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HEDGING

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Hedging tools:

1. Options

2. Futures

3. Swaps4. Forwards

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What is options?

An option is a contract that gives the buyer the right,

but not the obligation, to buy or sell an

underlying asset at a specific price on or before a

certain date. An option, just like a stock or bond, isa security.

Types of options

calls puts

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What is futures?

A financial contract obligating the buyer to

purchase an asset (or the seller to sell an

asset), such as a physical commodity or a

financial instrument, at a predeterminedfuture date and price.

Characterized by the ability to use very high le

verage relative to stock markets.

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What is swaps?

A swap is a derivative in

which counterparties exchange cash flows of

one party's financial intrument for those of

the other party's financial instrument.

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What is forward contract?

A forward contract or simply a forward is a

non-standardized contract between two

parties to buy or to sell an asset at a specified

future time at a price agreed upon today.

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Corporate Hedging Process

Identify the risks :-operating & financial

Distinguish between:- hedging & speculating

Evaluate the costs

Right measuring stick to evaluate the performance

Dont base hedge program on market view

Understand the correct hedging tools

Establish a system of control.

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HEDGE OR NOT TO HEDGE

US FirmGerman

Company

10,000

Sell

Equipment

Rate :-

1 =1.33 US $

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HEDGE OR NOT TO HEDGE

US Firm HEDGE

value = FX Loss US Firm

Full Exposure

Should

Reason

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How To Hedge

Bank Bid/Ask QuoteEuro 1.2300

Dollar 1.2400

US Firm1 =

1.1000 US $

/1.2500 US $

Value

{ Gain Forward Position}

Hedged Position =1 ( 0.2300 US $ ) * 10,000 = 2300

Hedged Position = 1 (-0.0200 US $ )* 10,000 = -200

{ Loose Forward Position}

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FUEL HEDGING IN AIRLINE INDUSTRY

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If we dont hedge jet fuel price risk, we are speculating.

It is our fiduciary duty to try and hedge this risk

Southwest was formed in 1971

by Rollin King and Herb Kelleher

and the airline began with

three Boeing 737 aircrafts

Today, Southwest operates

approximately 3,300 flights daily

and boasts of being the only

major airline to post profits

every year for the last thirty six

years

It justifiably claims to be the

United States most successful

third largest low cost airline in

the world

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Jet Fuel per Gallon

*Figure above shows Southwest's competitive advantage in

jet fuel price which is considered to be the most critical

expense category for any airline

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3.TERMS OFHEDGE

2.UNDERLYING

COMMODITIES USEDAND BASIS RISK

1.TYPES OFDERIVATIVE

CONTRACTS USED

Flexible long term

positions in caseof quantity and

prices while

designing its

hedgesChanges in

Demand and

Supply factors

undermine

Basis risk 1. Minimizationof cost

2. Flexible

hedging

strategy based

on oil price

cycle

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*Considerations to the Contract- Airlines hedge its jet fuel risk exposure

through Plain Vanilla contracts as well as combination of products based

on stages of oil price cycle Over the Counter Market sand Exchangetraded risks

CAPS

SWAPSCOLLARS

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UNDERLYING COMMODITIES AND

BASIS RISK

Basis Risk

The use contracts based on an underlying

asset different from the actual item hedged

creates basis risk.

changes in supply and demand.

Locational risk. Difference between the term of the hedge

and the risk exposure.

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Hedging Commodities

Jet fuelCrude &Heating

oil

Oil future marketsFuture Contracts OTC

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It is clear that the company tends to structure its program with a five/six year

time window. However, they adjust their hedges every year depending of the

short-term needs in term of quantity and prices.