Consider the situation of United Airlines (UA), an international airline based in United States of America....

Consider the situation of United Airlines (UA), an international airline based in United States of America. As part of its business it is heavily exposed to fluctuations in the price of jet fuel and foreign exchange rates. It sells tickets in foreign currencies and has significant EUR costs. For either jet fuel costs or forex, evaluate one derivative product UA could use to hedge fluctuations in the underlying price.

• Briefly describe how the product would be used to hedge the fluctuations

• Discuss the pro’s and con’s of this product

• Suggestions and recommendations

Your answer should be no more than 500 words

Solutions

Expert Solution

· For hedging fuel costs airlines can buy call option.

For example if price of oil is $40 per barrel and if airline is afraid that price of oil will increase than it can purchase call option , which will give it a right to purchase oil at a specific price in future.

· Pros of purchasing call option: if price rises significantly, airlines can still buy at predetermined price. Risk is capped.

· Cons of Purchasing call option: loss of premium due to time decay. Premium cost will raise overall; expenses.

· As airlines is not in the business of speculating on fuel prices , it is advisable to always hedge against volatility of fuel prices. When cost of fuel is capped airlines can focus on core business and not get worried on cost of fuel which is a major cost for airline.

jeff jeffy answered 2 years ago

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