Hedging Commodity Price Risk

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Hedging constitutes one of the most important financial decisions of any firm. It refers to different ways through which a company can minimize its exposure to various kinds of risks. Fuel represents a crucial cost in the total airline expenditure and thus fuel price risk has a great impact on the earnings and cash flows of airlines. Any drastic increase in oil prices can adversely affect cash flows. Effective hedging strategies are imperative for airlines to minimize the variability of cash flows due to volatility in the oil price (Carter, Rogers. and Simkins, 2003). This is why almost firms use various hedging strategies to protect their cash flow from variations resulting out of oil price fluctuations. Froot, Scharfstein and Stein propound that if a firm does not hedge, there will be some variability in the cash flows generated by assets in place. (1993, p. 1630) A non-hedging airline is also likely to be greatly vulnerable to any change in fuel market price.
Because of the effectiveness of hedging in commodity price risk management, firms are not adversely affected by the sudden rise in oil prices. Any adverse fluctuation in oil price can greatly affect a firm’s earnings and its ability to pay off its debt obligations. Froot, Scharfstein and Stein suggest that for a given level of debt, hedging can reduce the probability that a firm will find itself in a situation where it is unable to repay that debt. (1993, p. 1632) This is one of the greatest benefits of using hedging strategies to manage commodity price risk. These strategies assure management that even if the commodity price moves in the unfavorable direction, it will not have a great impact on the firm’s earnings and cash flows.
Forward contracts are the most common hedging strategies used by firms. Southwest airlines managed its exposure to oil price risk in the year 2005 with the help of forwarding contracts and successfully enhanced its earnings. On the contrary, in the same year, other airlines like Delta and United Airlines faced great difficulties. However, there is a high credit risk involved in hedging strategy using forward contracts. Froot, Scharfstein, and Stein elaborate that …because they are not settled until maturity, forwards can involve substantially more credit risk than futures. (1993, p. 1649) Forwards have a distinctive feature as compared to the futures contract that they cannot be settled before the maturity date. Hence, on one hand forwards strategy helps firms to considerably minimize their exposure to commodity price risk, it also leads to significant credit risk.
A futures contract is another most commonly used strategy that firms can use to hedge against the commodity price risk. Veld-Merkoulova and de Roon (2003) illuminate a ‘naïve’ strategy which relies on short term futures contracts for the purpose of hedging long term position in the spot market when the size of both the positions are the same. Under this hedging strategy, the futures contract is closed on the same date as that of the spot contract if a futures contract has a maturity date following the spot contract. In the opposite situation, this strategy requires a firm to constantly rebalance the hedging portfolio as the futures contract matures. It thus requires a firm to keep a short term futures contract for every single spot contract.