HEDGING

Hedging tools:
1. Options 2. Futures 3. Swaps 4. Forwards

What is options?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security.

Types of options calls puts

What is futures?
A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Characterized by the ability to use very high le verage relative to stock markets.

What is swaps?
A swap is a derivative in which counterparties exchange cash flows of one party's financial intrument for those of the other party's financial instrument.

What is forward contract?

A forward contract or simply a forward is a non-standardized contract between two parties to buy or to sell an asset at a specified future time at a price agreed upon today.

Corporate Hedging Process

Identify the risks :-operating & financial Distinguish between:- hedging & speculating Evaluate the costs Right measuring stick to evaluate the performance Dont base hedge program on market view

Understand the correct hedging tools

Establish a system of control.

HEDGE OR NOT TO HEDGE

Sell Equipment

US Firm

German Company

10,000 Rate :1 =1.33 US $

HEDGE OR NOT TO HEDGE

US Firm
Should
HEDGE

Full Exposure

value

= FX Loss

US Firm

Reason

How To Hedge
Bank

Bid/Ask Quote

Euro 1.2300 Dollar 1.2400

US Firm

Value

1 = 1.1000 US $ /1.2500 US $

{ Gain Forward Position} Hedged Position =1 ( 0.2300 US $ ) * 10,000 = 2300 Hedged Position = 1 (-0.0200 US $ )* 10,000 = -200 { Loose Forward Position}

FUEL HEDGING IN AIRLINE INDUSTRY

Southwest was formed in 1971 by Rollin King and Herb Kelleher and the airline began with three Boeing 737 aircrafts Today, Southwest operates approximately 3,300 flights daily and boasts of being the only major airline to post profits every year for the last thirty six years It justifiably claims to be the United States most successful third largest low cost airline in the world If we dont hedge jet fuel price risk, we are speculating. It is our fiduciary duty to try and hedge this risk

Jet Fuel per Gallon

*Figure above shows Southwest's competitive advantage in jet fuel price which is considered to be the most critical expense category for any airline

3.TERMS OF HEDGE

Changes in Demand and Supply factors undermine Basis risk

Flexible long term positions in case of quantity and prices while designing its hedges

2.UNDERLYING COMMODITIES USED AND BASIS RISK

1. 2. Minimization of cost Flexible hedging strategy based on oil price cycle

1.TYPES OF DERIVATIVE CONTRACTS USED

CAPS

COLLARS

SWAPS

*Considerations to the Contract- Airlines hedge its jet fuel risk exposure through Plain Vanilla contracts as well as combination of products based on stages of oil price cycle Over the Counter Market sand Exchange traded risks

UNDERLYING COMMODITIES AND BASIS RISK

Basis Risk The use contracts based on an underlying asset different from the actual item hedged creates basis risk. changes in supply and demand. Locational risk. Difference between the term of the hedge and the risk exposure.

Hedging Commodities
Jet fuel
Crude & Heating oil

Oil future markets Future Contracts OTC

It is clear that the company tends to structure its program with a five/six year time window. However, they adjust their hedges every year depending of the short-term needs in term of quantity and prices.