pose this question to the class: “What happens when the market switches from backwardation to contango (or vice versa). How does this impact hedging strategies?” The most famous example of what can happen to a hedging strategy when energy markets switch from backwardation to contango is the case of MGRM (Metallgesellschaft Refining and Marketing) in 1993. (See http://www.erisk.com, Wheel of Misfortune, for more on this subject, or published articles on this topic.). This question and the story about MGRM can lead to an insightful and fascinating classroom discussion. 8. What do you recommend to Scott Topping? Why? Answer: Most likely, students’ answers to this question will vary. The student should explain the pros and cons of the strategy selected and discuss why they selected a particular strategy over the other strategies. Southwest prefers to use the collar strategy (a premium collar) because it provides a good compromise to achieve flexibility at a reasonable cost. However, over time, they have used different strategies. Most of their hedging is in the OTC market through Goldman Sachs, Morgan Stanley, and Barclays. The instructor may want to make the following points when wrapping up the discussion: • It is management’s responsibility to fully understand the key risks of the hedging strategy selected. • Management should assess the interrelationships between market risks, liquidity risks, and basis risk in their hedging strategy. • The manager should communicate these risks to upper management and the board of directors when applicable. Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 19 CONCLUSION When presenting the conclusion, we suggested that the instructor give an epilogue for the case. This information is provided next in this teaching note. In concluding the case, the instructor should pose the following question to the class: If jet fuel hedging is a valuable activity, then why don’t all airlines engage in this practice? In other words, do non-hedgers act sub-optimally? After students discuss this question, the following is our summary of the answer: “No, non-hedgers may not be acting sub-optimally. If the benefits of hedging are less than the costs of hedging, then no net benefit would be gained from hedging by the airline. Given that smaller airlines do not hedge jet fuel purchases with derivatives suggests that the costs may outweigh the benefits for these firms. ” “Furthermore, airlines that are financially distressed will find it more difficult and expensive to hedge, whereas airlines with investment grade credit ratings can more easily hedge and have much greater flexibility in hedging strategies. Fundamentally, stronger credit ratings allow for more hedging, longer-dated hedging, and different types of hedging strategies that are not available to weaker airlines.” “Also, smaller airlines that are a regional carrier for a major airline may have a fuel pass-through agreement, which allows the smaller airline to pass on fuel price increases. This is a type of “operational hedge” and would reduce the need for a financial hedge. Charter airlines have a greater ability to increase ticket prices in response to fuel price increases due to the custom nature of their business.” Additional issues the instructor may wish to discuss is the impact of September 11 th , 2001 on the airline industry. Indirectly, this relates to fuel hedging because for the next year, air travel was significantly lower. For an article on the impact of September 11 th on the airline industry, refer to: “The Market’s Reaction to Unexpected, Catastrophic Events: The Case of Airline Stock Returns and the September 11 th Attacks” by David A. Carter and Betty J . Simkins, forthcoming in the Quarterly Review of Economics and Finance. Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 20 Epilogue When providing the epilogue, the instructor should first discuss jet fuel prices over the subsequent year. (Note: The instructor may want to ask students to analyze how the hedges performed using actual prices. To do this, the instructor should ask students to go to the Energy Information Administration (EIA) website and download all energy prices that are needed. The website is: http://www.eia.doe.gov/.) To view jet fuel prices over this period, See Exhibit 1 provided at the end of the epilogue. As shown, jet fuel prices dropped over the one-year period ending J une 14, 2002 from 79.45 to 66.75 cents per gallon for the Gulf Coast spot price of jet fuel. On J une 14, 2002, the spot prices of heating oil and crude oil were 65.8 cents per gallon and $25.90 per barrel, respectively. Ex-post, the best choice would have been to not hedge. However, it should be emphasized to students that prices could have increased instead. In other words, for Southwest to remain unhedged would be too risky and violate their business strategy. At this point, it is useful to restate the quote by Scott Topping provided at the beginning of the case: “If we don’t hedge jet fuel price risk, we are speculating. It is our fiduciary duty to try and hedge this risk.” To further emphasize the importance of hedging jet fuel costs, the instructor may want to quote the excerpts below from the article (“U.S. Airlines Show Disparity in Hedging for J et-Fuel Costs”) by Melanie Trottman, published in the Wall Street Journal on March 10, 2003. “Jet fuel, now more than twice as expensive as a year ago, is emerging as a major factor in survival and bankruptcy for airlines, as several carriers, including some of the weakest, find themselves with few protective price hedges in place. Airlines typically hedge by locking in fuel at prearranged prices or buying securities that rise in value when oil climbs. Yet the industry finds itself with wide disparity in hedging, with some airlines fully hedged at low prices, and others completely exposed to huge price increases. UAL Corp.'s United Airlines, operating under bankruptcy-court protection, has no hedges in place this year. That will likely cost the nation's second-largest airline more than $100 million in added fuel costs during the current quarter alone, estimates UBS Warburg analyst Samuel Buttrick. Analysts suspect US Airways Group Inc., also reorganizing in bankruptcy, has few hedges in place. US Air says it is hedged for 2003, but it wouldn't disclose prices or percentages. By contrast, Southwest Airlines, the only profitable major carrier, hedged 100% of its jet-fuel needs for the current quarter at prices that are the equivalent of $23 a barrel for crude oil, compared with recent crude-oil prices hovering around $36 a barrel. Southwest has lined up more than 75% of its fuel for the rest of this year and next at $23 a barrel for crude oil.” Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 21 On April 29 th , 2004, a conference call was held with Scott Topping, Director of Corporate Finance, Southwest Airlines, to get an update on his view of fuel hedging. Scott Topping emphasizes that their hedging program is integral to Southwest’s unit cost management and competitive advantage. He stresses that it helps Southwest to maintain their competitive advantage as the low cost provider in the industry. Below are six questions that students asked Scott Topping, together with a brief summary of his reply: Question #1: Do you think Southwest would be this financially sound if it did not choose to hedge jet fuel prices? • “Not quite, but still viable. We would have posted some quarterly losses, for instance, last quarter $ 24illion.” Question #2: What hedging strategies are you currently using? What is your most used hedging strategy? • “If you define strategy as a structure – collars (upside protection w/ some cost reduction via managed downside).” Question #3: Do you closely consider current trends in jet fuel prices when considering hedging strategies or are fuel prices too unpredictable to consider this? • “Trends are one factor to consider, especially when important technical levels are broken through. I wouldn’t consider technical analysis to be a major decision factor however.” Question #4: What’s the most effective hedging method used by Southwest to control the volatile jet fuel price over-time? (I mean: futures? options/collar? And Why?) • “With the benefit of hindsight, we could have spent less on options and managed risk with swaps in this bull market. However, that would not have been good risk management. All methods have been successful – we feel the collar is a good compromise to achieve optionality at a reasonable cost.” Question #5: How do you choose the hedging strategy dynamically? • “It takes a fair amount of market intelligence. You must have trusted sources and act upon the changing environment as it relates to your overall risk management objectives. Example: Preparing last year for the Iraq war and making a decision about hedging jet fuel directly or remaining in crude oil /heating oil as a proxy.” Question #6: How has FAS 133 affected your hedging strategy at Southwest? • “So far, a minor factor, we try not too put accounting ahead of economic sense. However, FAS 133 adds a lot of complexity to the corporate accounting/financial reporting side.” Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 22 Exhibit 1 Paper #9100933 Teaching Note for “Fuel Hedging in the Airline Industry: The Case of Southwest Airlines 23 Additional References Cited in the Teaching Note Kalotay, Andrew and Leslie Abreo, 2001, “Testing Hedge Effectiveness for FAS 133: The Volatility Reduction Measure”, Journal of Applied Corporate Finance, Vol. 13 (No. 4), 93-99. Allayannis, G., Ofek, E., 2001, “Exchange Rate Exposure, Hedging, and the Use of Foreign Currency Derivatives,” Journal of International Money and Finance, 20, 273-296. Allayannis, G., Weston, J .P., 2001, “The Use of Foreign Currency Derivatives and Firm Market Value,” Review of Financial Studies, Vol. 14, 243-276. Berkman, H., Bradbury, M.E., 1996, “Empirical Evidence on the Corporate Use of Derivatives,” Financial Management, Vol. 25 (No. 2), 5-13. Canabarro, Eduardo, 1999, “A Note on the Assessment of Hedge Effectiveness Using the Dollar Offset Ratio Under FAS 133,” Goldman Sachs Research Paper (J une). Charnes, Koch, and Berkman, 2003, “Measuring Hedge Effectiveness for FAS 133 Compliance”, Journal of Applied Corporate Finance, Vol. 15 (No. 4), 95-103. Dolde, W., 1995, “Hedging, Leverage, and Primitive Risk,” Journal of Financial Engineering, Vol. 4, 187-216. Gay, G.D., Nam, J ., 1998, “The Underinvestment Problem and Corporate Derivatives Use,” Financial Management, Vol. 27 (No. 4), 53-69. Graham, J .R., Rogers, D.A., 2002, “Do Firms Hedge in Response to Tax Incentives?” Journal of Finance, Vol. 57, 815-839. Haushalter, G.D., 2000, “Financing Policy, Basis Risk, and Corporate Hedging: Evidence from Oil and Gas Producers,” Journal of Finance, Vol. 55, 107-152. Howton, S.D., Perfect, S.B., 1998, “Currency and Interest-rate Derivatives Use in U.S. Firms,” Financial Management, Vol. 27 (No. 4), 111-121. Kalotay, Andrew and Leslie Abreo, 2001, “Testing Hedge Effectiveness for FAS 133: The Volatility Reduction Measure”, Journal of Applied Corporate Finance, Vol. 13 (No. 1), 93-99. Kawaller, Ira and Paul Koch, 2000, “Highly Effective Expectation Criterion for Hedge Accounting”, Journal of Derivatives, Vol. 7 (Summer), pp. 79-87. Nance, D.R., Smith, C.W., J r., Smithson, C.W., 1993, “On the Determinants of Corporate Hedging,” Journal of Finance, Vol. 48, 267-284. Paper #9100933