Financial derivatives are contracts that derive value from the performance of an underlying asset. The underlying asset can assume many forms such as interest rates, assets, commodities or indices. Derivatives constitute one of the major categories of financial assets such as stocks (shares or equities) and debt (mortgages and bonds). The most common types of derivatives include futures, forwards, options and swaps. The derivatives are used for various purposes such as protection against price movement. The act of using derivatives as a cover against price movements is referred to as hedging. Besides, the derivatives are used for speculation purposes. In such a case, they are used to access otherwise inaccessible assets or markets. Most derivatives are traded off the exchange as over the counter transactions. However, there are derivatives traded on an exchange such as the Chicago Mercantile Exchange (CME) (Hull 58).
A swap is a financial derivative where two parties agree to exchange cash flows of one party financial instrument with those of the counter party’s financial asset. The streams of cash flows are referred to as the legs of the swap. The swap agreement specifies the dates when the cash flows are supposed to be paid and the mode of calculating the accrued payments (Hull 58).
In the swap agreement, the airline pays fixed amounts to the bank; while, in return, the bank pays floating rates to the organisation based on the prices of jet fuel. It is thus covered by future increases in the price of jet fuel by entering into such an agreement. Consequently, the airline can budget for its fuel consumption costs. Besides, the airline can forecast its profits and price its services at a favourable position based on the anticipated costs. Despite the cover provided by the swap agreement, the airline is susceptible to other forms of risks such as basis risk, geographical hazards, price risk, market risk, liquidity risks, Interconnection risks, and counterparty risks (Hull 61).
Hedging inefficiencies cause basis risks. They occur due to changes in the spot price relative to the hedging position where the asset price fail to move in tandem with the hedged spot price. Basis = spot price - swap price. The basis changes in tandem with the price of the underlying assets. A strengthening basis denotes an increase in the difference between the spot and the swap and it is vice versa to a weakening basis. In the airlines case, a strengthening basis is caused by price decreases of jet fuel. Consequently, it works to the benefit of the bank. Increasing rates result into a weakening basis that works for the benefit of the airline (Hull 65).
Different types of basis risks result from many factors such as changes in transportation, financing, storage and processing costs. First is the locational basis risk. It results from hedging made on a product with a different delivery point to that of the airline. The risk is caused by price differential related to the location of the supplier of the jet fuel. Different areas are associated with different locational basis risks (Hull 65).
Second is the product/ quality basis risk. The risk arises from the related uncertainty with of the quality of the product. In the case of the airline, there is the uncertainty as to whether the jet fuel hedged by the airline matches the desired quality. Consequently, there are possible changes in prices due to quality requirements of the airline and the price of the hedged fuel. Therefore, it poses possible increases in prices to acquire the desired quality of jet fuel(Hull 65).
Third is calendar/ tenor basis risk associated with swaps deadline dates. For example, the airline might face a situation where jet fuel suppliers have contracts that do not expire in line with the swap payments. Due to the time constraints, the airline is faced with a situation where it has to decide between buying earlier and incurring warehousing costs or buying later and facing price risks exposures for many days (Hull 66).
Third, the airline is exposed to counterparty risks. The airline in addition to the swap contract enters into the agreement with various fuel suppliers. The swap agreement is an over the counter contract that is facilitated by a dealership. Over the counter contracts fail to meet exchange listing requirements. Besides, over the counter markets are less regulated compared to other trading exchanges. Trading exchanges assist in facilitating contract performance by requiring the parties to a contract to deposit margins. The margins are adjusted on a daily basis through a mark to market process. The absence of margins makes it possible for traders to move in and out of a trade agreement at will. Consequently, the airline is prone to suffer a loss upon the default of the suppliers to deliver the fuel supplies. In particular, suppliers have the incentive to default upon the rise of fuel prices after their contracting for a sales price. Such a default leaves the airline to obtain the jet fuel supplies necessary to meet its operations at a higher price despite their budget and forecasts for related airfares (Hull 66).
Fourth is a market liquidity risk. Commodity trading and hedging markets require firms to enter frequently and exit from positions hastily. The trading risks are lower to the extent that it is possible to enter and leave the market without having a large and diverse impact on the price levels. In short, hedging is less risky and cheaper in liquid markets. Hedging markets of petroleum fuels are liquid compared to those of coal or power derivative markets. Moreover, liquidity varies randomly and substantially with time. Besides, liquidity can decline precipitously especially during stressed market periods. Consequently, the market stress factors cause the firms to change positions. For example, increasing prices creates necessity for firms to lower their inventories by liquidating the available hedges. Supplier firms are pressed to sell to the highest bidders (Hull 66).
Fourth is interconnection risk. It is the risk associated with how the various derivative dealers and instruments are interconnected that may affect the airlines swap. There are possibilities of problems to occur on another derivative such as a forward or a future with the same or another bank to that of the airline. The problem has the possibilities of spreading to other derivatives hedged with the bank or other financial institutions due to the snowball effect threatening the stability of financial markets (Hull 66).
The two years historical price graphs for commodities indicate the trends for jet fuel prices. The monthly average of prices was obtained for each year. The averages were used as points on the graphs. The graphs indicate a general fall in prices of jet fuel from the year 2014 to 2015. Specifically, the prices of jet cargoes fuel declined from an average of 990 United States Dollars per barrel mark to a 450 United States Dollars per barrel by the end of the year. Besides, the jet cargoes fuel experienced minor increases in prices to the 600-dollar mark. However, the prices continued to fall in the year 2015 from the 450-dollar mark to the 390 dollars per barrel by the end of the year 2015. A similar trend was observed with the ICE gas oil prices for both years (Hull 66).
Prices of other fuels such as ICE Brent, WTI bbl., Kerosene sing and gas oil sing experienced a general decline in prices but at a lower magnitude. Specifically, the products were traded lower at a range of 150 to 170 compared to the ICE Gas Oil, and Jet cargoes fuel that began at 910 to 990 dollar per barrel mark. However, there is observed similarity of a general decline in prices from the year 2014 to 2015 (Hull 66).
The forward curves for the year 2016 indicate a general rise in the prices of ICE Gas Oil, and Jet cargoes fuel. The prices are forecasted to increase from the low of 400 to 420 in the year 2015 to a range of 450 to 490 dollars per barrel respectively. In contrast, the prices of ICE Brent, WTI bbl., Kerosene sing and gas oil sing are forecasted to experience constant prices at the range of 50 to 70 dollars per barrel. Variance indicates the volatility of various commodities. The variance indicates more volatility in the year 2014 compared to the year 2015. Besides, lower levels of volatility are expected during the year 2016 (Hull 69).