An article was published
by Reuters Business last week about the airlines industry and hedging. The
subject had to do with the latest continuing drop of oil prices. We are
witnessing an unprecedented phenomenon on world oil prices and their lowest
prices ever. The price of a barrel of oil is at about $35 and naturally for
countries dependent on oil this is good for their budgets and national debt.
The interesting point in
this news is not the airlines’ hedging, after all, it is only natural for
companies to want to protect themselves, their investments from unwanted
increase in prices. They do this by locking in prices early to avoid later
increase in prices. The problem is that they are rethinking hedging due to a
drop of oil prices. The article appeared on http://www.reuters.com/article/us-usa-airlines-fueloil-idUSKCN0V017B
.
A hedging transaction
takes a position that protects an investor from losses in another position.
Hedging involves the use of derivative instruments like options and futures. A hedge
is a position in options and futures and involves taking the opposite position
of what is expected to happen. For example, if a wheat farmer is expecting that
prices of wheat will rise because of a bad harvest, he will take an opposite
position to offset the losses. In such commodities like wheat, oil, futures
contracts are used.
Investors use options to
reduce portfolio risk or lock in profits. If an investor owes shares in stock
A, and expects the price of those shares to rise in the future. To protect from
a fall in price, the investor buys a put option that gives the investor the
right to sell at a specific price in the future accordingly. This strategy
limits how much the investor can lose.
A futures contract gives
the buyer of the contract the right and obligation, to buy the underlying asset
at the price at which he buys the futures contract. On the other hand, the
seller of the contract gives him the right and obligation, to sell the
underlying commodity at the price at which he sells the futures contract. In
practice, very few contracts end up being delivered, since, since most are
utilized as hedging, and are sold or bought back prior to the expiration date.
Businesses that need to
buy significant quantities of crude oil hedge against a rise in oil prices by taking
a position in the crude oil futures market. The position taken is a long hedge
to lock in the purchase price of a quantity that will be needed in the future.
A long hedge is where an investor takes a long position in a futures contract
in order to hedge against a future price volatility. A long hedge is a position
that allows a company to but something in the future, by locking in the price
today.
