Airline hedging
The goal of this project is to determine the trades Qantas would need to make at the end of a financial year to hedge (part of) its exposure to jet fuel prices over the next financial year. At the end of June 2014, you are being hired by Qantas management to develop a jet fuel hedging strategy for the 2014-2015 financial year.
Data
In the Excel workbook available on the LMS, you will find end-of-quarter prices for the spot jet fuel (kerosene) contract in USD per gallon (3.785 litres), as well as the end-of- quarter prices of futures contracts in crude oil in USD per barrel (158.97 litres) and natural gas in USD per Million British Thermal Units (MBTU). A crude oil futures contract specifies delivery of 1,000 barrels, and a natural gas futures contract specifies delivery of 10,000 MBTU.
Prices are observed at the end of the September, December and March quarter. For the futures data, the delivery is for the next quarterly expiration. That is, the price recorded at the end of September is for the futures contract that expires in December, the price recorded at the end of December is for the futures contract that expires in March and the price recorded at the end of March is for the futures contract that expires in June.
In addition to the data in the Excel sheet, you may use that the spot prices for jet fuel on 30/06/2013 and 30/06/2014 were USD 3.014 per gallon and USD 1.666 per gallon, respectively.
Background
Qantas consumed about 4.6 billion litres of jet fuel during the 2013-2014 financial year (Qantas Fuel Efficiency Report). Let’s assume that use has remained constant for a while and is therefore also the expected use during the 2014-2015 financial year.
Qantas buys its jet fuel quarterly in advance. That is, at the end of June 2014, Qantas purchases ¼ of its forecasted annual jet fuel use in the spot jet fuel market for use between July and September 2014. At the end of September 2014, Qantas buys ¼ of its forecasted annual jet fuel use in the spot jet fuel market for use between October and December 2014, and so on. You may assume that any jet fuel bought in advance can be stored by Qantas free of charge, unless specifically indicated otherwise.
Consider a plan to hedge the September-end, December-end and March-end acquisition costs by trading listed futures on oil-related products. Rather than trade in jet fuel futures, you are asked to consider the feasibility of instead hedging by trading in New York Mercantile Exchange-listed futures on crude oil or futures on natural gas. These contracts are quoted in US dollars (USD). Qantas is interested in determining the hedge that minimises the variance of the net amount spent on jet fuel using one or the other of these two contracts.
For simplicity, you may ignore the mark-to-market feature of futures contracts; e.g., if you buy a contract on 30/06/2014 and sell it on 30/09/2014 assume that your gain or lose is realized on 30/09/2014 and is simply equal to the change in the futures price over the three months.
Assume that to hedge its end-of-September jet-fuel purchase costs, Qantas takes a futures position on 30/06/2014 in futures contracts that mature in mid-December 2014; i.e., after September. When Qantas buys its spot jet-fuel needs for the October through December quarter by buying jet fuel in the spot market at the end of September, Qantas will close out its hedging position in the futures maturing in mid-December.
Similarly, assume that to hedge its end-of-December purchases, Qantas takes a position on 30/06/2014 in futures contracts that mature in mid-March 2015 and closes out that futures position at the end of December when it purchases jet fuel to use during the third quarter of the financial year. Finally, assume that to hedge its end-of-March purchases, Qantas takes a position on 30/06/2014 in futures contracts that mature in mid-June 2015.
Q1.
Comment on the following statement: “A hedging strategy is expected to make money; a strategy that loses money just shows that hedging is really not a good thing to do for companies.” (Use at most ½ a page for your answer)
Q2.
Suppose Qantas would also engage directly in trading option contracts on spot jet fuel. If Qantas had to choose between a European call and put option on jet fuel and to go long or short that option, which contract (e.g., long call) should they choose and why?
Q3.
In addition to hedging jet fuel costs, Qantas engages in other hedging activities as well. List at least two other risks that Qantas may hedge and explain why and how they could do so. (Use at most one page for your answer).