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The Role Of Oil Futures In Risk Management

3654 words - 15 pages

FInTHE ROLE OF OIL FUTURES IN RISK MANAGEMENT
From: To: Senior Management - Airlines Company

November 2011

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University of Westminster - Westminster Business School International Risk Management

COURSEWORK

THE ROLE OF OIL FUTURES IN RISK MANAGEMENT

Student: Student ID: Course: Word count: MSc. Finance and Accounting 2557/2617

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EXECUTIVE SUMMARY In the world today, oil is being used as the main source of energy for a lot of core industries. Due to its non-renewable characteristics and the global rising demand, oil has increased in its value, which results in many oil price crises recently. For all those industries using large amount of oil in operation, the risk of ...view middle of the document...

The hedging methods include futures contracts, forward contracts, options, collars and swaps which could prevent both the buyers and the sellers from the risk of fluctuating oil price. Among those methods, oil futures contracts are the most popular as they are standardised and can easily be traded on an exchange. The main exchanges offering oil futures contracts are the International Petroleum Exchange (IPE) in London and New York Mercantile Exchange (NYMEX) in New York. Medlock III and Jaffe (2009) suggested two types of oil futures traders. The first group is commercial traders using futures to offset the risk of price moving unfavourably and the second group is non-commercial traders using oil futures as a speculation method. Within this report, only the first group’s benefits from oil futures will be discussed in depth with the focus on the side of the buyer of oil futures. With the increasing use of oil futures contracts, the first part of this report aims at analysing the roles of this derivative in risk management with all the possible benefits and drawbacks of the contract. Later in the report, an application of oil futures contract in the US airline industry will be discussed. A conclusion will be followed to summary the report and make suggestion for future use of this hedging method.

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II. LITERATURE REVIEW Due to the popular practice of oil futures contract, a number of studies have discussed the roles of this derivative with in-depth analyse of typical cases study. Morrell and Swan (2006) suggested that among various types of fuel hedging, futures are the most popular as they are standardised and traded through exchanges, which allows the traders to easily get access to the contracts. Moreover, futures do not require actual delivery on the expiry of the contract (less than 1% of oil futures contracts resulted in physical delivery – according to NYMEX). In most cases traders offset their positions. Due to these characteristics, oil futures are more suitable for the purpose of hedging the risk of oil price volatility. According to a survey by KPMG and International Air Transport Association (IATA) in 1992 from 25 of the world’s largest airlines, the majority of passenger airlines hedge all or part of their future fuel needs. 13 out of 25 questioned airlines used oil futures contracts to hedge the exposures in six months to two years’ time. Though according to Modigliani-Miller (1958) theorem, in a perfect market condition, hedging does not add value to the firm as firm value is unaffected by its financing decision. However, in the real life, hedging could still influence the firm’s cash flow. The following studies could provide empirical evidences to support this hypothesis. Carter et al. (2006) found that jet fuel hedging accounted for a premium of roughly 12-16 percent for US airlines shares during the period of 1992-2003. This study suggested that changes in cash flow had negative correlation with changes in jet fuel price....

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