Question

Research paper “Dynamic Risk Management” (JFE, Rampini, Sufi, Viswanathan) showed that those US airlines that experienced financial distress in 2004-2005 chose not to hedge their commodity price risk. As financial health of US airlines improved they became active hedgers. Please explain the paper’s findings from the point of view of the agency theory (conflict between shareholders and bondholders)

Answer 1

The research paper “Dynamic Risk Management” (JFE, Rampini, Sufi, Viswanathan) talks about the lack of risk management. The paper says that lack of risk management is nothing but a reflection of a bondholder shareholder conflict. This conflict gives rise to agency problem.

It should be noted that managers (who are the agents) will want to take part and engage in risky actions so as to be able to maximize the benefit for shareholders (the principals). High risk will lead to high probable returns and this attracts the managers and the shareholders. Bondholders, on the other hand, are interested in a safer investment opportunity as they are not very keen on taking unnecessary risk. This creates a conflict between bondholders and shareholders.

This conflict or agency problem was apparently a crucial factor why many US airlines chose not to hedge their commodity price risk. However research and findings of the paper show that, in fact, the conflict or agency problem did not lead to risk shifting by the airlines. Airlines have a preference towards betting on a drop in fuel prices rather than hedging against a possible increase in fuel prices. The airlines will not hedge and instead will speculate. This shows that risk shifting is not due to any ex post conflict of interest between the shareholders of the airlines and the bondholders. Had this been the case the bondholders would have certainly required the airline to hedge a minimum amount.