More on the Good Sense of a Short-Term Focus for Hedging

In an earlier post we discussed one of several reasons why companies tend to focus their hedges on short-term cash flows, leaving long-term cash flows unhedged. There we pointed out that the right response over the long-run to fluctuating prices and other risk factors, is changes in the operations and investments of the firm in order to re-maximize profits in light of the new competitive conditions. But there are several distinct reasons for the practice, and that was only one of them.

Another reason why firms concentrate their financial hedges on short term cash flows has to do with uncertainty about the nature of the exposure at longer time horizons. Competitive exposures are very complicated, and involve many, many risk factors. We oftentimes focus on a single specific risk factor and quantify the exposure in very simplistic models. This is necessary if we are going to implement a financial hedge. For example, the airline needs to buy or sell futures contracts on a specific type of fuel delivered at a specific location on a specific date. To design that hedge we try to quantify the airline’s exposure measured in terms of the commodity represented by that specific fuel. But this focus on a single risk factor and exposure measured using recent data is only valid for very short horizons. The correlation between the futures price for that specific fuel and the airline’s actual cash flow may not hold at some distant date. All sorts of changes could undermine the validity of extrapolating that correlation. Some of these may be changes in the industry’s competitive dynamics, some may be in the types of fuels that are used by the airlines. For example, if bio-fuels gradually replace fossil-based fuels in jets, then the correlation between crude oil prices and the airline’s exposure will almost certainly change. The higher the uncertainty about the industry dynamics, the less a firm should commit to hedge, because it knows less how much it should hedge. And the essence of uncertainty is that it increases just with the length of time into the future. Prudence (i.e., sound risk management) indicates that it is not right to make commitments – either firm or contingent – when ignorance pervades.

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  1. […] How about simply abandoning hedging completely, and switching to a ticket pricing policy that includes a pass through of fuel costs? This is another alternative mentioned in the Bloomberg article. While it always makes sense to review assumptions about pricing and the pass through to consumers, it is a dangerous illusion to imagine that a company can reduce its exposure to zero just by willing it so with a simple pricing rule. Even if an airline were to explicitly price its tickets in two parts—a base airline fee, plus a fuel surcharge tied to the daily market price of jet fuel—the airline would still be exposed to fluctuations in jet fuel prices. This exposure has at least two parts. One has to do with the delay between the date on which the typical ticket is purchased and the date on which the passenger flies. The cost of the jet fuel can fluctuate between these dates. The second has to do with demand elasticity to price. If customers respond to an increase in jet fuel prices by cutting back on the number of flights they take, the airline will take a hit. It still has to pay for the airplanes it owns or rents. It still has to pay its labor bill. It still has costs tied to gate fees and other structural expenses. Re-optimizing the airline’s operations in response to changing factor prices takes time. In the meantime, cash flow is made volatile by the change in the jet fuel price. Instead of trying to imagine away exposure by force of will, an airline needs to realistically assess its industry, its flexibility, customer flexibility, and so on, and arrive at a comprehensive strategy. Financial hedging is almost certainly a part of that strategy. How large a part depends as well upon a realistic assessment of basis risk and the ‘cost’ of hedging. ……. Related posts on airline hedging here and here. […]

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