Category Archives: hedging

When a Short-Term Focus Makes Good Sense

People are often surprised at the short horizon of many corporate hedges. For example, airlines with disciplined hedging programs, only buy fuel forward for a short horizon. A typical hedging program locks in 100% of anticipated fuel purchases over only the next few months—possibly 3-6 months. Thereafter the hedge ratio declines sharply, so that the airline has no hedges for fuel purchases beyond 24 months or so. The airline is left fully exposed to long-term fuel price fluctuations. This fact contributes to the concentration of hedge trading in the shortest maturity futures contracts.

There are multiple reasons why it makes sense for corporates to concentrate their hedging on short horizon exposures. One of the main reason is that the best way to respond to medium and longer horizon exposures is through active management of the firm’s business operations and adjustments in the firm’s investment program. Financial hedges are useful for covering short-run exposures when the company has little flexibility to adjust its operations and investments.

A rise in fuel prices is a change in the real price of doing business. Operations and investments ought to respond to real prices.

One way an airline can respond is to pass the higher cost along to the customer in the form of higher ticket prices. When that is possible, it isn’t even technically correct to say that the airline is exposed to the price of fuel oil, and it doesn’t make any sense for the airline to lock in the price of fuel. Of course, the cost cannot always be passed on. In the short horizon, there may be frictions that prevent the airline from adjusting ticket prices. For example, it may have already sold some tickets and committed to the price. At longer horizons these frictions aren’t relevant, but some consumers will be price sensitive and may cutback on their flying, limiting the airline’s ability to simply raise prices. This brings us to the second way that an airline can respond. If some customers are unwilling to pay the higher cost of flying, then the airline needs to adapt the profile of products it is offering. This may include changing its route structure, its mix of business and economy class seating, as well as the number of flights/seats on certain routes, and so on. Obviously these actions take time and cannot happen immediately. But over a longer horizon these should be the real focus of the airline’s decision making.
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