CASE STUDTY

The Case of Southwest

Airlines

1&2
Why do firms like Southwest hedge?
What are the benefits of hedging?
Does heating oil or crude oil more
closely follow the price of jet fuel? (To
answer this
question, use the information in the
Excel spreadsheet)

3
a) Evaluate each of the five proposed hedging strategies.
What are the benefits of each hedge based on two fuel
price scenarios in one year?
In other words, assume in June 2002 that one of these
scenarios occurs.
Calculate your net cost of jet fuel under each scenario
incorporating the hedging strategies used. (Note: you can
analyze the hedges under as many price scenarios as you
wish, but be certain to include the following two
scenarios.)
For both scenarios, consider full hedging and a 50% hedge
strategy.

SCENARIO 1: 39.3 cents/gallon spot price for

jet fuel; 38.8 cents/gallon spot price for
heating oil, or $14.10 per barrel spot price for
crude oil, and
SCENARIO 2: 119.6 cents/gallon spot price for
jet fuel; 118.6 cents/gallon spot price for
heating oil, and $40,00 per barrel spot price
for crude oil.
(b) Discuss the pros and cons of each hedging
strategy.
(c) Describe how a combination of the hedging
strategies can be used.

4
What are the risks of being unhedged? Totally hedged? (Note: the
February 24, 2004 Wall Street Journal
article titled Outside Audit: Jet-Fuel
Bets Are Risky Business by Melanie
Trottman may be useful.)

5
(a) What is basis risk and how is it
different from price risk?
(b) What are the implications of a
changing basis?
(c) Does basis risk exist for
Southwest Airlines in their fuel
hedging program?

6
What do you recommend to Scott
Topping? Why?

5 Hedging Strategies

Plain Vanilla Swap

Differential Swaps and Basis Risk
Call Options (Caps)
Collars, Including Zero-Cost and
Premium Collars
Futures and Forward Contracts

Plain Vanilla Swap

The plain vanilla energy is an agreement
whereby a floating
price is exchanged for a fixed price over a
certain period of time.
Both parties settle their contractual
obligations by means of a
transfer of cash.
In a fuel swap, the swap contract specifies the
volume of fuel,
the duration (i.e., the maturity of the swap),
and the fixed and
floating prices for fuel.
The differences between fixed and floating

Differential Swaps and Basis Risk

differential swap is based on the difference between a
fixed
differential for two different commodities and their actual
differential over time
The airline can used an additional swap contract, the
differential
swap for jet fuel versus heating oil, to hedge basis risk
assumed
from the heating oil swap. The net result is that the
airline can
eliminate the risk that jet fuel prices will increase more
than
heating oil prices.

Call Options (Caps)

A call option is the right to buy a particular asset at a
predetermined fixed price (the strike) at a time up until the
maturity date. OTC options in the oil industry are usually cash
settled while exchange-traded oil options on the NYMEX are
exercised into futures contracts.
OTC option settlement is normally based on the average price
for
a period, commonly a calendar month.
Airlines like settlement against average prices because an airline
usually refuels its aircraft several times a day.
Since the airline is effectively paying an average price over the
month, they typically prefer to settle hedges against an average
price (called average price options).

Collars, Including Zero-Cost and Premium Collars

A collar is a combination of a put option and a call
option.
For a hedger planning to purchase a commodity, a
collar is created by selling a put option with a
strike
price below the current commodity price and
purchasing a call option with a strike price above
the current commodity price.
The purchase of a call option provides protection
during the life of the option against upward commodity
price movements above the call strike price

Futures and Forward Contracts

A futures contract is an agreement to buy or sell a
specified quantity and quality of a commodity for a
certain price at a designated time in the future.
A forward contract is the same as a futures contract
except for two important distinctions:
(1)Futures contracts are standardized and traded on
organized exchanges, whereas forward contracts are
typically customized and not traded on an exchange
(2) Futures contracts are marked to market daily,
whereas forward contracts are settled at maturity only.