The risk of hedging in the banking world - Free Essay Example

Sample details Pages: 11 Words: 3366 Downloads: 1 Date added: 2017/06/26 Category Finance Essay Type Cause and effect essay Did you like this example? Hedging is a risk management tool to offsetting the risk inherent of price in any cash market position by taking an equal but opposite position in the futures market. Hedging activities protect futures contract holder from fluctuations in the underlying assets price. Investors are benefit if the price of underlying asset moves in the same direction as what investors expected (Hedge Fund, 2009). Don’t waste time! Our writers will create an original "The risk of hedging in the banking world" essay for you Create order Short hedge is a short selling by borrowing underlying asset such as commodity, security or financial instruments from a broker and selling it by using the future contract. It then later bought back at lower price and returned to the broker. Short hedge is used by investors as a technique to capture the profit or protect losses from the falling price of the underlying asset. If the price is moves as investors expectation of going down, the investors are then buy at lower price and sell at the higher pre-determined agreed price. Thus, the investors gain from the differences of buying at lower price and selling at higher price. Furthermore, short selling can increase the liquidity in the market as investors can sell short the underlying asset without holding any stock (Short Hedge, 2010). For example, the price of corn is $3.50 per bushel at today. A producer of corn expects that the price of the corn will be dropping in six months later. Thus, the producer short sells the corn b y using future contract and lock in the price at $3.50 per bushel. Six months later, the price drops to $3.00 per bushel. The producer then buy the corn at $3.00 per bushel in cash market and sell the corn at $3.50 per bushel which is pre-determined agreed price in the future contract. Thus, the producer gained $0.50 per bushel by using the short hedging. Furthermore, producer is also protected from the losses of reducing in the price of corn by just locked in the selling price when enter into a contract. However, producer is making losses if the expectation of producer goes wrong. In the event of corns price rises to $4.00 per bushel six months later, the producer have to buy at $4.00 per bushel in the cash market and sell it out at pre-determined agreed price of $3.50 per bushel. From here, we know that the producer is making losses. A long hedge involves buying futures contracts with the intention of receive delivery of the underlying assets by locking the price of the asset. Investors will only enter into a long hedge contract when there is expectation of increase in prices of the underlying asset in the future. Long hedge is also enables investors to hedge and protect against the volatility and uncertainty of future price. A long hedge is beneficial for the investors who worry about the increasing of the underlying assets price in the future. Thus, long hedge allows investors to lock in the purchase price. In the event of the underlying assets price going up later, the investors are protected from the increasing in price by just paying the asset at the lower pre-determined agreed price (Long Hedge,2010). For instance, the seller of corn enters into the contract when he wants to purchase a certain amount of corn from the producer but is worrying about the rises in the price of corn in future. Let says corn price is $3.50 per bushel today and the seller locked in the price at $3.50 per bushel. If the price rises to $4.00 per bushel in six months later , the seller is protected from the rising of the corns price because the price is locked at $3.50. The seller is gained $0.50 per bushel from the long hedge. Same situation applies to long hedge when the price moves unfavorable for the seller. When price drops to $3.00 per bushel, the seller is facing losses. This is because the seller has to pay $3.50 per bushel instead of the actual market price is $3.00 per bushel after the six months period. b) The cost of jet fuel is an important issue for airline companies because it affects the profitability of the firms. This paper explores the hedging fuel costs strategies, implication of accounting rules for driving hedging strategies in United States. Besides, authors also conducted an industry survey to examine current hedging strategies and its benefits in United States business aviation. Cobbs and Wolf (2004) pointed out that there are three type of contracts utilized for fuel hedging purposes: over-the-counter instruments, exchange-traded-futures, and notÂÂ  hedging. Over-the-counter contracts entered by airlines are swaps, options and combinations of options such as collars structures. Despite of illiquid market and insufficient quantities available to hedge jet fuel consumption, many airlines still prefer over-the-counter instruments because of its customisation feature. Southwest successfully used this hedging strategy to implement its dynamic hedging program. It all ow the airlines to lock in prices at a lower point in the oil price cycle assuming that oil price cycle is a mean-reverting process. For examples, fixed swaps are used at the low point of oil price cycle because of the likelihood of price appreciation than price declines. Then, the airline can use swap contract to lock in at a lower price. Giving up potential savings from price decrease whilst hedging against further increases, airlines use collar to lock in a specified range of prices in the mid-range of the price cycle. Peak prices are more likely to require caps in the form of straight calls to allow company benefit from price depreciation and prevent losses from further appreciation. A substantial amount of monitoring is required for this strategy. United States do not have exchange-traded derivatives on jet fuel, therefore a similar hedge are set up such as between the price of heating oil and crude oil which highly correlated with jet fuel. These commodity future contrac ts result basis risk because of imperfectly correlation (contracts are based on an underlying asset other than jet fuel). Some airline companies employ another strategy- not hedging. There are two conditions should be met for this strategy to work: Firstly, other competitors also do not hedge jet fuel cost. In fact, this condition hardly is met, because hedging airlines have a competitive position (stable cash flow and better cash flow planning) over non-hedging airlines though aviation is not an actively hedging industry. Secondly, increase air fare and pass the change in fuel prices to passengers. It is more difficult for airlines to transfer additional fuel cost in highly competition nature of industry because being competitive on price was the key to any airlines survival and success. As such, aviation businesses in United States use various hedging strategies ranging from not hedging to fully hedging using a combination of instruments. Parties involved in hedging need som e accounting standards knowledge since it has great implication in adopting hedging instruments and enable the firms to receive preferable accounting treatment. Industry survey reveals that fuel costs is the second-largest expense for airlines which account for 16% of the carriers operating costs. To reduce the volatility of operating expenses and maintain bottom line profitability, airlines choose to hedge fuel prices. Study showed that Southwest and JetBlue are the industry leaders. Cobbs and Wolf (2004) indicated that there is a positive relationship between fuel hedging and the value of the firm by illustrating price/revenue ratio and hedging ratio of airlines. This study also suggests that airlines that are hedged have a competitive advantage over the non-hedging airlines. This paper concluded that a sophisticated hedging program can create a comparative advantage, overweight the costs and enhance firm value. c) Industry survey was conducted based on 13 United Stated domestic airlines. Survey shows that hedging jet fuel costs brings benefits to airlines. This result is supported by theory that hedging increases firm value. Cobbs and Wolf (2004) indicate that fuel costs is the second-largest expenses for airlines which account for about 16% of the carriers operating expenses after personnel expenses in year 2003. At least 80% of fuel costs were bear by each of the airlines in this industry survey. Aviation businesses average airfare pricing (available seat mile) decrease by 0.1%; airlines faced a compounded annual rise of 25.9% in fuel costs from 2001 to 2003. Few airlines have tried to transfer the rises in fuel costs to passengers by charging surcharges or increase in airfares during the period February to May 2004. However, it was an unsuccessful attempt because rival companies choose to not pass additional costs to their customers. Same case for United who also doubt on the decisi on of increase the pricing as Continental gives up the price increasing after a week due to the reason of other carriers are not responded to do so. This paper repeats the Carter et al. (2002) results: fuel hedging airlines trade at a premium. Cobbs and Wolf (2004) also suggest a positive correlation coefficient between fuel hedging and the firms value by illustrating price/revenue ratio and hedging ratio of airlines. Southwest is the largest fuel hedger who is hedged 82% of the fuel price and the price to revenue ratio is above 1.00. The second and third largest hedger is JetBlue and Airtran Holdings who are also having price to revenue ratio more than 1.00. Both United and Continental are remaining unhedged for the fuel price. Thus, their price to revenue ratio is relatively low. United is only achieving 0.01 while Continental is below 0.10. For EPS estimation in 2004, Southwest and JetBlue have positive value because both are the largest hedgers. Based on the findings from ind ustry survey, hedging is creating value which is like higher price to revenue ratio, lower price, positive EPS. Non-hedging airlines fuel cost were at or above the average spot fuel price. Southwest, JetBlue and Delta were the largest fuel hedgers in United Stated domestic airlines in 2003. Their actual fuel cost were in-line or below the average spot price of New York Harbor and U.S Gulf Coast. According to Southwests CEO statement, Southwest would face $8million loss due to rising in fuel prices if they not hedged their position. Southwest uses a combination of call options, collars, and fixed price swap agreements to hedge its jet fuel exposure. Whereas, JetBlue hedge its fuel consumption through swap agreement and crude oil option contracts and outsources its fuel management services. Dynamic hedging strategies enable Southwest and JetBlue- the industry hedging leader to save on fuel expenses and create competitive advantages compared to other carriers. Although hedging in creases firm value, there are still involves significant amount of hedging costs. For example JetBlue and Southwest limit their hedging operations in the past three years due to the reason of insufficient cash flow to finance the futures margin deposits and option premiums. Delta forced to close the positions of the fuel price hedging as to generate cash are needed for operations. In addition, many airlines (American, Continental Northwest and United) have to deal with liquidity issues which limit their ability to fully hedge their jet fuel consumption and protect themselves from oil price fluctuations. d) Jet fuel prices have been substantially volatile throughout the last decade. It drive airlines to hedge their fuel consumption to protect themselves from fuel price rising. For instance, the impact of fuel price changes drove United Airlines entered into options contracts to protect against increases in jet fuel prices (Carter et al., 2002). Jet fuel hedging is valuable for airline companies according to previous literature studies: US airlines which engage in fuel hedging activities increase in firms values (Carter et al.,2002; Cobbs and Wolf, 2004; Lin and Chang, 2008); Kvello and Stenvik (2009) study on European airlines hedging also has consistent results with US airlines. In the study of Carter et al. (2002), regression analysis is using to test whether there are hedging premium for the airlines that are using derivatives to hedge exposure of jet fuel price. The result showed 12%-16% statistically significant that hedging is creating vale for a firm. Fuel cost is one of the largest costs for airlines. It is more volatile than other courier expenses (Cobbs and Wolf, 2004). Hedging is considered as one of the ways to protect the airlines from the unfavorable price movements. For examples, in 2003, Korean Airlines entered into forward fuel contract which reduce their average fuel price paid by 34% and reported a gain of Won 282 million. Through dynamic hedging activities, Qantas offset 73% of their 2003/04 increased fuel price paid (Morrell and Swan, 2006). Thus, hedging activities is a tool to stabilize overall costs and reduce the volatility of profitability. Then, firms future expenses and earnings are able to predict, resulting in a more stable airlines financial markets. Investors are more confident to the stock price of airlines after hedging as earnings of airlines are more volatile if there is no any hedging activity. Carriers may face threat of bankruptcy if fuel prices keep increasing. For examples, Legend Airlines and National Airline s seek for insolvency protection because of rising fuel cost in 2000 (Cobbs and Wolf, 2004). Hedging aids in reducing the cash flows or accounting profits volatility, minimize risks, diminishing the probability of bankruptcy (Kvello and Stenvik, 2009). In 2003-2005, rise in fuel prices drove several airlines into bankruptcy. However, SouthwestÂÂ  was able to weather the changes in fuel prices by using extensiveÂÂ  fuelÂÂ  hedgingÂÂ  program (Ingrassia and Fleischer, 2006). Trempskis (2009) study note that Southwest and JetBlue Airlines- the industry leaders in fuel hedging strategy never has filed for bankruptcy, thus investors perceived them as more stable firm. Hence, fuel hedging would increase investors confidence and valuation of firms. During economic downturn period or fuel prices are very high, financially troubled airlines would sale its assets (e.g. aircrafts) below market prices (Carter et al.,2002). In this context, hedging airlines are allowed to take advantages buy these assets or acquire that carrier at prices below fair value (Pulvino, 1998; Cobbs and Wolf, 2004; Kvello and Stenvik, 2009). Kim and Singal (1993) implies that typically higher fare environments are created upon completion of the acquisition. By fuel hedging, airlines reduce cash flow volatility, improve its cash position thus enhance its flexibility in investment policies during economic downturns. Froot et al., (1993) analyze that hedged-airlines have sufficient internal funds and rely less on external sources of funds to complete this profitable capital expenditures or favorable investment opportunity. For example, American Airlines acquired Trans World Airlines by utilizing its available cash and assumption of Trans World Airlines debt in 2001 (as cited it Carter et al., 2002). Involving in positive net present value investment would strengthen hedged-airlines competitive position and increase firm values. Rob Fyfe, Air New Zealand chief executive c ommented that fuel hedging not only trying to remove volatility and also provide airlines ability to compete against its rivals. Fuel hedging makes sure airlines have some parity in fuel costs with competitors and prevent competitors from undercut on prices (in case rivals obtained a lower fuel cost). Fyfe statement is illustrated with a real case scenario. Qantas Airways fuel strategy successfully enhanced its competitive advantage and obtained cheaper fuel cost, resulting in captured some market share from rivals (Ballantyne, 2009). Fuel hedging is a complex business. Unless those airlines are able to maintain a long term and consistent hedging strategy through all stages of oil price cycle, airlines wouldnt be able to benefit from hedging. In fact, many airlines hedging losses in fuel hedging have been reported. For example, Air New Zealand had a loss of $134million from fuel hedging, other airlines to suffer include China Eastern Airlines ($908million), Air China ($994million ), Taiwans China Airlines ($629million), EVA Air ($267.8million), Malaysia Airlines ($755million) and Singapore Airlines ($223.5million). Besides, it becomes more difficult and more expensive for airlines to arrange hedging deals. Many banks and finance houses that heavily involved in past hedging have either bankrupted or in financial difficulties, e.g. Lehman Brothers. As a result, many airlines hedging deals collapsed and the remaining players are nervous (Ballantyne, 2009). However, most industry leaders and airline chiefs insist that hedging is the only way to smooth out the peaks and troughs of fuel price. This exercise will continue to be an important risk management tool in their strategy (Ballantyne, 2009). e) This study found that there is a positive relationship between fuel hedging and the value of the firm. This leads our attention to the aspects of reasons for hedging and which theory supported the finding. Theory that supported the finding Source of added value from jet fuel hedging is related to the underinvestment problem. Numerous literature studies supported for the underinvestment theory (Bessembinder, 1991; Froot et al., 1993; Stulz, 1996; Carter et al., 2002; Lin and Chang, 2008). Froot et. al (1993) developed a theoretical framework for hedging and value. He indicates that airlines facing financial distress will choose to underinvest. Underinvestment cost is one of the important indirect costs of financial distress (e.g. Stulz, 1996) thus hedging activity is a tool to alleviating the problem of underinvestment. When firms have profitable capital expenditures, the external cost of fund is more expensive than the internal funds (pecking order theory), so hedging can lower the variability of internal funds and ensure airlines have sufficient internal cost of capital to complete profitable investment opportunities (Bessembinder, 1991; Froot et. Al, 1993; Mello and Parsons, 2000). Based on Froots framework, Carter et. al (2002, 2006) and Kvello and Stenvik (2009) further proved that airlines main benefit of jet fuel hedging as it comes from reduction of financial distress cost and underinvestment costs. Their studies result show that positive relation between hedging and value increases in capital investment, while higher fuel costs are consistent with lower cash flow. Hedging add value to shareholders by aiming airlines avoid underinvestment and make value-creating investment. Reasons for hedging Probability of bankrupt is easily affected by non-systematic risk and thus levies costs. This probability of bankruptcy can be defined as financial distress costs which are included direct and indirect costs. Direct costs are costs incurred in the bankruptcy while indirect costs are derived as stakeholders perceive a realistic chance of future bankruptcy. These costs are defined the performance and market value are directly linked to volatility. (Haushalter, 2000). Hedging is allowed company to hedge against the fluctuation of the cash flow or accounting profit. Thus, it will reduce the probability of going to bankruptcy. Hence, the costs are lower and value of company is increasing. In the exhibit 5, Jet fuel price of Southwest, JetBlue and Delta are lower than average spot price of New York Harbor and U.S Gulf Coast. Thus, the findings are showed the hedging lowering the costs which are consistent with the theory of financial distress costs. Based on agency costs theory, agenc y conflicts arise when there is the divergence of interest of principal and agent. Thus, company should go for hedging to reduce the costs and increase the value of the company. Dobson and Soenen (1993) concluded that hedging reduce the fluctuation of cash flows and leads to probability of uncertainty also reducing. Consequently, the costs of external financing become lower. Furthermore, cash flow is more smoothing through exchange risk hedging when the firm is leverage. Based on the findings, the airliness value are enhancing after the hedging. In the theory of incentive structures, Smith and Stulz (1985) compensation scheme is influencing the managers choices in hedging. Managers are acted in the interest of shareholders who are always maximizing the wealth of shareholders. Managers manage the risk is to reduce the agency costs. However, interest rate risk and currency risk are not able to manage and control. Thus, managers are not likely to engage in hedging even though there are compensation scheme. Yet, the hedging may reduce the other unrelated financial risks of the company value. Indirectly, this is strengthening the relationship between share price and management performance. In the market imperfections, the external financing is more costly and cause the risk to the companies. This is consistent with the study of Froot et. al. (1993) suggested that market imperfections is explained why external funds are more high costs as compared to internal costs. In addition to internal financing, the companies are highly dependent to the external financing to funds their investments. Froot et. al. (1993) also concluded that the costs are higher when a company is facing difficulty to finance funds from external and this will result in the shortfall of their cash flow by assuming other things equal. Thus, the companies should go for hedge to prevent the fluctuation or shortfall of their cash flow. Company that facing market imperfection is more likely to hed ge against the risk in their companies and this theory is supported by Haushalter (2002).