Question

Comment on the desirability of a goal of trading futures in order to minimize the variability of the cost of acquiring aviation fuel. Your answer should consider:

i. The relation between Qantas’ profits and aviation fuel prices. Note that if aviation fuel costs do increase, then Qantas and its competitors might increase ticket prices.

ii. The nature of competition in the airline industry. Note that if Qantas locks-in its aviation fuel costs and Singapore Airline chooses not to hedge, then one airline will have a competitive advantage if aviation prices then rise while the other will have an advantage if instead aviation fuel prices fall.

iii. Whether Qantas’ shareholders do or do not benefit from a reduction in variance risk. Consider the relation between variance risk and systematic risk as well as shareholders’ ability to diversify away non-systematic risk.

Answer 1

Anwer-

                In aviation industry the largest operating cost center for airlines is procurement of aviation oil. A small up and down in prices of aviation oil largely Impact on aviation industry. Airlines generally price up and down there ticket fare to hedge this situation. So it is very necessary to design a strategy in order to minimize variability of the cost of acquiring aviation fuel to desirability of a goal of trading futures.

        When oil prices are increasing in the global economy, it's natural that the stock prices of airlines drop. When oil prices decline in the economy, it's equally natural that the stock prices of airlines go up. Fuel costs are such a large part of an airline's overhead percentage-wise that the fluctuating price of oil greatly affects the airline's bottom line.

In order to protect airline from variable oil cost and sometimes to take advantage of that situation airlines commonly usage fuel hedging. Buying or selling theexpected future price of oil through a range of investment products, protecting the airline companies against the rising prices. Quatas airline can use following strategy in order to minimize impact of variability of aviation fuel and can take competitive advantage in this scenario-

By purchasing aviation fuel at current oil price-

           If Qantas airline would have to believe that prices will rise in the future. To mitigate these rising prices, the airline purchases large amounts of current oil contracts for its future needs. By this Qantas can purchase aviation in current price at lower price. When price of aviation fuel will increase in near future, Qantas can able to take competitive advantage in future.

This is similar to a person who knows that the price of Petrol will increase over the next 12 months and that he will need 1000 Litre of Petrol for his car over the next 12 months. Instead of buying petrol as needed, he decides to purchase Petrol 1000 Litre at the current price, which he expects to be lower than the fuel prices in the future.

Purchasing Call Options/Contracts-

When a company purchases a call option, it allows the company to purchase a stock or commodity at a specific price within a certain date range. This means that airline companies are able to hedge against rising fuel prices by buying the right to purchase oil in the future at a price that is agreed on today.

For example, if the current price per barrel is $100, but an airline company believes that the prices will increase, that airline company can purchase a call option for $5 that gives it the right to purchase a barrel of oil for $110 within a 120-day period. If the price per barrel of oil increases to above $115 within 120 days, the airline will end up saving money.

Implementing a Collar Hedge-

Similar to a call option strategy, airlines can also implement a collar hedge, which requires a company to purchase both a call option and a put option. Where a call option allows an investor to purchase a stock or commodity at a future date for a price that's agreed upon today, a put option allows an investor to do the opposite: sell a stock or commodity at a future date for a price that's agreed on today.

A collar hedge uses a put option to protect an airline from a decline in the price of oil if that airline expects oil prices to increase. In the example above, if fuel prices increase, the airline would lose $5 per call option contract. A collar hedge protects the airline against this loss.

Purchasing Swap Contracts-

Finally, an airline can implement a swap strategy to hedge against the potential of rising fuel costs. A swap is similar to a call option, but with more stringent guidelines. While a call option gives an airline the right to purchase oil in the future at a certain price, it doesn't require the company to do so.

A swap, on the other hand, locks in the purchase of oil at a future price at a specified date. If fuel prices decline instead, the airline company has the potential to lose much more than it would with a call option strategy.

Qantas airline can use any of above strategy or hedging techniques to avoid variability in aviation prices.