Does Hedging Success Matter? An Empirical Study of Jet Fuel Hedging in the U.S. Airline Industry

Airlines commonly employ hedging as a risk management strategy to protect themselves against sudden, unpredictable increases in the price of jet fuel. In a seminal paper by Carter, Rogers, and Simkins (2006), it is established that jet fuel hedging by airlines increases the firm value of the airline. This dissertation replicates their study using an expanded dataset over a greater period of time. This study finds a smaller “hedging premium” than Carter, Rogers, and Simkins (2006). It is shown that the leasing of aircraft plays an important role in the relationship between the hedging premium and capital expenditures. The measure of jet fuel hedging used in the previous studies, the percentage of next year’s fuel requirements hedged, accounts for the amount of hedging done by the airline, but it does not consider the performance of the jet fuel hedges. This dissertation for the first time determines the effect of jet fuel hedging performance, as measured by the realized gains and losses from jet fuel hedging, on the value of the firm. The analyses find that the realized gains and losses have a negative relationship with firm value. However, after identifying outliers (such as the significant hedging losses in 2009 resulting from falling jet fuel prices during the financial crisis) using a simple box plot and removing them from the sample, realized gains and losses show a positive correlation with firm value. Furthermore, successful hedging may induce principal-agent issues such as buying market share behavior. When an airline experiences a run of hedging success, a manager may mistakenly believe that the cost of jet fuel is decreasing. This is not the case, however, as the cost of using jet fuel is the price that can be received selling it on the open market, not the price paid for the jet fuel. A manager may attempt to pass on the “savings” to consumers in the form of lower fares, lowering the price below its profit-maximizing level. This in turn can increase the airline’s market share, although it comes at the expense of reduced profit. This dissertation tests the relationship between successful jet fuel hedging and market share. A positive and statistically significant correlation between successful hedging and market share is found for Southwest Airlines and American Airlines, two carriers known for successful hedging, but statistically insignificant results for smaller carriers Alaska Airlines and JetBlue Airways