FUEL HEDGING IN THE AIRLINE INDUSTRY: THE CASE OF SOUTHWEST AIRLINES Harvard Case Solution & Analysis

FUEL HEDGING IN THE AIRLINE INDUSTRY: THE CASE OF SOUTHWEST AIRLINES Case Solution

            In the real world, the prices of fuel are unpredictable and highly volatile therefore, the airline companies have to increase their ticket prices in order to cover up the costs of fuel. However,since the airline industry is highly competitive therefore, most of the companies are not willing to pass on these huge costs to the customers. For instance, one of the airline companies does not hedges and covers up its high fuel prices by increasing the prices of the tickets, whereas another company hedges its fuel prices in order to set competitive ticket prices for its customers to prove them with their desired service.

Therefore, the hedged company will also have to hedge in order to survive the competition in the industry. Hence, nowadays, most of the firms hedge their positions in the market to save their companies from future costs and reduce the risks of financial distress. On the other hand, most of the airline companies hedge in order to exploit the high investment opportunities. For example, through hedging most of the airline companies become able to buy the under priced assets of the other distressed airlines in the market.

There are numerous benefits associated with hedging. In addition to the avoidance of the financial distress costs, different hedging strategies also help the airline companies to reduce their cash flow variations. Most of the airline companies hedge for two main reasons. Firstly, these companies are highly conservative in terms of risk taking and secondly, these companies want to avoid the future financial distress costs. With hedging, the companies are also able to focus on their core competencies and thus enhance the effectiveness and efficiency of the operations of the company. Overall, hedging reduces the price risk, minimizes cash flow volatility, avoids financial distress costs and maximizes the wealth of the shareholders and profitability of the firm.

Question 2

What is the strength of the relationship between crude oil and jet fuel? [+10]

            The correlations of the crude oil and the jet fuel oil have been computed in the excel spreadsheet. The strength of the relationship between the crude oil and the jet fuel prices is strong and positive with a correlation of 95%. All the contracts show high positive correlations.

Question 3A

Evaluate each of the proposed hedging strategies.

            Five hedging strategies have been considered by the management of Southwest Airlines and it has been estimated that the jet fuel usage for the next year would be 1100 million gallons. Each of these five hedging strategies have been evaluated below:

Hedge Using Heating Oil and Plain Vanilla Swap for Jet Fuel

            Under this hedging strategy, a certain amount of the floating price would be exchanged for a fixed price. In the case of Southwest, the company would be paying the fixed price and receiving the floating price.....................

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