Edited by Adrian R. Bell, Chris Brooks and Marcel Prokopczuk
Chapter 14: Does hedging reduce economic exposure? Hurricanes, jet fuel prices and airlines
Does hedging reduce corporate economic exposure to input cost risk factors? Surprisingly, this question has not been well addressed in prior literature. A recent survey article by Smithson and Simkins (2005) highlights that the population of published studies of the effect of hedging on firm risk factors is limited to those analyzing currency risk, financial institutions or commodity producers. Notably, none of the surveyed articles utilize a sample of firms for which an input cost factor poses significant risks to the financial health of the sample companies. In this chapter, we demonstrate how the multivariate regression model (MVRM) can be used to analyze whether hedging affects economic exposures. We utilize information from extreme events to assess whether corporate hedging reduces an input cost risk exposure. In particular, we use the fact that two major hurricanes occurring in 2005 caused major spikes in jet fuel prices. We analyze whether jet fuel hedging by US airlines is able to reduce market value losses during unexpected increases in jet fuel prices. We argue that the standard methodology for measuring risk exposure is not well suited to improving our understanding of how hedging affects risk exposures across firms with differing risk management strategies. Because the cost of jet fuel is a significant operating expense for airlines, a sudden, unexpected increase in fuel costs could have a serious negative effect on their operating performance and stock price.
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