Fuel hedging in the airline industry : a case study on Malaysia Airline

Abstract

The cost of jet fuel is the second largest operating expenditure in the airlines sector. Even a small increase in the fuel price often leads to a significant increase of expenditure on the operating cost of the airlines. Airlines use derivatives as hedging instruments for hedging their fuel requirements. However, derivative contracts on jet fuel, is not often traded in exchanges and the airlines engages themselves in cross hedging. This practice exposes them to another risk known as basis risk, while protecting them from the price risk. The primary objective of this paper is to look into the effectiveness of cross-hedging practiced by the airline industry. It looks into the problem of basis risk attempting to identify its' significance in terms of un hedged exposure it creates which could possibly lead to very significant financial losses. The effectiveness of hedging strategy of Malaysia Airlines was analyzed using secondary data obtained on the proxy commodity used by the airline. The data was analyzed using standard practices of airline industry in designing an optimal hedge. The calculations made attempts to identify the proportion of the price risk volatility that can be hedged and the proportion of the exposure that remains un hedged, when the said proxy is used to hedge jet fuel. The result showed that a significant portion of the price risk volatility remained un-hedged. This finding was in agreement with the established theory that high correlation between commodities does not remove the basis risk. It concludes that along with many other factors, the un-hedged exposure due to basis risk would have contributed to the losses suffered by the airline in their fuel hedge for the year 2011, unless precise measures are taken to hedge the basis risk.