Monday, October 20, 2008

In Hedging you win some and you lose some.

Southwest's infatuation with fuel hedges backfires - MarketWatch:
"Given oil's relentless ascent, investors have been dumbfounded that Southwest's hedging program wasn't universally used by other airlines, who unfailingly blame their weak financial performance in part on rising fuel costs.
Then came the crash. Oil is now trading at half the price it fetched just three months ago. Suddenly, Southwest's aggressive bet on the market went bad"
No it did not go "bad". Almost by definition hedges will lose money when the risk the firm is hedging moves in their favor. So airlines worry about jet fuel prices. Holding other things constant, airlines drop in value as teh fuel prices rise and vice versa. So, their hedges are designed to "lose" money when the firm can better handle the losses and make money when operations would otherwise be hurting. In doing so they allow the firm (Southwest in this case) to focus on what they do well (run an airline) and not worry about what is outside of their control (price of fuel). The hedges are not designed to make money 100% of the time.

The AP had some more details and did come a bit closer to the story:

"The fuel-hedging deals at the core of Southwest's numbers include options to buy fuel in the future at below-market prices. They succeeded again in saving the airline money on its largest single expense.

Southwest's fuel spending jumped 52 percent, to $1 billion, but the airline paid less per gallon than did other major U.S. airlines.

And while Southwest took a charge to write down the value of its hedges, it also recognized cash settlement gains of $448 million from fuel contracts, and included that money in its net income."

So if I am reading this correctly, the loss was an accounting write-down, while the savings are cash saved.
A good deal in my book! But even if I am not reading it correctly, hedging (as opposed to speculating) is still the way to go in my opinion!



2 comments:

Jonathan said...

You're right hedging increases firm value. Carter Rogers Simkins show it works for airlines (Financial Management 2006?) and new work presented at FMA shows it's good for biotech.

J. Futures Markets will soon have a brilliant piece on how airlines should hedge.

Anonymous said...

Heding is a form of insurance. People don't intend to make money on their fire insurance. Home fire insurance for a home owner (more correctly, most home owners are debt owners, not home owners) is a put option. The option (or warrant) can be exercised (American style) upon the occurrence of a fire and sell the home back to the insurance company
for replacement or some other value.

Hedges can also be thougth of as a risk transfer mechanism. In fact, as a former CBOT floor broker, the CBOT will tell its visitors at the old visitors gallery that CBOT performs two functions, price discovery and risk transfer.