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

As a second measure of exposure, we use an approach suggested by Guay and Kothari (2003). They measure cash flow sensitivity to price risk by using a three standard deviation price change to illustrate the effects of an extreme move in underlying asset prices (i.e., interest rates, currencies, and commodities). In the case of jet fuel, a 45-cent (per gallon) change represents approximately three standard deviations. Thus, for each firm-year observation, we multiply gallons consumed by 45 cents to estimate the cash flow impact of an extreme jet fuel price change. Scaling this amount by firm-year capital expenditures provides an estimate of the decline in investment possible if jet fuel prices increase dramatically from one year to the next. Across firm-years from 1994-2003, the median of this value is 91%. Alternatively, this measure may be interpreted as the relative cash flow from the hedge resulting if the firm has hedged 100% of its fuel consumption. The median percentage of next year's fuel consumption hedged is 24% (for firms that hedge). Multiplying the prior amounts by 24% suggests that "normal" amounts of hedging would generate cash flow equal to 21.7% of capital expenditures in the event of an extreme price move. By contrast, Guay and Kothari find that the median firm in their sample would generate cash flow amounting to only 9% of investing cash flow. While the 21.7% vs. 9% figures mentioned above are not directly comparable, we note that capital expenditures are greater than or equal to investing net cash flow for over half of our sample. Thus, our comparison understates the greater importance of jet fuel hedging relative to the firms in Guay and Kothari's sample. Clearly, jet fuel hedging by airlines is economically meaningful in terms of their measure.

B. Jet Fuel Prices, Investment, Cash Flow, and Financing Environment

Froot et al. (1993) show that firms find hedging more valuable when the correlation between investment opportunities and cash flows resulting from hedgeable risks is lower. For airlines, this framework implies that hedging increasingly benefits shareholders if valuable investment opportunities are available when jet fuel prices are high (and internal cash flow is low as a result).

There are two major ways in which hedging can assist in an airline's ability to invest. First, airlines typically negotiate large purchase orders with aircraft manufacturers years in advance of delivery of some of the aircraft. Purchase orders are disclosed as firm commitments in the financial statement footnotes. However, the orders appear to include deferral/cancellation options as most carriers exercised such options following the terrorist attacks. Hedging preserves internal cash flow to meet future commitments to purchase aircraft.

Second, periods of economic downturn often result in failure and/or asset sales by financially weak airlines. Financially stronger airlines may be in a position to buy these assets at prices below fair value (e.g., Pulvino, 1998, 1999). Investment may also take the form of acquisition of a financially weak carrier. Kim and Singal (1993) show that such acquisitions typically yield higher fare environments upon completion of the acquisition. If hedging improves its cash position during economic downturns, the hedged airline may rely less (or not at all) on external sources of funds to make such capital expenditures (e.g., Froot et al., 1993). For example, AMR disclosed that its purchase of TWA during 2001 was funded with existing cash and assumption of TWA debt. (10)