This article explains the financial instruments airlines use to protect against rising oil prices, including futures, options, and swaps. These tools form part of a strategy known as fuel hedging, which helps airlines manage one of their largest and most volatile costs.
Focus: Fuel hedging and financial instruments
Level: Introductory
Topics: Futures, swaps, options, risk management
At the time of writing, there has been considerable news coverage around rising oil prices, and the potential impact this may have on airline operations. Given that fuel is one of the largest costs for airlines, fluctuations in oil prices can have significant financial implications.
This makes it an ideal moment to explore some of the financial instruments used to manage these risks, specifically how airlines protect themselves against rising and falling fuel prices, and how these instruments are priced.
Futures and Forwards – the “Mystic Meg” instrument and its cousin
One of the simplest and most accessible instruments used to protect against price movements is the forward contract. A forward is an agreement between two parties to buy or sell an asset at a fixed price on a specified date in the future.
To illustrate their use, consider an airline that expects oil prices to rise. The airline could enter a forward contract to purchase oil at a fixed price in two months’ time. If, at that point, the market price of oil is higher than the agreed price, the airline benefits by effectively paying less than the prevailing market rate. However, if the market price falls below the agreed price, the airline will still be required to purchase at the higher fixed price.
Forwards have a close cousin known as futures. These are similar in that they also create an obligation to buy or sell an asset at a fixed price on a specified future date. However, unlike forwards, futures are standardised and typically traded on exchanges, meaning they are more liquid and have publicly available market prices. This publicly available price is extremely useful for market participants, as it gives an indication of expected future pricing, which is useful when pricing other instruments. This is why I have referred to futures as the “Mystic Meg” instrument.
Swaps – a game of give and take
One financial instrument used to protect against price movement is the humble swap. This contract effectively exchanges a floating cost for a fixed cost over time, giving greater certainty over future expenses.
Perhaps the closest day-to-day equivalent is a fixed-rate mortgage, where the borrower agrees to pay a fixed interest rate over a specified period, protecting them from fluctuations in interest rates.
Turning to our airline example, if the airline anticipates significant volatility in oil prices, it may choose to enter a swap contract. This would allow it to lock in a fixed price over time, thereby insulating itself from movements in the market.
Options – the mysterious protectors
Perhaps the most enigmatic, and certainly one of the most interesting, instruments used to protect against price movement is the option. An option is a contract that gives the holder the right, but not the obligation, to buy or sell an asset at a fixed price within a specified time-period. Unlike forwards or futures, options do not create an obligation for both parties to complete the transaction at the agreed price.
A basic option can take two main forms:
- A put option: gives the holder the right to sell an asset at a fixed price.
- A call option: gives the holder the right to buy an asset at a fixed price.
Put simply, a put option protects against falling prices, while a call option protects against rising prices. Let’s put their operation into practice with an example.
Role playing with an options – an example
To illustrate this, consider an airline that expects oil prices to rise. In such a situation, it could enter a call option on oil, typically arranged through an investment bank. This option would give the airline the right, but not the obligation, to buy oil at a fixed price over a specified period. This fixed price is called a “strike price”.
If the market price of oil, then increases above this strike price, the airline can exercise the option and benefit from the difference between the contract price and the market price. However, it is important to note that the airline must pay an upfront premium for this option, meaning that any overall benefit depends on whether the increase in oil prices exceeds this initial cost.
Why are options instrument mysterious?
While this may appear to be a relatively simple idea from the airline’s perspective, the mechanics of option pricing for investment banks and other market participants are considerably more complex. This is because the future movement of the underlying asset is uncertain. As a result, pricing models must account for the inherently random nature of asset prices.
This randomness is often described mathematically through a field known as stochastic processes. This is a subject I could spend months exploring, but one I will leave for another day, likely with a strong coffee in hand and a clear head. In a future post, I will take this further by looking at the Black–Scholes model.
Option collars – the dance of the options
Instead of using just put options or just call options, an airline can utilise something called an option collar to keep the price of oil within a specific pricing band. An option collar combines both put and call options and is perhaps best illustrated by an example.
Let’s say the airline buys a call option with a strike price of $80. In this case, if oil rises above this price, the airline can exercise the call option and benefit from the difference between the strike price and the higher market price.
At the same time, the airline sells a put option with a strike price of $70. If the price of oil falls below this level, the counterparty may exercise the put option, requiring the airline to purchase oil at $70, thereby giving up the benefit of further price decreases.
Ignoring premium costs, this combination effectively constrains the airline’s fuel price within a range of $70 to $80, providing a degree of certainty over future costs. The price has been “collared” between two threshold prices.
Why does this matter?
Taken together, these instruments allow airlines to manage one of their largest and most volatile costs. While none of them eliminate risk entirely, they provide different ways of balancing certainty, flexibility and cost and therefore help to keep the cost of holidays abroad down. Now that I have explained these instruments, it also gives me an excuse to delve deeper into the mathematics of derivative and option pricing.