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

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We start our analysis by identifying publicly held US passenger airline companies with information available on the Compustat database during 1992-2003 (SIC code is 4512 or 4513). We use the 10-K filings of these firms to obtain data regarding management of interest rate, foreign currency, and jet fuel risk exposures. Twenty-nine airlines disclose adequate levels of data for our analysis. We eliminate one airline (Western Pacific) because its filings contain limited data covering only two years of the sample period.

We find that airlines manage all three of these risks. From 259 firm-year observations, we find 65 (58) disclosures of derivative usage specifically to manage interest rate (foreign currency) risk. Meanwhile, 88 firm-year observations include disclosures that some of next year's jet fuel requirements have been explicitly hedged as of fiscal year-end. Many of the airlines that do not disclose hedging future jet fuel purchases discuss using fuel risk management tactics such as fuel pass-through agreements entered into with major airline partners or charter arrangements that allow for fuel costs to be passed along to the organization chartering the flight. Examples of airline disclosures about various mechanisms for managing fuel price risk are shown in the Appendix.

Overall, airline disclosures suggest fuel price risk is of significant importance. Fuel price risk is ubiquitous across all airlines, as opposed to foreign currency price risk that applies only to the relatively small set of airlines that operate in foreign markets. For example, foreign sales as reported by Compustat are non-zero for only nine of the companies in our sample. Interest rate risk would seem important in a highly levered industry, but interest rate derivatives usage among our sample firms suggests that interest rate risk is of a lower magnitude than jet fuel price risk. As such, we focus the attention of our analysis on jet fuel price risk. Nevertheless, our subsequent analyses incorporates interest rate and foreign currency decisions separately from jet fuel hedging decisions. (3)

Table I summarizes jet fuel costs and hedging policies of the sample airlines across available firm-years. For the full sample of firm-year observations, fuel costs average about 13.6% of operating expenses. The percentages range from 8.5% (Mesaba Holdings) to 18.8% (Airtran Holdings).

The next set of three columns in Table I reports information regarding hedging of future jet fuel requirements. We show the calendar years in which fuel hedges are in place as of fiscal year-end, maximum maturity of the hedge in years, and percentage of next year's fuel requirements hedged, respectively. (4)

Major airlines (defined as carriers with annual revenues in excess of $1 billion) more commonly hedge future jet fuel purchases than do smaller ones. While all major airlines hedged during part of the period 1992-2003, only AMR and Southwest Airlines always had hedges in place at the end of every year for which we have data. Eighteen of the 28 firms reported hedging jet fuel in at least one year. Of hedging firms, the average hedged percentage (on an equally-weighted basis) of next year's fuel consumption is approximately 15%. (5) We observe wide variation in the amount of fuel hedged, even among hedgers. Recently, Southwest Airlines has often hedged close to 80% of its coming year's fuel requirements. In the late 1990s, UAL typically had hedges in place for most of their next year's expected consumption. However, it is not uncommon to observe airlines that hedge very little or none of its future fuel purchases. This type of cross-sectional variation within an industry setting is generally consistent with recent theoretical models such as Adam, Dasgupta, and Titman (2004) and Mello and Ruckes (2004). Most hedging airlines also report the maximum maturity of jet fuel hedges. In recent years, airlines have been increasing the maximum lengths of hedging horizons. Southwest has gained some notoriety in the press recently for extending its fuel hedges to a maximum maturity of six years. (6)