SWAPS

CASE STUDTYThe Case of Southwest Airlines1&2Why do firms like Southwest hedge? What are the benefits of hedging?

Does heating oil or crude oil more closely follow the price of jet fuel? (To answer this question, use the information in the Excel spreadsheet)3a) Evaluate each of the five proposed hedging strategies.

What are the benefits of each hedge based on two fuel price scenarios in one year? In other words, assume in June 2002 that one of these scenarios occurs. Calculate your net cost of jet fuel under each scenario incorporating the hedging strategies used. (Note: you can analyze the hedges under as many price scenarios as you wish, but be certain to include the following twoscenarios.) For both scenarios, consider full hedging and a 50% hedge strategy.3SCENARIO 1: 39.3 cents/gallon spot price for jet fuel; 38.8 cents/gallon spot price for heating oil, or $14.10 per barrel spot price for crude oil, and

SCENARIO 2: 119.6 cents/gallon spot price for jet fuel; 118.6 cents/gallon spot price for heating oil, and $40,00 per barrel spot price for crude oil.

(b) Discuss the pros and cons of each hedging strategy.(c) Describe how a combination of the hedging strategies can be used.4What are the risks of being un-hedged? Totally hedged? (Note: the February 24, 2004 Wall Street Journal article titled Outside Audit: Jet-Fuel Bets Are Risky Business by Melanie Trottman may be useful.)5(a) What is basis risk and how is it different from price risk?(b) What are the implications of a changing basis?(c) Does basis risk exist for Southwest Airlines in their fuel hedging program?6What do you recommend to Scott Topping? Why?5 Hedging StrategiesPlain Vanilla SwapDifferential Swaps and Basis RiskCall Options (Caps)Collars, Including Zero-Cost and Premium CollarsFutures and Forward Contracts

Plain Vanilla SwapThe plain vanilla energy is an agreement whereby a floating price is exchanged for a fixed price over a certain period of time.

Both parties settle their contractual obligations by means of a transfer of cash.

In a fuel swap, the swap contract specifies the volume of fuel, the duration (i.e., the maturity of the swap), and the fixed and floating prices for fuel.

The differences between fixed and floating prices are settled in cash for specific periods (usually monthly, but sometimes quarterly, semi-annually, or annually).Differential Swaps and Basis Riskdifferential swap is based on the difference between a fixeddifferential for two different commodities and their actual differential over time

The airline can used an additional swap contract, the differential swap for jet fuel versus heating oil, to hedge basis risk assumed from the heating oil swap. The net result is that the airline caneliminate the risk that jet fuel prices will increase more than heating oil prices.Call Options (Caps)A call option is the right to buy a particular asset at a predetermined fixed price (the strike) at a time up until the maturity date. OTC options in the oil industry are usually cash settled while exchange-traded oil options on the NYMEX are exercised into futures contracts. OTC option settlement is normally based on the average price for a period, commonly a calendar month.Airlines like settlement against average prices because an airline usually refuels its aircraft several times a day. Since the airline is effectively paying an average price over the month, they typically prefer to settle hedges against an average price (called average price options).Collars, Including Zero-Cost and Premium CollarsA collar is a combination of a put option and a call option.

For a hedger planning to purchase a commodity, a collar is created by selling a put option with a strike price below the current commodity price and purchasing a call option with a strike price above the current commodity price.

The purchase of a call option provides protection during the life of the option against upward commodity price movements above the call strike priceFutures and Forward ContractsA futures contract is an agreement to buy or sell a specified quantity and quality of a commodity for a certain price at a designated time in the future.

A forward contract is the same as a futures contract except for two important distinctions: (1)Futures contracts are standardized and traded on organized exchanges, whereas forward contracts are typically customized and not traded on an exchange (2) Futures contracts are marked to market daily, whereas forward contracts are settled at maturity only.