Does hedging affect firm value? Evidence from the US airline industry

Financial Management (Financial Management Association), Spring, 2006 by David A. Carter, Daniel A. Rogers, Betty J. Simkins

Does hedging add value to the firm, and if so, is the source of the added value consistent with hedging theory? We investigate jet fuel hedging behavior of firms in the US airline industry during 1992-2003 to examine whether such hedging is a source of value for these companies. We illustrate that the investment and financing climate in the airline industry conforms well to the theoretical framework of Froot, Scharfstein, and Stein (1993). In general airline industry investment opportunities correlate positively with jet fuel costs, while higher fuel costs are consistent with lower cash flow. Given that jet fuel costs are hedgeable, airlines with a desire for expansion may find value in hedging future purchases of jet fuel. Our results show that jet fuel hedging is positively related to airline firm value. The coefficients on the hedging variables in our regression analysis suggest that the "hedging premium" is greater than the 5% documented in Allayannis and Weston (2001), and might be as large as 10%. We find that the positive relation between hedging and value increases in capital investment, and that most of the hedging premium is attributable to the interaction of hedging with investment. This result is consistent with the assertion that the principal benefit of jet fuel hedging by airlines comes from reduction of underinvestment costs.

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Recent literature in corporate finance has fostered an improved understanding of why nonfinancial firms may hedge. (1) However, very little research has focused on whether hedging achieves reasonable economic objectives. In particular, many researchers are interested in whether hedging increases firm value. Allayannis and Weston (2001) examine the relation between foreign currency hedging and Tobin's Q. They conclude that hedging is associated with higher firm value. On the other hand, Jin and Jorion (2004) find no relation between hedging and firm value for oil and gas producers.

This article contributes to the body of corporate risk management research in two important ways. First, given the conflicting results on the relation between hedging and firm value, we provide additional evidence regarding this question by studying the hedging of jet fuel price risk exposure by US airlines. The airline industry offers a unique perspective from which to analyze the value of firms' hedging activities because the industry is largely homogeneous and competitive. Further, we focus on the hedging of a single, homogeneous and volatile input commodity, jet fuel. Second, and perhaps more important, our analysis provides a better understanding of the source of potential value from hedging by airlines. To our knowledge, we are the first to find empirical evidence pointing to the source of value from hedging operations. We find that the airline industry exhibits two characteristics consistent with the general assumptions and framework developed in Froot, Scharfstein, and Stein (1993). First, the airline industry's history of investment spending is not negatively correlated with jet fuel costs, as one might expect. In fact, the relation between these two variables is largely positive. Second, airlines face significant distress costs. For example, Pulvino (1998, 1999) finds that distressed airlines are forced to sell aircraft at below-market prices. Froot et al. (1993) suggest that firms facing significant expected distress costs will choose to underinvest. The underinvestment cost is an indirect cost of financial distress (e.g., Stulz, 1996). They show that hedging is a mechanism to alleviate this underinvestment incentive. In their model, hedging is more valuable when investment opportunities display lower correlations with cash flows from hedgeable risks. Simply put, the airline industry provides an excellent sample setting because its environment conforms well to this theory of hedging.

The results show that airline firm value is positively related to hedging of future jet fuel requirements. Additionally, changes in hedging are positively associated with changes in firm value. As in Allayannis and Weston (2001), we interpret certain results from our regressions as the "hedging premium" (i.e., the added firm value attributable to hedging). Our results suggest that the average hedging premium for airlines is likely in the range of 5%-10%.

Given investment patterns in the airline industry, the value premium suggests that hedging allows airlines more ability to fund investment during periods of high jet fuel prices. The positive relation between hedging and value further suggests that investors view such investment as positive net present value projects. We find that the interaction between hedging and capital expenditures captures a large majority of the hedging premium. We also examine a two-stage system in which hedging impacts value through its effect on capital expenditures. The results of this procedure also suggest that the hedging premium is largely attributable to the effect of hedging on capital investment.