Thursday, April 02, 2009

Airlines Return to Hedging -

According to the WSJ, airlines are making a switch from futures to options for their hedging programs.

Airlines Return to Hedging -
"..oil prices are starting to rebound, creating a quandary for the industry. If the airlines dive back into hedging, they could end up overpaying once again should oil prices fall back. Remaining unhedged would leave airlines exposed should the recent rally extend into a price spike.

The answer, some airlines say, is to hedge their bets on how to hedge. Carriers are relying increasingly on instruments that reduce the burden of rising oil prices, but leave open the option of purchasing fuel at market rates should costs fall back. These derivatives have greater upfront costs, but airlines are unlikely to see a repeat of the massive charges they reported in their fourth quarters from hedging programs gone wrong."
and later
" The airline is using a mechanism known as a call option, which grants it the right to buy oil futures at $60 a barrel, even if their value has risen above that level. The options are pricier than other hedging instruments, but still allow an airline to take advantage of cheaper fuel when oil prices fall.
Excusing the article appears it was written for an introductory finance class, it is interesting to see the switch to options. It is surprising that futures were used as much as they were when they create an obligation to lose if prices move against your hedge. Or as you learn in any finance class: options hedge the moves against you while allowing you to participate in moves that are in your favor. The disadvantage is that they often are not as liquid and have higher transaction costs.

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