Derivative Securities

FINA 3204
Fuel Hedging by
Hong Kong Listed Airlines
Andrew Chiu, PhD
andrew.chiu@ust.hk

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

Cathay Pacific

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

Fuel Surcharge as a Hedge

Even with the latest increase, the airline estimates that surcharges cover less
than half of the increased cost of fuel. Soaring jet fuel prices are posing an
enormous challenge to the aviation industry. Jet fuel costs now account for about
half of the Cathay Pacific's net operating costs, compared with 39% a year ago.

A Cathay Pacific spokesperson said, There is a significant time lag of two to three
months from the time we submit our fuel surcharge application to the CAD to the
time the new surcharges become effective. For example, the supporting
information we submitted earlier this month to the CAD was based on average jet
fuel prices in May and June since the last review.

Despite the recent drop in crude oil prices, jet fuel prices are still very expensive
and higher than the levels when fuel surcharges were last adjusted two months
ago.
Press Release, Cathay Pacific, 25 July 2008
The Hong Kong University of
Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

How is fuel hedged?

The simplest way of hedging is buying a swap, and following that, buying a call,
says Lim. "The problem comes where you buy a call and sell a put," he says.
"Collars were very common when WTI crude oil was $120-130 a barrel in summer
2008. You're selling a put to fund the call you're buying. If oil goes up, you profit
because of the call, but if it goes down you get hit on the flip side because of the
put.

"If you'd done a simple call option, which was very expensive at the time (in mid2008, because the expectation was that prices would rise), you would have lost
the value of it (because the oil price dropped)," he adds, "but you wouldn't have
had the downside risk.

But Lim concedes it is getting increasingly difficult to analyse airlines' fuelhedging positions, because "they won't tell you what the strike price is; they
won't tell you how much they've got exposed; and they won't tell you what
structure they are using".

Source:

http://www.energyrisk.com/public/showPage.html?page=839641
Feb 12, 2009

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

Clues from 2006 Financial Report

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

Jet Fuel & Crude Oil Relationship

http://www.iata.org/whatwedo/economics/fuel_monitor/price_development.htm
The Hong Kong University of
Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

Oil Swap

Pay Fixed Oil Rate

Cathay
Pacific

Oil / Fuel
Producer
Receive Market Rate
based on Oil Index

Unlike a forward, no oil is transferred

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

Collar
Payoff

Buy Call
Crude Oil Price

Sell Put
Buy Jet Fuel

Collar

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

3-Way Option
Payoff

Buy Call
Crude Oil Price

Sell Put

Write Call

Buy Jet Fuel

3-way Option

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

ICE Brent Crude Oil Prices (2008 Jan - 2009 Mar)

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

Proposed Strategy (Mar 18, 2009)

Payoff

Buy Call
Crude Oil Price

Protective Call Option

Buy Jet Fuel
The Hong Kong University of
Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

China Eastern Airlines

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

Hedging Losses
China Eastern Airlines Corp and other state enterprises involved in
derivative trading are being investigated by the National Audit
Office, indicating that Beijing is taking action to hefty losses incurred
in hedging activities by key enterprises. Officials from the watchdog
were at China Eastern for several days, in search of information on
hedging transactions that incurred 6.2 billion yuan (HK$7.04
billion) of unrealised losses for the Shanghai-based carrier, a
report by Shanghai's Eastern Morning Post said yesterday.

Source: South China Morning Post, Jan 14, 2009

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

Clues from 2006 Financial Statement

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu

Buy 1 Call, Sell 2 Puts

Payoff

Buy 1 Call

Sell 2 Puts
Crude Oil Price

Buy Jet Fuel

Protective Call + Speculative Put

The Hong Kong University of

Science and Technology

FINA 3204: Derivative Securities

Andrew Chiu