Southwest Hedging Strategy Case Study Solution
Introduction
Southwest is one of the successful airline companies started in 1971 by Herb Kelleher & Rollin King. The aircraft is providing its services in (Texas cities) Dallas, Houston, and San Antonio. The key strategy to the success of the airline is to provide passengers fastest services with the lowest possible fares so that people will prefer to fly with the airline. The airline had been innovative and had realized the importance of airline as a commodity business in the future. Southwest provided its services to 58 airports and operated 344 Boeing 737 aircraft in 57 cities all over the U.S. at the end of the year 2000.
The cost of fuel had been a major concern for Southwest as an increase in jet fuel prices had resulted in chaos in the overall airline industry. Scott Topping (Director of Corporate Finance) of Southwest had realized that to survive, the airline has to control the fuel cost. Since the jet fuel price is considered the main operating expense after labor the growth stability and profitability depend mainly on the controlled fuel cost. (Pfeffer, 1996)
The importance of hedging for Southwest
Airlines like Southwest choose to hedge the price to avert vast fluctuations in their operating expenses and profitability. The firms have some specific goals and objectives regarding management of the risk and elevating their financial performance. The firms are concerned about the management of price volatility of raw materials and fuel and foreign currencies.
Therefore the firms hedge the risk of fuel price fluctuation by using derivative instruments grounded on heating oil, crude oil, or jet fuel. A hedge involves taking an offset position against the potential losses that may occur in a financial instrument. However, the most effective and common hedge is the use of derivatives such as forward, option, and future contracts. The mainly used hedging instrument in the airline industry is plain vanilla (call options, future, swap, and collars).
Hedging can benefit the firm in the following ways. (Dellinger)
Mitigate the price volatility
Firms can protect themselves in the market for the cost (inputs) against price volatility which can reduce the risk and help them to maintain price stability in the market. By hedging the price of jet fuel Southwest can get an offset position and thus it can maintain the fuel price.
Risk reduction
Hedging allows firms to reduce the risk against abnormal price fluctuations and maintain stability financially. Thus Southwest needs to hedge the risk and retain financial stability.
Enhanced budgeting and planning
For firms like Southwest hedging is effective in way that it can plan and budget more effectively. Since firms can confine the prices for the cost (inputs) for a specified period hedging against oil prices will enable Southwest to fix the price and hence they can plan and budget effectively.
Better financial performance
By reducing the effect of price fluctuations on the firms’ cost firms can advance their financial performance by keeping more potential profit margins. Thus it will help Southwest to increase its profit and improve its finances.
Evaluation of swap strategy vs the call option strategy
Evaluation of Plain vanilla swaps
The plain vanilla swap is considered to be the simplest business instrument to hedge the risk contracted between two parties. In this interest rate swap, an agreement is made between two parties to exchange the cashflows on a notional price for a specified time. Usually, one party reaches an agreement to pay a fixed rate of interest whereas the other party decides to pay a floating interest rate which is set on a benchmark (LIBOR). The plain vanilla swap allows the party to exchange a fixed interest rate for a floating interest rate.
Evaluation of call options(Caps)
A call option is an instrument that gives the owner the right (not obligation) to be given a payment if the benchmark rate of interest (LIBOR) surpasses the pre-agreed rate. The holder of the option will pay the premium for the option and if the price does not exceed the benchmark rate the agreement will expire and vice versa.................
Southwest Hedging Strategy Case Study Solution
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