Does Operational and Financial Hedging Reduce Exposure? Evidence from the U.S. Airline Industry

• Date: 01 February 2014
• Published date: 01 February 2014
• DOI: http://doi.org/10.1111/fire.12029

The Financial Review 49 (2014) 149–172

Does Operational and Financial Hedging

Reduce Exposure? Evidence from the U.S.

Airline Industry

Stephen D. Treanor∗

Department of Finance and Marketing, California State University

Betty J. Simkins

Department of Finance, Oklahoma State University

Daniel A. Rogers

School of Business Administration, PortlandState University

David A. Carter

Department of Finance, Oklahoma State University

Abstract

We examine the effectsof both financial and operational hedging on jet fuel exposure in

the U.S. airline industry. Specifically, we investigate two operational hedging strategies: the

extent to which airlines operate different aircraft types and the degree to which airlines operate

fuel-efficient fleets. Wefind that both financial and operational hedging are important tools in

reducing airline exposure to jet fuel price risk. However,operational hedging strategies appear

to be more economically important, which suggests that hedging with derivativesis more likely

∗Corresponding author: Department of Finance and Marketing, College of Business, California

State University, Chico, Chico, CA 95929; Phone: (530) 898-6403; Fax: (405) 744-5180; E-mail:

streanor@csuchico.edu.

Wethank participants at the 2009 Eastern Finance Association, 2009 Financial Management Association,

and 2010 Financial Management Association European meetings for their helpful comments. In particular,

we thank Martin Glaum for his suggestions.

C2014 The Eastern Finance Association 149

150 S. D. Treanor et al./The Financial Review 49 (2014) 149–172

to be used to “fine-tune” risk exposure, whereas operational choices have a higher order effect

on risk exposure.

Keywords: operational hedging, financial hedging, risk management, airline industry

JEL Classifications: G30, G31, G32, L93

1. Introduction

Firms are frequently exposed to adverse changes in exchange rates, interest

rates, or commodity prices. Financial derivatives offer one way to hedge these risks.

However, Guay and Kothari (2003) criticize the conclusions of prior research stud-

ies that conclude hedging has economically significant effects on critical variables

such as firm leverage (Graham and Rogers, 2002) and firm value (Allayannis and

Weston, 2001). They find that derivative holdings by most firms are too small from

an economic standpoint to provide the benefits implied in various studies of cor-

porate hedging. Instead, they argue that the studies critiqued measure hedging too

narrowly by focusing only on the use of financial derivatives. They suggest that op-

erational hedging is likely the dominant form of corporate risk management in terms

of reducing exposures, whereas derivatives are used to “fine-tune” the overall risk

management policy.

In this paper, we investigatethe effects of both financial and operational hedging

in the U.S. airline industry.As such, we are able to comment on the relative importance

of operational and financial strategies in reducing jet fuel price risk of airlines.

Although numerous authors examine the effects of hedging on risk exposures, most

of these studies analyze the effects of foreign currency derivativeusage (i.e., financial

hedging only) on exchange rate exposures.1Further, few studies have assessed the

degree to which operational hedging decisions affect exchange rate exposures (e.g.,

Carter, Pantzalis and Simkins, 2006; Bartram, Brown and Minton, 2010).

As an alternative to studying exchange rate exposure sensitivity to hedging, we

choose to analyze the effects of hedging on airline exposures to jet fuel prices for sev-

eral reasons. First, an airline’s exposure to jet fuel prices is relativelystraightforward

to analyze and understand. Airlines are inherently “short” jet fuel (i.e., they benefit if

jet fuel prices decline), thus they should be negativelyexposed to short-term increases

of jet fuel prices. The longer term volatility of jet fuel prices is also a concern for

airlines if the demand for passenger air travel is price elastic.2In contrast, exchange

1See Smithson and Simkins (2005) for a survey of articles.

2Recent history suggests that the airline industry in the United States has been plagued by overcapacity

resulting in limited ability to raise prices in response to higher jet fuel costs. This idea was highlighted by

Warren (2005).