Category Archives: hedging

Southwest Airlines Changes Tack

A key challenge in executing a sensible hedging strategy is the inevitable second guessing that happens with the benefit of 20-20 hindsight. Whenever a hedge loses money, outsiders question how much more profitable the company could have been without the hedge. Comparisons are made against competitors that did not hedge, and so performed better. No matter that the hedge accomplishes its objective—reducing volatility. When that reduced volatility is windfall profits foregone, the carping begins.

Last week, American Airlines was the last of the major U.S. airlines to report its 2014 financial results, and every airline was announcing improved operating cash flow due to the huge drop in jet fuel prices. Since American does not hedge, analysts were quick to announce that “they have won big time.”

Airlines that do hedge, have had to report losses on their hedge positions. Delta’s 4th quarter announcement revealed more than $1 billion in charges due to mark-to-market adjustments on its fuel hedges. The losses on hedges offset some of the benefits the airlines are capturing from the drop in fuel prices. If they hadn’t hedged, shareholders would have seen a larger gain from the drop in fuel prices. That puts pressure on management to get rid of the hedging program.

Southwest Airlines announced that it had eliminated its hedge on 2015 prices, so if the oil price drops any further, all of that will drop to its bottom line. It also reduced the scale of its hedging in 2016, 2017 and 2018.

Does it make sense to eliminate the hedge? Is this a case of trend following—having missed the initial decline, the company hopes to catch the next decline? Is this a case of not standing by a well thought through strategy when short-term events fail to go your way? These are real problems in executing a hedging strategy.

A case can be made for adjusting the hedge ratios in response to the fall in price. After all, as Southwest’s executives explained, the purpose of hedging is to provide “catastrophic protection”, meaning against sky high jet fuel prices. With prices as far down as they are, we’re far away from catastrophe. If prices start back up, and if the company is nimble, there will be time to insure against catastrophe.

End-User Horror Stories #1 – FMC

horror victim

ISDA, the trade association for OTC derivatives, released a paper today purporting to document the dangers of derivatives reform. As usual, the alleged victims are ‘end-users’, the non-financial firms using derivatives to hedge risk. The paper is organized around 4 case studies of firms and their OTC derivative hedges, and makes specific claims about their specific hedges. This is a refreshing change from the usual vague generalities, so it is worthwhile examining those claims in some detail. Moreover, ISDA hired two accomplished finance professors to author and lend their credentials to the paper, so there is a promise that the arguments will have more substance than the usual lobbying pitches.

Unfortunately, the promise of something new is unfulfilled. The paper repackages old, debunked claims. Its arguments are shallow and unpersuasive.

Take as an example the case of the chemical company, FMC, and its hedge of natural gas prices. Although the abstract says that the authors will examine hedge effectiveness, the accounting treatment and the impact on earnings per share, in fact, the paper does none of those things. Instead, it makes two other points which I will examine in turn.

First, the ISDA paper claims that the reform increases FMC’s administrative burden of hedging. How? By forcing FMC out of the OTC derivative market and into exchange traded futures. It takes a cumbersome assemblage of 13 futures to reproduce what can be done with 1 OTC swap. The paper implies that managing this cumbersome assemblage is costly, although it never really accepts the burden of quantifying the extra cost.

This argument does not stand up to scrutiny. The whole premise is wrong. The reform does not prohibit FMC from using OTC swaps instead of futures. So why is the comparison of 13 futures to 1 OTC swap relevant? The paper never explains the premise. It’s just implicit in the comparison of the burden of managing an OTC swap against managing a package of futures. Moreover, suppose we imagine that the OTC market was outlawed. Even then, there is nothing in FMC’s customized swap that cannot be reproduced in the futures market. Clearly the risk profile can be perfectly reproduced, as the package of 13 futures demonstrates. So the only problem we are left with is the administrative burden. FMC cannot handle the 13 contracts itself in house. That’s why it’s dealer constructed a packaged swap. But our imaginary prohibition of the OTC market doesn’t outlaw all forms of financial services. FMC’s banker is free to offer the service of managing a package of 13 futures which replicates FMC’s desired risk profile. In fact, that’s exactly what FMC was getting from its OTC derivative dealer. And you can be sure that FMC paid for that service, although the paper’s authors conveniently overlooked the price charged. There is absolutely nothing in the derivatives reform that stops FMC from outsourcing the management of its natural gas exposure using futures contracts. And there is absolutely nothing in the ISDA paper to suggest that it is more costly for the finance industry to provide that service using futures contracts.

Second, the ISDA paper claims that the reform increases the amount of margin FMC must post, and the paper calculates the margin on FMC’s natural gas hedge. The paper implies that this extra margin is an extra cost. This assumes a false equality between margin paid and cost incurred. An OTC derivative saves FMC the burden of paying margin only by having the dealer extend FMC credit. You can be sure that FMC is charged for that service. Unfortunately, the ISDA paper completely overlooks the price paid for credit risk. My paper on “Margins, Liquidity and the Cost of Hedging,” with my colleague Antonio Mello, shows that when you take into account credit risk, FMC’s costs are exactly the same whether they use the non-margined OTC swap or a fully margined futures package.

It takes 2 to tango, and 3 to intermediate.





Unhedged. …oooops.

Clean Currents


Clean-Currents sent this message to customers:

Dear Customers:


We are extremely saddened to share this news with you.

What does this mean for you?




Gary Skulnik & Charles Segerman, Clean Currents Co-Founders



American Airlines Stops Hedging















Be careful how you swing that hatchet!








CSI: prop trading investigation squad.

Does JP Morgan’s derivative portfolio hedge its other lines of business? This picture says ‘no’.

Does JP Morgan’s use derivatives to make prop trade bets on interest rates. This picture suggests ‘yes.’


Piazzesi et al.

Let me explain.

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Can Hedging Save Cyprus?

Lenos Trigeorgis has a piece in the Financial Times’ Economists’ Forum advocating the use of GDP-linked bonds for Cyprus.

Suppose that its steady-state GDP growth is 4 per cent and that fixed interest on EU rescue loans is 3% per cent Instead of the fixed rate loan, Cyprus could issue bonds paying interest at its GDP growth minus 1% (the difference between the average growth rate and the EU bailout rate). If GDP growth next year is 0 per cent, lenders would pay the Cypriot government 1%, providing Cyprus with some relief in hard times. But if after, say, 10 years GDP growth is 7 per cent, lenders would instead receive 6 per cent. In essence, during recession EU lenders will provide insurance and interest subsidy to troubled Eurozone members, helping them pull themselves up, in exchange for higher growth returns during good times. Increased interest bills in good times might also discourage governments from sliding back into bad habits.

As we’ve written in a couple of earlier posts, this is easier said than done. But it’s certainly thinking along the right lines.

Margins, Liquidity and the Cost of Hedging


Our paper on end-users and the cost of margins is now out in Morgan Stanley’s Journal of Applied Corporate Finance.

Dynamic Hedging or Futile Speculation?


Chesapeake still thinks it can time the market.




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