Cost, Risk-Taking, and Value in the Airline Industry
This chapter develops empirical measurements of the shape of airline firms’ cost functions as they relate to price variation of oil-based inputs and outputs during the 1998–2009 periods. Using the estimates, we assess the value-added potential for hedging
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Abstract This chapter develops empirical measurements of the shape of airline firms’ cost functions as they relate to price variation of oil-based inputs and outputs during the 1998–2009 periods. Using the estimates, we assess the value-added potential for hedging and risk taking with respect to oil prices. We find reasons to believe that the potential value-added of hedging fuel costs with oil derivatives is somewhat limited on average, but that it varies across the business cycle. Our evidence helps explain why, although many airlines hedge, also many do not hedge, why hedging is incomplete, and why hedging intensity varies over time within many airlines. Keywords Airlines
Risk management Hedging Industry studies
1 Introduction This chapter develops empirical measurements of airline firms’ cost functions as they relate to price variation of oil-based inputs and outputs during the 1998–2009 periods. Using the estimates, we assess the value-added potential for hedging and risk taking with respect to input prices.
P.A. Laux (&) Department of Finance, University of Delaware, Newark, DE 19707, USA e-mail: [email protected] H. Yan Department of Applied Economics and Statistics, University of Delaware, Newark, DE 19707, USA e-mail: [email protected] C. Zhang Department of Finance, Temple University, Philadelphia, PA 19122, USA e-mail: [email protected] © Springer-Verlag Berlin Heidelberg 2014 S. Ramos and H. Veiga (eds.), The Interrelationship Between Financial and Energy Markets, Lecture Notes in Energy 54, DOI 10.1007/978-3-642-55382-0_2
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The potential for corporate risk management to add value is a classic issue in finance. Under the perfect markets reasoning of Modigliani and Miller (1958), that potential is nonexistent because investors can replicate the firm’s risk management choices and arbitrage away any benefits. In more realistic settings, Smith and Stulz (1985) show that concavity in the relationship of a firm’s value with respect to a particular source of uncertainty opens the door to valuable risk management. Intuitively, if the probability-weighted downside effect on value when the uncertainty is resolved unfavorably more than offsets the upside effect of favorable resolution, then it can make sense to lay off the risk and take the value outcome associated with the expected value outcome of the risk driver. Mathematically, the point follows from Jensen’s inequality. Smith and Stulz (1985) focus on specific examples such as progressive corporate tax codes (the tax bite is disproportionately greater on the pre-tax profits upside) and financial distress costs (the distress costs are disproportionately greater on the profits downside). Investors cannot replicate the firm’s managed tax or financial distress risk positions.1 The converse reasoning also applies. If the probabilityweighted upside effect on firm value when a risk is resolved favorably is greater than the probability-weighted downside effect if the risk is resolved badly, then expected value would not be enhanced by hedging. In that
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