2012 Fuel Hedging at JetBlue Airways – Case Solution

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2012 Fuel Hedging at JetBlue Airways Case Answers

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1. Introduction – 2012 Fuel Hedging at JetBlue Airways Case Study

During the lifetime of a business, many different risks could affect its overall value. Companies use insurance to protect themselves against unlikely events that could affect the value of their assets.

These losses in value are derived from damaging hazards such as catastrophes outside their ordinary course of business. Together, firms face many other dangers as part of their business operations (Berk & DeMarzo, 2011).

Corporations implement risk management skills to protect against corporate value-decreasing exposures, such as currency exchange rates, interest rates, and commodity prices; therefore, they increase their corporate market value.

For companies such as JetBlue Airways, excess volatility in the costs of the commodities they use and/or products can be the highest cause of risk to their profitability.

According to Matos (2017), JetBlue’s purchase of jet fuel represents almost 40% of the total operating expenses. To secure from these risks, the financial market provides multiple different instruments for hedging. Hedging involves contracts or transactions that provide the firm with cash flows that offset its losses from price changes (Berk & DeMarzo, 2011).

The purpose of this report is to advise JetBlue on its hedging strategy by looking at the current trend in the oil commodity-related prices and the value-adding that hedging could provide to JetBlue Airways’ market value. The remainder of the report proceeds as follows.

Section II introduces the theory of hedging and explains what futures and forwards are as hedging contracts. Section III discusses in detail if JetBlue should hedge in the following expected year of the case: 2012.

Moreover, as an analysis, the correlation of different oil commodities is shown together with a back-test on the profit and loss from different hedging scenarios.

Also, the JetBlue Airways time series before and after the hedges graphs are shown. Section IV compares the literature on corporate finance risk management with this case. Finally, section V concludes.

2. Hedging Theory

Hedging is a critical strategy to implement for listed companies for several reasons. It’s challenging to play out hedging strategies for all the possible risks deriving from reasonably significant business activity.

However, it is fundamental to protect the core business of a company by momentary speculation opportunities. For a company like that, opportunities are mainly derived from certain commodities that are physiologically necessary for the operating practice.

But risks to hedge for a company also come from foreign currency exchange rates or interest rates. Swings in prices of those mentioned commodities could indeed represent a loss in the value of the assets, which JetBlue Airways cannot ignore.

Companies should also decide to assume hedge positions towards the core risks of their business to protect their investors. Shareholders, who could also consider a hedge position on their own, could not have the necessary information about risks faced by the company or just the financial knowledge required to implement such an exceptional investment strategy.

Also, transaction costs represent quite a high barrier for the single investor to hedge their risk exposure privately. All these elements make the hypothesis of self-hedging shareholders impossible, in fact.

However, the main reason managers should hedge is that lowering the idiosyncratic risk of the company is a necessity they need to supply, providing several benefits the company should not go without in terms of risk transfer to better bearers.

In particular, categories of risk like the product or geographic risk, which an average investor could be easily protected from by an essential portfolio diversification, could represent a significant menace to a company. Finally, lowering the company’s tax liability could be a determinant factor for a manager to decide to hedge some of the core risks since insurance premiums are often tax-deductible.

Hedging aims to reduce the company’s inertia towards fluctuations in commodities prices, decreasing the risk associated with such fluctuations, and trying to fix a stable value to account for those assets. This technique is implemented in purchasing term contracts whose value is negatively correlated with commodity prices they are hedging from.

The basis is the difference between the spot price of the underlying commodity and the cost of term contracts. They do not necessarily vary by the same amount, so this difference (the basis indeed) may enhance or decrease, causing variable gains or losses depending on the hedged position.

The uncertainty regarding the value of the basis is defined as basis risk – or hedging risk – which is generally attenuated by computing the optimal variance hedge ratio. This, depending on the relationship between the variations of the two prices, allows us to adjust the hedge position and minimize the basis risk. This operation is called “tailing” and is perpetrated by multiplying the hedge ratio by the daily spot price to the futures price ratio (Hull, 2012).

Forward and Futures

Term contracts are typically divided into futures and forwards. The main difference between them is that futures are standardized and consequently more liquid and tradable on regulated markets.

Forwards contracts show more customized terms (they practically represent private agreements between two parties) and have one settlement date at the end of the contract. The benefit deriving from hedging with forwards is evident in that they are less exposed to the mentioned basis risk and don’t need any tailing operation due to their not being marked-to-market (traded and settled daily).

However, being sold over-the-counter, they include high…