Question

Assume that you were approached by the CFO of USC Airlines, an established hypothetical airline, in your capacity as a Risk Analyst who is familiar with Derivative products.

The CFO is debating the effectiveness and business viability of hedging jet fuel and is seeking your advice. Her opinion is mainly driven by an international report that shows that not all airlines hedge jet fuel.

Question 1: (250 words)

The CFO is concerned about the strategic decisions of competing airlines. Airline fuel is a significant operating expense to airlines in general and may have significant price volatility. At the same time hedging using futures might be quite costly.

Given the statement above. Discuss whether hedging is beneficial for USC Airlines.

Answer 1

Hedging will be beneficial for USC Airlines. For any airline costs of jet fuel (also known as aviation fuel) is a major operating expense. The oil market is volatile and oil costs and profitability of airlines are susceptible and vulnerable to the risks of a volatile oil market.

USC will be able to safeguard its profits against the volatility of oil prices by fuel hedging. They can do this by agreeing to purchase oil at a future point in time at a pre-determined price. Thus USC can hedge the risk of a possible increase in oil prices by purchasing forward contracts. So when the expectation is that jet fuel prices will rise in future then USC Airlines can enter into futures contract and lock in the purchase price today. The airline will not have to pay higher price for oil in future when the price of oil/fuel rises.

USC can also purchase call options. By purchasing a call option USC will have the option of buying oil/fuel at a specific price within a certain date range. Thus USC will be 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.

Thus hedging is certainly beneficial for USC Airlines provided that it makes use of the hedging instruments in an optimal and systematic manner. The benefits from hedging will far exceed the costs and the company will be able to be insulated from rising fuel costs.

(word count = 250 words)