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

Date01 February 2014
Published date01 February 2014
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
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:
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.
C2014 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).

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