The Airline Industry (Part 6): Hedging - Calls and Collars

Call Options

If airlines want more flexibility than swaps, futures, or forwards can provide, they may turn to call options to secure a ceiling for fuel prices. A call option gives the owner the right to buy a commodity at a particular “strike price” until the maturity date of the option.

Buyers of call options pay a premium for the right to buy the commodity at the specified price. The amount of this premium depends on the value of the underlying commodity, the volatility of its price, and the time to maturity of the call. As you might expect, the price of a call increases if the value of the underlying commodity is highly volatile or if the option has a long time to maturity.

Since the call gives the owner the right to buy at a specific price, the owner will make money when the market price of the commodity exceeds the strike price. Theoretically, the owner could exercise the option at the lower price and immediately sell at the higher price, making arbitrage profits. For this reason, more volatile commodities command higher option premiums since the likelihood that the price will fluctuate above the strike price is greater. Similarly, options with a long time until maturity are worth more since the owner has more time for the price to increase above the strike price.

Airlines often purchase heating oil or crude oil call options to avoid liquidity concerns for OTC jet fuel options. These energy calls are expensive since oil has a volatile price. This means that buying call options is effective for setting price ceilings, but also cost-intensive (see example to the left). In this case, the airline will exercise the option when jet fuel rises over $2.70/ gallon. For the airlines to actually save money, the price must surpass $2.80 (which includes the distributed option premium.)

Call options are attractive because they set price ceilings but still let airlines take advantages of price drops. In the example, if fuel never reaches $2.70, the airline simply pays the market price and lets the option expire. The airline will lose the $1,000 it spent on the call, but it can buy fuel at a lower cost. If the price was fixed in a swap contract, the airline would not have this flexibility.

If airlines want to ensure price protection through call options but offset some of the expense they have an alternative: option collars.

Collars (Zero-Cost & Premium)

Collars involve the sale of a put option to help offset the cost of purchasing a call. A put option gives the owner the right to sell a commodity at a given strike price. In return for this right, the buyer will pay the option writer a premium which is then applied to the purchase of the call (see example to the right).

The first step to build a collar is to buy a call option with a strike price above the current price of the commodity the airline wants to hedge. In this example, the airline pays $1,000 for an option to buy jet fuel at a strike price of $3.75/gallon. This gives the airline the protection it wants against an increase in prices.

Next, to help offset the cost of the call the airline will sell a put option. The airline will receive a premium for the put. However, since the put has a strike price below the current market price, the airline will have a cost floor it will pay for jet fuel (see example to the left). In this case, the airline is liable to the option holder for any decrease in price below $3.45. The airline will purchase its own fuel at market price but be forced to pay the difference between the price and the strike price to whomever exercises the option. As the example illustrates, the net activity will result in the airline paying the strike price rather than the lower market value for its fuel. A graphical representation of the call, put, and combined collar are shown at the end of this entry.

Collars have several advantages. They offer considerable protection for a low cost because the sale of the put offsets some or all of the cost of the call. Also, there is no speculative return – the airline has a set band of prices within which it will pay for its fuel. It is also possible to create premium collars that offer more protection from increases and greater ability to profit from price decreases. The airline can sell calls with lower strike prices (and pay higher premiums) while selling calls with lower strike prices (and receive lower premiums.) Airlines can tailor collars to match their tolerance for risk and variance in fuel prices.

Timing is important in the construction of collars. If an airline creates the hedge at the wrong time, its band of prices can be set too high. If prices drop far below the airline’s price floor, competitors will have a cost advantage that could threaten the airlines position. However, if a collar is created at the right time, it can lock in favorable prices for months or even years.

Hedging Today

Now that we have seen the ways airlines can hedge fuel prices, it’s time to examine how they are being applied today. Most airlines have operated without substantial hedges since 2006. There are two main reasons for the lack of activity.

First, most airlines don’t have the credit profile that would allow them to hedge without cash collateral. Cash reserves are often the only cushion airlines have against bankruptcy. Without upfront cash, airlines have difficulty finding counter-parties willing to take on default risk when entering into hedging contracts.

Second, hedging only protects against future price increases. There’s no way for airlines to retroactively hedge at lower prices, so now is a difficult time to get started. For example, Delta started hedging after emerging from Chapter 11. When the price of oil dropped in 2006 because of the September 11 terrorist attacks, Delta’s hedges had a net trading loss of $108 million. A similar fate could befall airlines who start hedging if prices fall from today’s highs.

Call Option Sets Ceiling	Put Option Sets Floor	Combined Price Collar

YouTube Channel