Term Paper: Use of Derivatives in a Chosen Company

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International Finance

The Use of Derivatives by Southwest Airlines

Southwest Airlines is one of the most successful airlines in the U.S.; remaining profitable in many years when other airlines suffered losses, including the aftermath of 9/11. The low cost airline achieves this with a range of strategies, including a very active hedging strategy using derivatives. To appreciate the way that derivatives have played a role in Southwest Airlines financial performance the subject may be discussed, looking at what is meant by the term derivative and the way they are used by Southwest in their hedging strategy, along with consideration of the reasons the firm may have utilized this strategy along with the results achieved by the firm.

Derivatives are financial tools designed to create a price exposure based on the valuation of an underlying asset, commodity or even event and capture the market price changes or fluctuations (Dodd, 2002). The term derivative reflects the structure of the financial tool, deriving their value with reference to the underlying asset or security (Dodd, 2002). This is usually achieved without the transference of any title (Dodd, 2002). There are different types of derivative which may be utilized; these include forwards, futures, options and swaps. A brief consideration of the different categories of derivatives will help one to appreciate the way in which they may be used by firms such as Southwest, usually with the aim of reducing some type of risk as part of a wider risk management strategy.

A forward is one of the oldest types of derivative, with records of this type of people demonstrating its use as long ago as 2000 BCE in India (Markham, 1987). This is a contract where there is an agreement to buy, borrow, sell or lend a specific amount of a commodity at a specific time in the future for a specific price. Forward contracts are individual, so terms and conditions for each will vary (Howells and Bain, 2007). Futures are similar to forwards, as they are in agreement for a transaction to take place in the future for a set amount of a commodity/asset at a set price. Unlike forwards they are standardized contracts and fungible, and are easily traded on secondary markets (Sundaram, 2010).There is in trading increases their potential use as a speculative tool (Sundaram, 2010). These are useful tools, but Southwest Airlines does is not used futures or forwards with in their hedging program, as they now require a higher level of flexibility having made losses with the use of futures in the past. Instead, the hedging program currently utilizes only options and swaps.

An option is similar to a future, but rather than purchasing a contract where there is a commitment to undertake a transaction, the contract offers the purchase of the option to undertake that transaction. Two types of option exist; a call option where there is an option to buy, and a put option where there is an option to sell. After purchasing the option the owner of the contract will decide whether or not to exercise the option by comparing the price for the underlying asset in the contract with the spot price, if the contract owner does not exercise the option by the specified time the option will simply expire. It is notable that there are differences between options sold in the U.S. And the EU, U.S. options can be exercised at any time during the contract, whereas options sold in the EU markets can only be exercised on the specified date (Sundaram, 2010). Southwest purchases U.S. options to protect its exposure in its fuel hedging strategy (Southwest Airlines, 2012).

The last of the main types of derivatives swaps, these are more recent than the former derivatives discussed, developed in 1981 (Sundaram, 2010). This contract is agreement where two different parties will make an agreement to swap to different types of payments; different types of swaps exist, including interest rate swaps including exchange rate swaps. Southwest utilizes swaps in both fuel hedging program strategy as well as the interest rate hedging strategy (Southwest Airlines, 2012).

Therefore, different types of derivatives may be utilized in order to create a contract it increases certainty, or rather reduces uncertainty in transactions that a business may undertake. One of the main uses of derivatives is in the practice of hedging, as seen with Southwest. Hedging is utilized by firms to protect and "open" position. An open position may be defined where an organization has exposure to potential losses depending on the way that market prices of commodities of the underlying assets move, and regardless of the price movements the organization will need to make a purchase undertake the relevant transaction.

Hedging is a financial tool that can help to reduce the exposure of an organization to the movement of market prices. Giddy (2002) defines hedging as a financial tool which facilitates the transformation of "Unacceptable risks into an acceptable form….. The goal of any hedging program should be to help the corporation achieve the optimal risk profile that balances the benefits of protection against the costs of hedging."

The practice of hedging may be performed using a range of different financial tools, with derivatives being the most commonly utilized (Cusatis and Thomas, 2005). There are two potential types of hedging, short hedging and long hedging. Short hedging takes place where a contract is purchased for the sale of the commodity, long hedging is the acquisition of the contract for the purchase, or write to purchase a commodity at a future date (Howells and Bain, 2007). Therefore, as Southwest Airlines open position concerns the acquisition of commodities, the strategy followed is that of long hedging, utilizing options and swaps.

At face value Southwest Airlines undertake this strategy as a method of reducing exposure to risk. However, it is notable that a number of airlines do not undertake similar strategies, and looking at some countries such as China, companies were not allowed to use derivatives for hedging until 2008.

In contextual terms Gibbons (2011), argues that undertaking hedging can be seen as a conservative approach, as it is effectively the purchase of an insurance policy, limiting the upper price will be paid for a commodity in the future. However, it also needs to be noted that while this insurance policy may help to reduce the risk of the commodity price volatility, it also creates a divergent risk exposure; basis risk.

Basis risk occurs as a result of the potential difference between the contract spot price for a commodity and the agreed price for the underlying commodity in the derivative. The derivative price for the commodity will reflect the market expectations of the future influences on the commodity, whereas the spot price is the current price (Sandaran, 2010). The ideal situation will see the difference in the commodity price in the derivative contract and spot price move closer to zero as the contract moves closer to maturity (Chorafas, 2008). However, this convergence of price does not always occur due to the asymmetrical nature of the marketplace (Chorafas, 2008). In addition to asymmetries of information there is also the potential for unexpected intervening events to impact on spot prices (Chorafas, 2008). The higher the difference between the contract price and the derivative and the spot price the greater the potential basis risk. It may be argued that where there is use of options rather than futures and forwards the level of basis risk is reduced, as the company is not necessarily committed to making a purchase if the spot prices lower. However, this does not eliminate risk, as the company will still have incurred the cost of purchasing the option contract in the first place. Therefore, the company is swapping one type of risk for another.

When looking at the underlying reasons why Southwest airlines may undertake hedging with derivatives research indicates that the main trend is that for risk reduction. However, research undertaken Smith and Stulz (1985) and Ross (1996) identified a number of potential benefits in utilizing this type of strategy. Companies, including airlines, which undertake hedging, may be perceived by stakeholders as presenting a lower level of risk compared to comparator companies which do not utilize hedging. It is argued that the strategy of undertaking hedging may help to prevent potential bankruptcy costs, as creditors may feel more confident in management of the company and their ability to recover debts (Ross, 1996). Ironically, it is companies that face the greatest financial challenges/difficulties which are least able to undertake risk management from hedging in derivatives (Rampini et al., 2011). The difficulties for these firms are caused due to the upfront investment in the contracts and commitments that are required as part of that strategy and their own constrained liquidity (Rampini et al., 2011). It may be noted that Northwest Airlines reduced their hedging due to liquidity problems prior to filing for bankruptcy (Adams, 2005).

This theory may also support the theories of Smith and Stulz (1985), where firms with an active risk… [END OF PREVIEW]

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