 ## FUEL HEDGING IN THE AIRLINE INDUSTRY: THE CASE OF SOUTHWEST AIRLINES Case Solution

The total exposure would be equal to 1100 million gallons of fuel and the contract size as provided would be 1 million gallon. The conditions of the market would decide the fixed payment, which would be paid by the company and the floating rate would be based upon the futures monthly prices.

The current spot price for scenario 1 is 0.39390 per gallon and for scenario 2 it is 1.1960 per gallon. Based upon the size of one contract, if the company goes for full hedge, then it will have to purchase 92 contracts and if it goes for 50% hedge, then it will have to purchase 46 contracts. The effective cost per gallon for the 50% hedge would be around 0.6683 and for full hedge it would be \$ 0.7606 per gallon and for scenario 1. On the other hand, effective cost per gallon for the 100% would be \$ 0.7591 per gallon and for 50% it is going to be around 0.8850 for scenario 2.

Hedge Using Call Options

The call option is a hedging instrument which gives the holder of the option to buy an underlying asset at a pre agreed price before or on the date of its maturity. In the case of SWA, if the prices of fuel would increase in future, then the management would exercise its call options and pay a reduced fuel price and vice versa. These call options would have strike price of \$ 28 and premium costs of \$ 1.8. At June 2001, the future price of the crude oil would be \$ 26.39 and the spot prices for scenario 1 and 2 would be \$ 14.10 and \$ 40 respectively.

The total contract size for the future contract is 1000 barrels and therefore, the total usage of the fuel per barrel would be equal to 26.19 million barrels. The profits or the losses made by these options would be offset by the actual price fluctuations in the market and a lower effective price would be paid by the management of SWA. The effective cost per gallon for scenario 1 would be \$0.6192 and \$0.5978 for full 100% and 50% hedge respectively. On the other hand, the effective cost for scenario 2 would be \$0.7680 and \$0.8894 for full 100% and 50% hedge respectively.

Hedge Using Futures Contract over Crude Oil

The futures contracts are also much similar to forwards but under futures contracts, the management can bur an underlying commodity at the predetermined price at an agreed future date. Currently, the prices of fuel are rising therefore, SWA would take a long position in order to counter the risk of increasing fuel prices. The crude oil and the heating oil futures contracts would be purchased by SWA. Each contract would have a size of 42000 gallons. The expected spot price are around \$ 0.7920 per gallon and \$ 0.0792 per gallon for scenario 1 and 2 respectively.

This strategy would generate profits and they would offset the actual losses. The total amount of the fuel to be hedged in both the scenarios would be equal to 26.19 barrels. SWA will shorten its cash position at the spot rate and then long its futures position at the futures predetermined price. The effective cost per gallon for scenario 1 would be \$0.8685 and \$0.7222 for full 100% and 50% hedge respectively. On the other hand, the effective cost for scenario 2 would be \$0.6868 and \$0.8488 for full 100% and 50% hedge respectively………………..

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