Business environment is fraught with risks; each company in order to succeed in this unpredictable environment must mitigate risks. Risks can arise from varied sources; the airline industry is like any other industry, also confronted by pressures from several business areas. In the late 90's and beginning of this decade the biggest risk confronting the airline industry was high fixed labor costs and competitive pressure from low cost airlines with substantially less fixed labor costs. Just as the industry reorganized itself to become more competitive and lean from the perspective of labor costs, a new form risk has arisen in the last 3-4 years. Now energy posses the greatest risk to airline industry. The importance of energy in the airline industry is reflected by the fact that airlines like Air India, which had never engaged in energy risk management through hedging using financial derivatives, are now doing so . The objective of this paper is to understand how airlines are mitigating the risks posed by primarily high oil prices.
[...] South West Essentially sets the fares and most airlines have to react and match the fares to stay in the business. Some of the larger airlines, especially Delta, Northwest and Continental have no hedges because the limited hedging that these companies held were sold under court orders during the restructuring process, post 9/11[7]. Without current hedges, and poor credit ratting these companies are essentially at the mercy of the oil markets An outlook into the future What implications does Southewest's ability to hedge fuel as far as 2009 have for the entire industry? [...]
[...] Uncertainties concerning further oil prices make hedging strategies difficult to implement as a drop of the price could lead the airlines to book losses than gains. But airlines will have to use those ones if they still want to use their planes. Appendix Appendix Payoffs from forward contracts Source: http://www.riskglossary.com/link/forward.htm Appendix Main differences between forwards and futures contract Forwards Futures Contract Customisable Standardised terms Negotiation By phone Trading floor or electronic ways system Counterparty Yes No (clearing house) risk Liquidity High Low Price Opacity Transparency Delivery Final cash settlement Contract usually close out prior maturity Settlement A the end of the contract Settled daily Source : Hull (2003) p36 Appendix 3 : Correlation coefficient between jet fuel spot price and crude oil futures Source: Cf Cobbs, Wolf (2004) Appendix 4 : Heating oil futures description Heating Oil Futures Trading Unit: 42,000 U.S. [...]
[...] The FAA estimates that domestic RVSM will save users $ 5.3 billion in fuel costs between 2005 and 2016. Advanced Technologies and Oceanic Procedures (ATOP)[16] ATOP allows more aircraft to have access to more fuel-efficient trajectories in oceanic airspace through the use of advanced satellite communications Risk Management: Using Financial Tools Hedging Strategies As we have seen previously, airlines are so extensively affected by the movement of jet fuel prices that it can jeopardise the entire profitability of the business. [...]
[...] Also the significance of jet fuel prices to the Airlines and its impact on the bottom line is explored in greater detail Crude oil and Jet fuel The relationship between Crude oil and Jet fuel prices is that of father and son. Jet fuel is refined from Crude Oil, and naturally the jet fuel prices closely follow the prices of crude oil. Traditionally the crack spread of jet fuel and crude oil has been $5. The Crack spread is the variation between the price of crude oil and the price of Jet fuel. [...]
[...] These financial instruments are traded directly between the airlines and the investment banks. Forward contracts and commodities swaps are the most common form of OTC products. Forward contract is an agreement to buy or sell an asset at a certain future time for a certain price. One of the parties agrees to buy the underlying asset at this date (long position) whereas the other party agrees to sell the asset on the same date for the same price[17]. At settlement forwards has a market value given by n = where: - St is the spot price of the asset at maturity of the contract - K is the delivery price The linear payoff resulting from this formula can be negative or positive and depends on the position (long or short) and the spot price at maturity[18]. [...]
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