Transportation Research Part E 127 (2019) 206–219

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Transportation Research Part E

journal homepage: www.elsevier.com/locate/tre

Flying with(out) a safety net: Financial hedging in the airline

T
industry
Rico Merkert , Hassan Swidan
⁎

The University of Sydney Business School, NSW 2006, Australia

ARTICLE INFO ABSTRACT

Keywords: This paper re-examines risk management theories in the airline context and investigates whether
Airlines financial hedging (fuel, foreign exchange and interest rates) is an effective strategy for enhancing
Risk management operational profitability. Based on data from 100 international airlines over six years, we eval-
Integrated financial hedging uate the impact of hedging on financial airline performance. Our results suggest that fuel price
Corporate strategy
hedging significantly decreases EBIT margin volatility (hence effective in mitigating financial
Competitive advantage
risks) but has no significant effects on profitability (hence ineffective as a speculative tool) and
operating costs. Low current ratios are shown to increase operating profits, highlighting the
importance of liquidity in capital-intensive industries.

1. Introduction

Traditional hedging theories suggest that during volatile periods, hedging strategies can create competitive advantages for firms
by locking in prices for future input requirements. However, such strategies can also place companies at a significant disadvantage
when prices decrease sharply, because unhedged competitors can purchase inputs at relatively cheaper spot market prices. Financial
risk management can play a vital role in forming firms’ corporate and competitive strategies (Amit and Wernerfelt, 1990); for
example, firms can gain competitive advantages in volatile industries just by holding sufficient amounts of cash (Kim and Bettis,
2014). Particularly in environments where technological change, competitive pressures and significant dependence on one or two
inputs/resources (such as oil) dominate the procurement and production/service process, it appears to be worthwhile to consider risk
management strategies such as hedging to improve financial performance. Airlines are a prime example of such a sector given that it
is capital-intensive and also very dependent on jet fuel as a key input. Oil prices have been volatile, dropping from roughly $110 a
barrel to $30 a barrel from 2013 to 2016, only to more than tripling and then loosing 35% in the short space of the last three months
of 2018. Some forecasters expect prices to rise again while others expect further deterioration in prices as the global economy faces a
recession and more shale oil rigs are brought into production in the United States (Baker Hughes, 2017; IEA, 2018). The fact that
sport market prices can also fall sharply makes fuel hedging a very difficult exercise as evidenced by the Cathay Pacific fuel-hedging
losses of HK$6.45 billion in 2017 (Park and Whitley, 2018) and leaves airline management with the not obvious question as to
whether financial hedging is a sensible strategy and whether they should engage in such practices at all. However, if airlines do not
hedge, they risk very substantial cost increases for services that they sold in advance of departure and (with locked-in prices and
hence revenues).
In addition to risks related to volatile commodity prices, international businesses (particularly firms with high foreign sales and/
or U.S. dominated debts, such as airlines) are exposed to significant fluctuations in foreign exchange rates and interest rates, which

⁎
Corresponding author.
E-mail address: [email protected] (R. Merkert).

https://doi.org/10.1016/j.tre.2019.05.012
Received 25 July 2018; Received in revised form 7 April 2019; Accepted 22 May 2019
Available online 28 May 2019
1366-5545/ © 2019 Elsevier Ltd. All rights reserved.
R. Merkert and H. Swidan Transportation Research Part E 127 (2019) 206–219

can potentially increase borrowing costs. These variables have been volatile too, in particular since the global financial crisis in 2009,
with global shocks and uncertainties (such as BREXIT or potential trade wars), central bank interference and technological change all
having an impact.
Integrated risk management strategies and financial hedging can potentially help international businesses (such as airlines or
mining companies) mitigate volatility risks linked to commodity prices, foreign exchange and interest rates (Miller, 1998). Firms can
use hedging tools such as futures contracts to secure the right to buy commodities at a fixed price in the future, thereby stabilizing the
volatility of input prices. Derivatives such as put or call options and collars may help international firms manage their currency risk
exposure. Likewise, firms can use interest rate swaps to exchange their fixed-rate obligations for floating rates that may decrease their
borrowing costs. In addition to financial hedging, businesses may engage in operational hedging to manage their risk exposure and in
some cases operational hedging may substitute using financial derivatives (Almeida et al., 2017; Bonaimé et al., 2014). Given the
particulars of the aviation industry, it is however not clear whether financial hedging has any benefit to airlines.
The aim of this paper is to evaluate for the global airline context whether integrated financial hedging and hence a holistic
approach to hedging (i.e. fuel prices as well as interest and foreign exchange rates), not only improves airlines’ operational profit-
ability in the short run (within a year), but also reduces the volatility of profit margins, which enhances commercial success in the
long run. Our results (based on global panel data from 100 international airlines) suggest that such strategies can improve fore-
casting, procurement, planning and cost management (e.g., demand, prices of inputs/outputs and/or capital) for firms that operate in
economically volatile environments, thereby enhancing the sustainability of financial performance and firm value. Since not all
airlines hedge, in an environment of increasing volatility and exogenous industry shocks, a successful hedging strategy may indeed be
perceived as transformative by airline managers and competitors and thus be important for gaining or maintaining competitive
advantage. Perhaps the more pressing part of that equation is that not hedging could be interpreted as a very risky strategy (flying
without a safety net) that could not only result in substantial losses but also in the relevant airline going bankrupt.
This paper is organized as follows. Section 2 provides a brief background to the airline context and why we think airlines are
different to other industries. Section 3 reviews the literature on financial hedging and develops our hypotheses. Building on this,
Section 4 discusses the methodology and the sample of our analysis. Section 5 presents our results which are discussed in detail in
Section 6, including limitations and management implications. Our key findings and conclusions are summarised in Section 7.

2. The airline context

Airlines are a great example of international businesses that are exposed to volatility and operate in extremely competitive
environments. Global deregulation and increased competition in local and global markets have not only diversified the traditional
business model and financial performance in the airline industry (e.g., Scotti and Volta, 2017) but also introduced several industry
shocks. The entry of low-cost carriers (LCCs) into the market has intensified competition and consequently resulted in a sharp decline
in industry yields. In concert with demand uncertainties and increasing cost pressures stemming from product and process in-
novations, airlines face significant pressures and risks associated with volatile input prices. A key input for airlines is jet fuel, which is
not only a highly volatile commodity but also accounts for a large share of airlines’ operating costs. The International Air Transport
Association (IATA) indicates that the share of airlines’ total operating costs attributed to fuel rose from 13% in 2001 to 22% in 2005,
to between 30 and 50% in 2014 (IATA, 2014). Volatility in jet fuel prices therefore significantly affects airlines’ total operating
expenses. Unlike other industries, airlines cannot easily pass on the increase in jet fuel prices to customers due to intense competition
and tight industry regulations on fuel surcharges.
While hedging has been researched in a number of industries with the aim to better understand strategic and financial decision-
making (Bertrand et al., 2015; Weiss and Maher, 2009), empirical evidence on the impact of financial hedging is not conclusive and
the literature is divided. While some have argued that hedging increases firm value (Allayannis and Weston, 2001; Carter et al., 2006;
Korkeamäki, et al., 2016), others have found no significant effect of fuel hedging (Guay and Kothari, 2003; Morrell and Swan, 2006).
Moreover, recent developments in the airline industry have made it more difficult to justify fuel hedging. After the recent collapse in
oil prices, many airlines with jet fuel hedging contracts continued to pay well above market spot prices (e.g., evidenced by Cathay
Pacific’s fuel-hedging loss of HK$6.45 billion in 2017 (Park and Whitley, 2018)) while their unhedged competitors enjoyed a much
lower cost base. Thus, airlines that did not hedge (either by choice or because their balance sheets were not strong enough to engage
in hedging strategies) gained a competitive advantage by paying lower prices in jet fuel spot markets. For example, in 2014, United
and Delta reported large fuel price hedging losses (Delta Airlines, 2015), while American Airlines reported $600 million in savings
from buying fuel directly in the spot market (American Airlines, 2015). As a result, many airlines decided to cut their fuel hedging
programs (Air France-KLM, 2015), thereby potentially increasing their risk in future earning periods, as recently evidenced in Q1
2017 when American Airlines reported a 37.8% increase in fuel expense.
In addition to jet fuel volatility, airlines typically face foreign exchange rate fluctuation risks in their operations, particularly
airlines with high foreign currency sales and/or foreign currency debts but also who sources most of their supplies (such as jet fuel) in
foreign currency. Perhaps even more important, a large proportion of airline tickets are sold well in advance, many in foreign
currencies either to travel agents or directly to consumers. Since airlines’ revenues are as a result often locked in well in advance of
specific flights, the risk exposure to both jet fuel price and foreign exchange rate movements is amplified. Additionally, what is
complicating this is that airlines, who are known to be a capital-intensive sector, depend on different forms of debt to finance their
fleet obligations. Because much of this debt being held in foreign currencies, airlines are often exposed to substantial foreign ex-
change and interest rate risks.
Volatility in jet fuel prices, currency exchange rates and interest rates can lead to dire financial consequences and places intense

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pressure on already tight profit margins.1 Although the profitability of the airline sector has improved since 2015, it is still seen as one
of the worst performing industries, with notable Chapter 11 bankruptcies in the United States and many financial failures globally. It
is clear, however, that appropriate integrated strategies that reduce exposure to volatilities in fuel prices, foreign exchange rates and
interest rates can help international businesses—especially those that rely on a key input factor to provide a service (e.g., airlines)—to
improve their financial performance and gain or maintain a competitive advantage (Porter, 2008). In addition to financial hedging
strategies, airlines use operational hedging to reduce the risk of exposure to fuel price changes. As illustrated in Fig. 1, examples of
such hedging strategies include adjusting flight plans and operations (Naumann and Suhl, 2013), diversifying the fleet, replacing
aircraft and optimizing capacity. Many airlines also benefit from natural hedges since some foreign exchange rates (e.g., AUD to USD)
have traditionally been closely correlated with jet fuel prices.
Many (but not all) airlines manage financial risk by hedging future jet fuel prices, foreign exchange rates (Fornes, 2008), cash flow
and capital cost/interest risks. Relevant to our paper, the FY2017 (on paper) losses in jet fuel hedging positions announced by many
large airlines have resulted in different strategic responses with large regional variation. As illustrated in Fig. 2, many large carriers in
the US such as Delta, United and American Airlines have recently stopped jet fuel hedging whilst most European airlines such as
Ryanair and Lufthansa have maintained their relatively high hedging ratios (IATA, 2018). Some airlines employ hedging in a
speculative manner by engaging in ad-hoc/selective hedging based on their predictions about the market (e.g., Ryanair tries to
second guess the market). It is worth noting that selective hedging is not very common and there is no robust evidence suggesting that
this is a successful strategy, since airlines’ core competencies typically do not include outmaneuvering financial markets.
Motivated by the intend to provide airline management with strategic guidance on whether it is sensible for them to engage in
integrated financial hedging, which is currently not an obvious question due to the lack of robust evidence in the literature as well as
recent global industry changes, we aim to re-examine hedging theories in the airline context. Building empirically on the theoretical
notion that hedging strategies can (in principle) improve profitability, and perhaps more importantly, maximize cash flows and
minimize risk exposure (Calandro, 2011), we argue that airlines can use integrated financial hedging strategies to gain competitive
advantages. Understanding the effects of hedging strategies is particularly crucial for full service airlines, which have been competing
for survival since the deregulation of global airline markets and the emergence of low-cost carriers and are trying to adapt by
studying their rivals’ strategies (as shown more generally by (Tsai et al., 2011).

3. Theoretical considerations and hypotheses development

Under the assumption of perfect capital markets, Modigliani and Miller (1958) have shown that risk management strategies such
as hedging have no impact on firm value. However, since then corporate risk management theorists have challenged the assumption
of perfect markets by considering capital market frictions. These frictions lead to market imperfections that make risk management
strategies relevant to corporations, because risky decisions may yield greater rewards in the form of better firm performance (Singh
and Upneja, 2008). In the presence of market imperfections, hedging can add value by mitigating exposure to risks associated with
market frictions such as taxes, financial distress costs (Myers, 1977), agency costs (Leland, 1998), and underinvestment costs (Gay
and Nam, 1998). Smith and Stulz's (1985) theoretical model demonstrates that hedging can smooth earnings and cash flow volatility,
thereby potentially decreasing the probability of bankruptcy, and in turn reducing financial distress costs and increasing firm value.
Froot et al. (1993) further theorized that hedging can add value to firms to financially constrained by stabilizing their cash flows and
safeguarding internal financing options. Corporate risk management theories also include managerial risk aversion as an incentive for
corporate hedging. When compensation is tied to earnings and stock prices, managers tend to be risk averse and hedge to mitigate the
risk of volatility associated with earnings and stock prices (Smith and Stulz, 1985). Stulz (1996) further argued that corporate
managers may utilize hedging as a speculative tool, incorporating their expectations about movements in commodity prices or
exchange rates to increase firm value through selective hedging. Contrary to risk management theories, selective hedging anticipates
generating profit from information asymmetry, not from managing volatility risks.
Scholars developed these theoretical frameworks for non-financial corporations, assuming that firms in various industries might
hedge using similar approaches. Building on Leland (1998), however, we argue that the airline industry characteristics, influence
firms’ hedging decisions and strategies. As detailed in the following sub-sections, findings in the extant literature suggest that the
capital-intensive nature of many businesses such as airlines, mining operations, steel manufacturers or hotels would provide a
useful—and more importantly, untapped—laboratory for testing the theoretical framework of integrated financial hedging (interest
rates, foreign exchange rates and jet fuel prices) as a strategy to gain competitive advantage. We therefore use empirical evidence
from the international airline context to evaluate whether current hedging theoretical frameworks can explain the financial impact of
hedging for operations in capital-intensive industries with high volatility affecting both demand and supply.

3.1. Hedging and leverage

Leverage is a measure of a firm’s capital structure and financial health based on the ratio of total debt to total assets. High leverage
increases the probability of bankruptcy for airlines and thus increases expected financial distress costs, whereas low leverage in-
dicates robust financial performance with less debt and high shareholder equity. Stulz (1996) and Leland (1998) argued that hedging
can yield tax benefits by reducing the volatility of taxable income (assuming convexity of most tax codes), by keeping taxable income

1
The 40-year average profit margin in the airline industry was 0.1% for many years (IATA, 2008).

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Fig. 1. The spectrum of strategic jet fuel hedging.

Fig. 2. Percentage of Fuel Consumption Hedged for H1 2019.

Source: IATA.

within a range with an optimum tax rate. Hedging is further assumed to stabilize cash flow and earnings volatility and consequently
increase a firm’s debt capacity, which leads to a decrease in leverage and potential further reductions in tax liabilities. All this
provides firms with tax incentives to hedge, as evidenced (despite not properly addressing the reserved causality relation between
hedging and leverage) by a cross-sectional sample of U.S. firms that added 1.1% to firm value through hedging-related tax benefits
(Graham and Rogers, 2002). Nonetheless, due to the capital-intensive nature of the airline industry, debt structures differ from those
in other industries. Different to what has been shown in the extant literature, many airlines may not have the necessary financial
resources (such as cash collateral and credit conditions) to engage in hedging strategies (as evidenced in many interviews with airline
management and also by Rampini et al., 2014). To date, empirical evidence on this point has been inconclusive; Nance et al. (1993)
results suggest that the least financially constrained firms with lower leverage hedge more, while the findings of Géczy et al. (1997)

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and Gay and Nam (1998) suggest the opposite. Particularly in capital-intensive industries such as hospitality and tourism, scholars
have identified higher leverage as a determinant of hedging (Singh and Upneja, 2008). Allayannis and Weston (2001) used leverage
(measured as long-term debt to equity) as a control variable in a model that examined the effect of hedging on firm value and they
found that firms with more leverage generally have higher firm value. However, depending on how which measure of leverage they
used, it had either a positive or negative impact on hedging in their Tobin’s Q models. Similarly, Carter et al. (2006) found incon-
clusive results (sign of the relationship changing depending on which model they use) regarding the effect of leverage on determining
the amount hedging. Further evidence shows that financially constrained airlines often are unable to utilize hedging due to in-
sufficient resources (Morrell and Swan, 2006; Rampini et al., 2014). Contrary to current hedging theories, airlines with higher
leverage may not be able to hedge at all in practice.
Moreover, since the extant literature is focused on the impact of leverage on hedging, there is little evidence on the impact of
hedging on leverage and debt capacity in capital-intensive industries (nor causality of these effects). Although risk management
theory suggests that hedging may reduce financial distress costs and the risk of bankruptcy, and indirectly magnify tax benefits by
increasing debt capacity, the airline industry’s capital-intensive nature makes the relationship between hedging and leverage less
obvious. The aim of our first hypothesis is therefore to evaluate the impact of hedging on an airline’s debt capacity.
Hypothesis 1. Hedging improves (i.e., decreases) an airline’s leverage.
We argue that reducing indebtedness of airlines is a key benefit of hedging. As generally shown by the hedging literature, hedging
can reduce costs of external financing through minimizing expected financial distress costs as well as underinvestment costs, thereby
enhancing firm’s debt capacity. Although, some firms may utilize the growth in debt capacity increasing leverage to exploit growth
and investment opportunities (Campello et al., 2011; Gilje and Taillard, 2017), airlines generally have a conservative stance on
elevating leverage levels (Pires and Fernandes, 2012). As demonstrated by Capobianco and Fernandes (2004), many global airlines
focus on reducing leverage levels as their overall financial performance is positively associated with reduced indebtedness. Our
hypothesis therefore is that hedging improves airlines’ general financial operating performance through decreased leverage (reduce
debt levels).

3.2. Hedging and profitability

In the extant literature, hedging is viewed as a risk management strategy to deal with market imperfections, not as a speculation
strategy to improve profitability, because the assumed net present value of hedging output is zero. However, empirical evidence from
the mining industry suggests that the net cash flow gains of derivatives add to firm value (Adam and Fernando, 2006; Brown, 2001),
supporting Stulz's (1996) notion that managers occasionally engage in selective hedging. In fact, a number of industry surveys have
demonstrated that corporations utilize selective hedging by adjusting their hedging strategies based on their views about the market
(Baker et al., 2010; Smithson and Simkins, 2005). There is also a more extrinsic motivation for selective hedging, since various
elements of managerial compensation (e.g., stock options or stock ownership) are usually linked to profitability and may hence
significantly affect managers’ appetites for risk (Martin et al., 2013; Sanders, 2001). In the context of airlines Korkeamäki, et al.
(2016) have shown that passive hedgers are on average associated with significantly higher firm value than selective hedgers and
found an inadequately significant positive relationship between management ownership and firm value. However, in addition to
presenting conflicting results, more importantly they did not provide any evidence on the impact of hedging on profitability and
whether managers use hedging to actively take positions in the market to generate profits. The lack of evidence around selective
hedging is expected as it is difficult to empirically measure the effect of selective hedging and most studies focus on finding cor-
relations between hedging ratio and movements in market prices, anticipating that changes in hedging ratios correspond with price
fluctuations which may be used as some proxy (evidence) for the performance of selective hedging. Building on Guay and Kothari's
(2003) work on hedging of non-financial corporations, we argue that managers in the airline sector, which is relatively capital-
intensive and volatile, are particularly inclined to use selective hedging to manage risk associated with jet fuel prices, foreign
exchange rates and interest rates in an attempt to boost operating profits. Clearly, there is a need to re-examine and challenge risk
management theories that suggest hedging strategies deliver zero net present value, which paves the way for our second hypothesis:
Hypothesis 2. Hedging improves airlines’ operating profitability.
Contrary to Morrell and Swan's (2006) empirically unsupported notion on the ineffectiveness of hedging, we expect that hedging
affects airlines’ operating profitability. This would be consistent with findings of other scholars who have suggested that hedging
would enable those firms that hedge to (as a result) acquire assets from financially distressed competitors (Carter et al., 2004; Carter
et al., 2006) or elements of the production chain (Amit and Wernerfelt, 1990) at relatively low prices during periods of high volatility,
which consequently leads to potentially less risk exposure and improved firm value.

3.3. Hedging and operating profit margin volatility

As discussed in the previous section, corporate risk management theories focus on hedging as a strategy to reduce tax liabilities,
bankruptcy and financial distress costs by smoothing market volatilities. However, the extant empirical evidence is divided: some
suggest that foreign exchange hedging has reduced financial costs and improved firm value (Allayannis and Weston, 2001; Géczy
et al., 1997), while others have found no impact of hedging on firm value (Guay and Kothari, 2003; Jin and Jorion, 2006). In the
airline context, Guay and Kothari (2003) argued that the amount of cash that might be generated from a hedging portfolio is very

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small compared to the amounts attributable to firm size, cash flow and earnings. Therefore, Morrell and Swan (2006) argued that
airline shareholders and investors are better positioned to manage that risk than those in other industries. However, other risk
management tools such as operational hedging are often seen as more important in mitigating firms’ risk exposure and improving
firm value (Berghöfer and Lucey, 2014; Treanor et al., 2014; Merkert and Hensher, 2011). The extant literature does hence not
sufficiently explain hedging behavior and corporate strategies in the airline industry.
Perhaps more importantly, we argue that contrary to the previous literature, using firm value to measure the impact of hedging on
corporations is not meaningful in the airline context. Firm value functions contain market values of equity that reflect stock prices for
publicly traded companies. However, many airlines are not publicly traded, but are either private companies or government owned
corporations; therefore, it would be misleading to focus on how hedging might yield benefits in the form of higher stock prices.2
Evaluating the impact of hedging on operating profit margin volatility thus could prove to be more illuminating. Evidence from other
capital-intensive industries such as hospitality and tourism (Kim and Kim, 2008; Singh and Upneja, 2008) and mining (Kim et al.,
2009) shows that derivatives have a significant impact on cash flow and earnings volatility. Petersen and Thiagarajan (2000) offered
one explanation, suggesting that managers tend to utilize financial derivatives to mitigate earnings volatility risk when quarterly or
annual earnings are included in a firm’s compensation structure. We further argue that hedging can potentially reduce financial
distress and underinvestment costs and consequently improve firms’ financial performance by reducing volatility. Examining the
relationship between hedging and volatility is hence crucial to assess the ability of risk management theories to explain potential
benefits of hedging strategies.
Hypothesis 3. Hedging reduces airlines’ operating profit margin volatility.
Our expectation is that hedging significantly reduces operating profit margin volatility. This would prove that rather than being a
speculation vehicle, financial hedging is a risk management strategy that can provide airlines with means of more stable revenue
management and better internal financing for their investment projects.

3.4. Hedging and operating costs

Jet fuel expenses account for large percentage of airlines’ operating costs (according to IATA the 2018 expected industry average
for the share of fuel cost in operation cost is 24.2%). Therefore, jet fuel price volatility is reflected in operating cost volatility, which is
considered a significant risk for airlines because it intensifies financial distress and underinvestment costs (Carter et al., 2006; Froot
et al., 1993). Results of studies on the impact of hedging on operating costs have been inconclusive (Berghöfer and Lucey, 2014; Lim
and Hong, 2014). We expect that hedging reduces the volatility of jet fuel costs, thereby reducing overall operating cost volatility and
ultimately resulting in significant reductions in operating costs.
Hypothesis 4. Hedging reduces airlines’ operating costs.
It is worth noting that hedging can often be associated with significant transaction costs (see e.g., Alizadeh, 2013) such as
establishing and maintaining derivative portfolios as well as financing premiums and cash collaterals. We expect however that the
predicted financial benefits of hedging in terms of minimizing distress and underinvestment costs outweigh hedging expenses, re-
sulting in reduced operating costs and increased profitability.

4. Methods

4.1. Sample and data

We collected data from 100 major international airlines over six consecutive fiscal years (2009/https://doi.org//10-2014/15).
Our sample is comprised of 36 Asian, 33 European, 18 North American, 5 Oceanian, 5 African, and 3 South American carriers. To our
knowledge, this is the first study on financial hedging strategies with such a globally representative sample of public, private and
government owned airlines. The main data source was airlines’ annual reports which provided operational, cost and hedging data. To
obtain data for our jet fuel, currency and interest rate hedging dummy variables, we manually searched the annual reports for key
words such as swap, hedge, derivatives and risk management. We used COMPUSTAT to collect the necessary financial data. To fill in
gaps and validate the data, we used information from the Centre for Aviation (CAPA), Flight Global (RELX Group), the International
Air Transport Association (IATA) and the airlines themselves. Since some airlines filed for bankruptcy and others merged during the
study period, the final dataset was an unbalanced panel with a total of 387 observations.

4.2. Measures

4.2.1. Dependent variables

To test our four hypotheses, we used indicators of leverage, profitability, profit volatility and cost as dependent variables. Building
on the extant empirical financial economics literature, we measured leverage as the ratio of total debt to total assets, since as airlines

2
It is worth noting that in previous studies on airlines, researchers have focused on publicly traded U.S. airlines (see, for example Turner and Lim,
2015).

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often use leases and other forms of debt to finance their fleets, weakening their balance sheet. Although the majority of the sampled
airlines are publicly traded (77 airlines out of 100), some are not and it is therefore preferable to use the total debt to total assets ratio
rather than the long-term debt to shareholder equity ratio which has been popular in previous airline studies (e.g., Pires and
Fernandes, 2012).
We measured profitability by calculating operating profit margin as the ratio of operational profit (earnings before interest and tax,
EBIT) to operational revenue. Using a ratio rather than the absolute value of profit has the advantage of avoiding distortion resulting
from currency conversions. To evaluate the impact of hedging on the volatility of profitability, we calculated operating profit margin
volatility by squaring the difference between the profit margin of the focal fiscal year and the previous fiscal year. We selected
operating profit margin as a measure for profitability mainly due to the large impact of jet fuel prices on operating revenues, focusing
on capturing the effect of hedging on stabilizing operating costs and revenues. As demonstrated by IATA (2016), fluctuations in oil
prices can be directly reflected in airlines’ operating profit margins in the short term whilst other profitability measures such as return
on invested capital (ROIC) and return on capital (ROC) reflect the long- term ability of airlines to attract capital (IATA, 2013). In
addition, operating margin has been widely used by investors to evaluate the overall economic performance of the airline industry
(IATA, 2016).
We measured our final dependent variable, unit cost, by calculating operating cost per available seat kilometer (CASK), controlling
for both number of seats and distance flown, as is common practice in the airline industry.

4.2.2. Independent variables

We included three hedging variables in our analysis to mirror our hypotheses, which are focused on jet fuel prices, foreign exchange
rates and interest rates. For all three we used dummy variables to indicate whether an airline engaged in hedging in the current fiscal
year. We used lagging hedging variables in our volatility models to overcome potential issues related to simultaneity and reverse
causation as volatility was estimated based on differences between current and previous years’ operating profit margins.

4.2.3. Control variables

We used three control variables in our models. Passenger load factor (PLF) of the current year t is calculated by dividing revenue
passenger kilometers (RPK) by available seat kilometers (ASK), the most common measure of aircraft capacity utilization. PLF
typically has a significant impact on (and is in fact highly correlated with) airlines’ operating cost and profitability (Morrell, 2013).
We used total debt to total assets to control for leverage. Since most airline markets are mature, airlines with high total debt to assets
ratios have tight financial constraints that affect their profit margins, and subsequently profit margin volatility. Finally, we controlled
for firm liquidity because evidence shows that failing to meet short term financial obligations can have an impact on profit margins.
We used current ratio as a measure for liquidity, which is calculated as current assets divided by current liabilities.
Our relatively large sample of international airlines spans across 61 countries which enhances the potential contribution and
validity of our models. However, with international samples also come, by definition, potential challenges. Despite US Generally
Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) being widely deployed by all airlines
in our sample, accounting standards (i.e. for reporting hedging and financial performance data) and hedging practices may depend on
the region an airline resides in. To minimize such potential distortion (bias) we controlled for the effect of various accounting/
hedging standards by adding region dummy variables to our models. Furthermore, ownership (privately versus publicly owned
airlines) may affect the decision to hedge and therefore impact the effect of hedging on financial performance indicators. As a
government owned dummy variable was correlated with some of the region dummy variables we control for ownership through a
dummy that indicates whether an airline has publicly traded shares. This does in our view also better reflect the power of equity/
shareholders.
In summary, Table 1 provides the descriptive statistics and correlation matrix of the variables used in our models.

4.3. Model specification and estimation

To evaluate our hypotheses, we primarily utilized random-effects panel regression models estimated by the generalized least
squares (GLS) method. This approach overcomes the heteroscedasticity and autocorrelation problems associated with ordinary least
square (OLS) panel analysis methods (Bliese, 2000; Certo and Semadeni, 2006; Martin et al., 2013; Sanders, 2001). Our Hausman test
results suggest that the difference in coefficients is not systematic, which is why we used random, rather than fixed-effects models.
The variation across airlines in the panel is hence assumed to be random and uncorrelated with explanatory variables, as are the error
terms ( i).

Leveragei, t = a1 + b1 Fuel Hedging Statusi, t + b2 FX Hedging Statusi, t + b3 Interest Hedging Statusi, t + b4 Profit
Margini, t 1 + Region Dummyi + Publicy Traded Dummyi + µ + (1)

Profit Margini, t = a1 + b1 Fuel Hedging Statusi, t + b2 FX Hedging Statusi, t + b3 Interest Hedging Statusi, t + b4
PLFi, t + b5 Total Debt to Total Assetsi, t + b6 Current
Ratioi, t + Region Dummyi + Publicy Traded Dummyi + µ + (2)

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Table 1
Descriptive Statistics.
Source: Airline Accounts, CAPA and COMPUSTAT.
Variable Mean Std. 1 2 3 4 5 6 7 8 9 10 11 12 13 14

1. Profit Margin (t) 2.78 15.80 1.00

2. Profit Margin Volatility 56.64 253.44 −0.17 1.00
3. CASK (USD) 0.09 0.06 −0.20 0.05 1.00
4. Jet Fuel Hedging Status (t) 0.84 0.37 0.14 −0.09 0.07 1.00
5. Foreign Exchange Hedging Status (t) 0.66 0.48 0.06 0.03 0.09 0.37 1.00

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6. Interest Rate Hedging Status (t) 0.45 0.50 0.16 −0.08 −0.04 0.14 0.38 1.00
7. Jet Fuel Hedging Status (t−1) 0.86 0.35 0.15 −0.10 0.07 0.82 0.33 0.12 1.00
8. Foreign Exchange Hedging Status (t−1) 0.59 0.49 0.06 0.04 0.07 0.34 0.94 0.36 0.33 1.00
9. Interest Rate Hedging Status (t−1) 0.41 0.49 0.14 −0.07 −0.04 0.11 0.36 0.94 0.13 0.38 1.00
10. Leverage 0.81 0.33 −0.42 0.10 0.07 −0.06 −0.10 0.00 −0.06 −0.09 0.00 1.00
11. Current Ratio 0.92 0.53 0.39 −0.12 −0.10 0.02 −0.02 −0.12 0.00 −0.02 −0.13 −0.47 1.00
12. Profit Margin (t−1) 2.83 16.33 0.71 0.18 −0.11 0.12 0.09 0.16 0.12 0.08 0.14 −0.39 0.29 1.00
13. PLF (t) 77.31 6.67 0.31 −0.14 −0.16 −0.09 −0.05 0.14 −0.06 −0.03 0.15 −0.04 0.03 0.19 1.00
14. PLF (t−1) 77.07 6.81 0.24 −0.08 −0.22 −0.10 −0.04 0.15 −0.05 −0.02 0.15 −0.01 −0.01 0.23 0.88 1.00
Transportation Research Part E 127 (2019) 206–219
R. Merkert and H. Swidan Transportation Research Part E 127 (2019) 206–219

Profit Margin Volatilityi, t

= a1 + b1 Fuel Hedging Statusi, t 1 + b2 FX Hedging Statusi, t 1 + b3 Interest Hedging Statusi, t 1 + b4 PLFi, t + b5
Total Debt to Total Assetsi, t + b6 Current Ratioi, t + Region Dummyi + Publicy Traded Dummyi + µ + (3)

CASKi, t = a1 + b1 Fuel Hedging Statusi, t + b2 FX Hedging Statusi, t + b3 Interest Hedging Statusi, t + b4

PLFi, t 1 + Region Dummyi + Publicy Traded Dummyi + µ + (4)
Given the unbalanced nature of our panel, we ran a further set of modified Hausman tests (Verbeek and Nijman, 1992) which
confirmed that missing data points in the panel are random, suggesting that the missing-at-random assumption is not violated, and a
panel regression can be used without correcting for selectivity bias. To control for the remaining small chance of potential bias and to
improve the robustness of our GLS regression, we used the maximum likelihood method as well the Swamy-Arora method (1972)
derived and modified for unbalanced panels by Baltagi and Chang (1994) to estimate the variance components, which enabled
comparison with and validation of the regression results of the GLS models.
Another potential bias problem that may affect the validity of regression results for unbalanced panels is endogeneity that may
occur when there is a correlation between any of the explanatory variables and the error term. To test for simultaneous relationships,
unobserved heterogeneity, omitted variables and self-selection of variables, we used the generalized method of moments (Arellano
and Bond, 1991; Arellano and Bover, 1995). Since the GMM methodology is a dynamic panel estimation procedure and because our
panel fulfills the GMM suitability requirements in terms of sample size and time span (Berry, 2015), we were able to utilize lagged
values of the independent variables to create exogenous instrumental variables and hence control for potential endogeneity problems
by diminishing biases. Following Blundell and Bond (1998), we used a Sargan-Hansen test to examine whether the explanatory
variables are exogenous and inspected the general validity of the instruments by testing over-identifying restrictions. In addition, we
used an Arrellano-Bond serial correlation specification test to confirm that the error term is not serially correlated at the second order
(Arellano and Bover, 1995).
To further minimize the risk of not accounting for potential endogeneity of our explanatory variables, we then utilized two-stage
least squares (2SLS) regressions based on instrumental variables (IVs) to test for potential endogeneity. Since the GMM uses all
explanatory variables as IVs, we used the 2SLS regression method in combination with Durbin-Wu-Hausman tests only for the most
critical independent variable that may cause endogeneity problems (David et al., 2010), namely PLF. Based on anecdotal evidence
suggesting a possible simultaneous relationship with airlines’ financial indicators, we defined the instrumental variable as the value
of PLF lagged by one fiscal year.

5. Results

To facilitate a robust and valid estimation of the impact that hedging has on our various dependent variables, we used three
regression methodologies: generalized least squares (GLS) random effects, maximum likelihood random effects and the Swamy-Arora
estimator. Initially we also tested OLS but prefer the above mentioned models given the nature of our panel data. We further tried the
Petersen (2009) OLS two-way adjusted clustered standard error approach for both our random effects and fixed models but did not
detect any significant differences to our GLS results (there were some differences related to the magnitude but not in regards to the
significance of the effects). Methodologically, we agree with Petersen’s (2009) suggestion that for estimating a random effects model
using a GLS approach is the most efficient approach as it eliminates the bias in ordinary standard errors for a data set such as the short
panel data used in this paper where there is usually no decay over time. To illustrate the robustness of our findings, Table 2 sum-
marises the main results of all of our models.
As shown in Table 2, for jet fuel price, foreign exchange and interest rate hedging as well as profit margins (t−1) have no
significant impact on leverage. This finding suggests that hedging cannot change the capital structure of airlines, with one possible
interpretation being that the financial gains from hedging are too small to affect total debt or total assets of the average airline. This
contradicts previous studies in which scholars found inconclusive and to some extent contradictive evidence regarding the re-
lationship between hedging and leverage (Allayannis and Weston, 2001; Carter et al., 2006; Graham and Rogers, 2002). It is however
consistent with the findings presented by Guay and Kothari (2003), confirming that the cash gains of derivative portfolios in some
industries are too small to economically affect firm value or operating and investment cash flows. This is particularly the case in the
airline industry, due to its capital-intensive leverage structure which heavily depends on debt to finance and lease aircraft.
With regard to our second hypothesis (model 2), the hedging dummies for jet fuel prices, foreign exchange and interest rates again
have no significant impact, while our control variable, PLF (t), shows a highly significant positive impact on profit margins, as
expected. It is worth noting that although it is insignificant, the direction of the impact of hedging is positive, which suggests that
hedging may generate profits, but in insufficiently large amounts to significantly change airlines’ profit margins. This supports
findings reported by Brown (2001) and Adam and Fernando (2006), confirming that while selective speculative hedging may gen-
erate gains, they are too small to meaningfully change firm value. In addition, the significance of PLF highlights the potential
financial benefits of operational hedging strategies such as capacity optimization (please note that capacity optimization such as
putting aircraft into storage or diversifying operations geographically is often also undertaken to reduce costs but interviews with
Lufthansa and Qantas management confirmed that it is part of reducing exposure to forecasted demand volatilities too). Our second
control variable, current ratio, also significantly increases profit margins, indicating not only that the model results are plausible, but
also the importance of liquidity for achieving enhanced profitability in capital-intensive industries. This finding is consistent with the

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Table 2
Panel Random Effects Regression Results.
GLS Maximum Likelihood Swamy–Arora

Independent Variables Coeff. z P > |z| Coeff. z P > |z| Coeff. z P > |z|

Model 1: Dependent Variable (Leverage = Total Debt to Total Assets)

Jet Fuel Hedging −0.03 −0.95 0.34 −0.03 −0.96 0.34 −0.03 −0.95 0.34
FX Hedging Status −0.03 −0.81 0.42 −0.03 −0.84 0.40 −0.03 −0.82 0.41
Interest Rate Hedge −0.02 −0.63 0.53 −0.02 −0.59 0.55 −0.02 −0.61 0.54
Profit Margin (t−1) 0.00 −1.13 0.26 0.00 −1.19 0.23 0.00 −1.18 0.24
Publicly Traded −0.06 −1.16 0.25 −0.06 −1.19 0.23 −0.06 −1.17 0.24
South America 0.05 0.33 0.74 0.05 0.34 0.74 0.05 0.33 0.74
North America −0.01 −0.13 0.90 −0.01 −0.13 0.89 −0.01 −0.13 0.90
Europe −0.02 −0.18 0.86 −0.02 −0.19 0.85 −0.02 −0.18 0.85
Asia −0.06 −0.64 0.52 −0.07 −0.67 0.50 −0.06 −0.65 0.52
Oceania −0.10 −0.79 0.43 −0.10 −0.82 0.41 −0.10 −0.80 0.42
Constant 0.93 8.57 0.00** 0.93 8.86 0.00** 0.93 8.66 0.00**
Rho (G. of Fit in %) 52.10% 52.10% 52.10% 50.40% 50.40% 50.40% 51.30% 51.30% 51.30%

Model 2: Dependent Variable (Profit Margin)

Jet Fuel Hedging 0.94 0.67 0.51 0.83 0.59 0.55 1.82 1.25 0.21
FX Hedging Status 2.10 1.16 0.25 2.06 1.15 0.25 2.37 1.33 0.18
Interest Rate Hedge 0.66 0.39 0.70 0.67 0.40 0.69 0.59 0.36 0.72
PLF (t) 0.32 3.13 0.00** 0.32 3.19 0.00** 0.31 3.05 0.00**
Debt to Assets ratio −2.77 −1.38 0.17 −2.62 −1.31 0.19 −4.06 −1.94 0.05*
Current Ratio 2.65 2.61 0.01** 2.64 2.66 0.01** 2.70 2.58 0.01**
Publicly Traded 2.69 0.74 0.46 2.70 0.73 0.46 2.59 0.86 0.39
South America 1.39 0.15 0.89 1.39 0.14 0.89 1.46 0.19 0.85
North America 4.84 0.67 0.50 4.78 0.66 0.51 5.25 0.89 0.38
Europe −4.86 −0.73 0.47 −4.89 −0.72 0.47 −4.62 −0.84 0.40
Asia 3.48 0.52 0.61 3.44 0.50 0.62 3.76 0.68 0.50
Oceania −1.85 −0.22 0.83 −1.84 −0.21 0.83 −1.95 −0.28 0.78
Constant −27.41 −2.60 0.01** −27.45 −2.61 0.01** −27.13 −2.75 0.01**
Rho (G. of Fit in %) 82.62% 82.62% 82.62% 83.79% 83.79% 83.79% 72.97% 72.97% 72.97%

Model 3: Dependent Variable (Profit Margin Volatility)

Jet Fuel Hedge (t−1) −132.43 −2.70 0.01** −130.72 −2.72 0.01** −142.73 −2.82 0.01**
FX Hedging (t−1) −26.28 −0.42 0.68 −24.64 −0.4 0.69 −33.16 −0.53 0.59
Interest Rate H (t−1) −30.70 −0.55 0.58 −30.67 −0.56 0.58 −30.59 −0.56 0.58
PLF (t) −6.39 −1.76 0.08† −6.34 −1.78 0.08† −6.67 −1.82 0.07†
Current Ratio −56.18 −1.51 0.13† −57.50 −1.58 0.12† −46.93 −1.21 0.23
Debt to Assets ratio 148.29 2.16 0.03* 139.27 1.98 0.05* 205.23 2.87 0.00**
Publicly Traded 123.62 1.09 0.28 122.93 1.07 0.29 126.73 1.32 0.19
South America 52.28 0.18 0.86 52.87 0.17 0.86 48.44 0.19 0.85
North America −11.79 −0.05 0.96 −10.27 −0.05 0.96 −19.56 −0.10 0.92
Europe 161.07 0.78 0.44 163.14 0.77 0.44 147.67 0.85 0.40
Asia 46.13 0.22 0.83 47.05 0.22 0.82 41.73 0.24 0.81
Oceania 24.38 0.09 0.93 23.83 0.09 0.93 28.26 0.13 0.90
Constant 505.90 1.39 0.16 507.57 1.41 0.16 488.74 1.41 0.16
Rho (G. of Fit in %) 85.08% 85.08% 85.08% 86.24% 86.24% 86.24% 77.27% 77.27% 77.27%

Model 4: Dependent Variable (CASK)

Jet Fuel Hedging 0.00 0.21 0.84 0.00 0.17 0.86 0.00 0.20 0.84
FX Hedging Status 0.01 0.52 0.60 0.01 0.65 0.52 0.01 0.53 0.59
Interest Rate Hedge −0.01 −0.72 0.47 −0.01 −0.75 0.45 −0.01 −0.72 0.47
PLF (t−1) 0.00 −2.89 0.00** 0.00 −3.35 0.0** 0.00 −2.94 0.0**
Publicly Traded 0.01 0.68 0.50 0.01 0.83 0.41 0.01 0.69 0.49
South America 0.10 3.68 0.00** 0.10 4.13 0.0** 0.10 3.71 0.0**
North America 0.03 1.56 0.12† 0.03 1.80 0.07† 0.03 1.58 0.12†
Europe 0.03 1.85 0.07† 0.03 2.10 0.04* 0.03 1.87 0.06†
Asia 0.02 1.17 0.24 0.02 1.33 0.18 0.02 1.18 0.24
Oceania 0.05 1.97 0.05* 0.04 2.14 0.03* 0.05 1.98 0.05*
Constant 0.19 3.65 0.00** 0.21 4.16 0.00** 0.19 3.70 0.00**
Rho (G. of Fit in %) 13.11% 13.11% 13.11% 6.01% 6.01% 6.01% 12.37% 12.37% 12.37%

Bold are those that are significant in at least one method.

†
p < 0.10.
* p < 0.05.
** p < 0.01.

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significance of our third control variable, total debt to total assets, in reducing profit margins, demonstrating that elevating debt
levels in a capital-intensive industry can lead to dire financial consequences.
With regard to our most central hypothesis (model 3), we find that jet fuel price hedging (t−1) has a very significant impact while
foreign exchange and interest rate hedging have no significant impact on reducing profit margin volatility. What is particularly
encouraging is the high goodness of fit of models 2 and 3 (high Rho in comparison to models 1 and 4). Interest rate hedging having no
impact in both models is not unexpected, as the majority of interest rate derivatives are interest rate swaps, which typically are used
to change liability structures (Bicksler and Chen, 1986; Titman, 1992). We argue that interest rate hedging instruments such as swaps
are more likely to have a long-term effect (beyond the period analysed in our models) often stretching to maturity of the liabilities
being swapped. In addition, foreign exchange exposure is naturally hedged in many cases through having significant revenues in
foreign currencies, balancing the exposure on the cost side. In contrast, jet fuel price hedging has a significant (and short term t−1)
negative impact on EBIT margin volatility, which is gives weight (in the form of empirical evidence from the airline industry) to those
risk management theories that view hedging as a risk mitigation strategy to reduce variability in profit (Stulz, 1996). The reduction in
volatility resulting from fuel hedging has potential effects on financial flows for airlines. In particular, it improves their ability to
implement a robust revenue management system and decreases the probability of bankruptcy, financial distress costs and agency
costs, as well as underinvestment costs (Carter et al., 2006). Furthermore, our model shows a highly significant relationship between
hedging status in the previous fiscal year and the impact of hedging on volatility. This supports our hypothesis that time lags and
contract maturity matter in the hedging context, adding to the discussion that commenced with Rao (1999), who found that the
timing of hedging transactions has a significant impact on hedging benefits. In addition, similar to model 2, our control variables (i.e.,
current ratio, leverage and PLF) have significant impacts on EBIT margin volatility in the expected directions. This underlines the
importance of having a strong balance sheet with sufficient liquidity and moderate debt levels and indicates that operational hedging
used in conjunction with jet fuel price hedging can significantly reduce airline operating profit margin volatility.
Our fourth hypothesis is rejected (model 4), as the results suggest that hedging status does not have a significant impact on
airlines’ operating unit cost (CASK). This finding is consistent with hedging theories and the extant literature (Lim and Hong, 2014),
and confirms that hedging is not effective as a profitable speculative tool or as a strategy to reduce unit cost. In contrast, PLF plays a
very significant role in decreasing airlines’ operating costs (without any time lags), which is consistent with the results of model 2 and
adds to the discussion as to whether operational or financial hedging is more significant in reducing airlines’ operating costs (e.g.,
Treanor et al., 2014). In addition, contrary to the other models, the region dummy variables had a significant impact on unit cost,
demonstrating the effect of an airline’s geographical location on operating costs. We also tested for a change in offered capacity (ASK)
and did not find any significant impact. Our combined model results therefore support the view that hedging benefits are centered
around decreasing volatility and do not, on average, impact airlines’ future operations. Hedging does not, on average, change airlines’
profit margins and operating costs, so it unsurprising that it has no impact on subsequent capacity growth.
The maximum likelihood regression method returned results comparable to the generalized least square (GLS) estimates, in-
dicating the unbalanced panel did not impact the robustness of our random effects regression results. In addition, the Swamy-Arora
estimates are similar to the GLS random effects, apart from the current ratio in model 2 and PLF in model 3, both showing only
slightly higher significance using the Swamy-Arora model, as expected. Results of the modified Hausman test further confirm that
missing values in the panel are random and do not violate panel regression assumptions.
Besides validating the unbalanced panel output, our results are robust to endogeneity tests. Table 3 summarises the GMM one-step
difference model specifications and robustness tests. We used the Sargan-Hansen test to check our instruments validity through
examining the entire set of overidentifying restrictions with a null hypothesis that all instruments are valid and uncorrelated with the
error term. To test the exogeneity of the deployed instruments (IVs), we used the Sargan test to examine the significance of excluded
instruments, assessing if included instrumental variables (IVs) are valid and correlated with endogenous regressors. As recommended
by Roodman (2006), we report “difference-in-Sargan” test statistics to evaluate the endogeneity of a subset of instruments (IVs) in
each model.

Table 3
GMM One-Step Difference Models.
GMM One-Step Difference Models

Model Model 1 Model 2 Model 3 Model 4

Leverage Profit Margin Profit Margin Volatility CASK

Arellano-Bond test for Autocorrelation AR(2) (Pr > z) 0.67 0.63 0.54 0.70

Validity Tests for Instruments

Sargan-Hansen Overid. restrictions (Prob > chi2) 0.71 0.62 0.98 0.02**

Exogenous Instruments (IVs) tests

Sargan test excluding group (Prob > chi2) 0.62 0.52 0.94 0.11
Difference (null H = exogenous) (Prob > chi2) 0.75 0.64 0.90 0.02*

†
p < 0.10.
* p < 0.05.
** p < 0.01.

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Results of the Sargan-Hansen test are not significant for models 1–3 (p > Chi2 = 0.77, 0.233, 0.714), suggesting that all ex-
planatory variables are exogenous. Results are significant for model 4 (p > Chi2 = 0.021), indicating that variables in this model
may be endogenous. This is not unexpected, since PLF is often endogenous to CASK (possible simultaneity) because airlines change
their load factors regularly at the route (but not firm) level to manage their operating unit costs. Reassuringly, results of the Durbin-
Wu-Hausman endogeneity test are not significant for any of our models (p > 0.05), indicating that at the firm level, PLF is not
endogenous in our analysis. Finally, results of the Arrellano-Bond test results are not significant for any of our models (p > 0.05),
demonstrating that the error term is not serially correlated at the second order (AR2). As a result, our model results pass all of the
recommended robustness checks.

6. Discussion

6.1. Theoretical and practical implications

We have contributed to the literature by applying financial hedging theories to the transportation and logistics context and more
specifically a large sample of international airlines. Unlike previous studies, we have gone beyond firm value in assessing the benefits
of hedging. A variety of measurements, particularly profit margins, profit volatility, operating costs and capacity, have helped us to
examine different aspects of risk management theories. Our key finding is that jet fuel price hedging should not be used as a
speculation tool to increase profit margins but is an effective risk and procurement management strategy to mitigate profit volatility.
This finding aligns with risk management theories (Froot et al., 1993; Smith and Stulz, 1985), but contradicts findings from previous
studies (Stulz, 1996) that support the benefits of speculative hedging (e.g., selective hedging). In contrast to the extant literature
(Allayannis and Weston, 2001; Carter et al., 2006; Leland, 1998), we have shown that financial hedging does not impact operating
profit margins and leverage, and hence has no direct or short term impact on firm value of airlines. Depending on how investors value
volatility, however, there might be a longer-term impact on firm value through reduced EBIT margin volatility.
Our results further suggest that capacity optimization (load factor), a key element of operational hedging, leads to enhanced
operational profitability (EBIT margins), whereas financial (i.e., jet fuel price) hedging primarily reduces EBIT margin volatility. An
integrated strategy that combines both operational (capacity) and financial hedging appears to be effective for achieving sustainable
financial returns in the airline industry. As expected, managing the passenger load factor (PLF) is important for reducing operating
costs at the firm level. This finding is consistent with recent studies that revealed operational capacity hedging to be more important
than financial hedging in reducing airlines’ operating costs (e.g., Berghöfer and Lucey, 2014). However, our results reveal that
operational capacity hedging does not have the same potential to reduce volatility, which in turn highlights the vital role of financial
hedging. Thus, airline managers should not forego their jet fuel price hedging practices. Since tight profit margins are typical in the
industry, any increase in volatility could lead to negative financial repercussions such as intensified financial distress, increased
probability of bankruptcy and high underinvestment costs. In general, an integrated financial hedging risk management strategy is
thus more likely to result in sustainable financial performance of the operations of airlines and robust growth.
Despite the significance of jet fuel price hedging as a component of financial hedging, foreign exchange and interest rate hedging
were not significant in any of our models. Foreign exchange and interest rate hedging hence do not decrease operating profit margin
volatility or unit cost (CASK), nor do they have an impact on operating profitability. In their annual reports, airlines disclosed that the
majority of interest rate hedging instruments were interest rate swaps. Interest rate swaps are generally used by firms to change their
liability structures, enabling them to extend borrowing in the short term by swapping floating rates for fixed rates, thus reducing their
borrowing costs. Although interest rate swaps may reduce a firm’s borrowing costs, this change in liabilities may not be reflected in
firm’s profitability and/or operating costs. Furthermore, foreign exchange exposure may be naturally hedged through ancillary
supplies and revenues obtained in foreign currencies, offsetting this risk exposure for the operations of many international airlines.
Our empirical evidence supports this conclusion by showing the insignificance of foreign exchange and interest rate hedging on
airlines’ operating profitability, volatility or operating costs.
Given recent industry developments, including rising volatility in commodity and foreign exchange markets and strategic deci-
sions by several major airlines to no longer hedge jet fuel prices (see Fig. 1), our results have important practical implications for
airlines and other industries (e.g., mining). It is understandable that managers affiliated with several major airlines (e.g., Delta Air
Lines, United Continental, Emirates) have suspended or substantially reduced fuel hedging activities due to the risk of large paper
losses and competitive cost disadvantages. However, our empirical findings show that this may not be the best long-term strategy; a
combination of operational and financial (jet fuel price, foreign exchange and interest rates) hedging can be an effective strategy for
successful airline management as it can reduce profit volatility, improve financial performance and sustain competitive advantage.

6.2. Future research and limitations

While we are confident that our results are robust and meaningful, empirical studies have some inherent limitations. First, we collected
panel data for six fiscal years. A longer and more granular time period would provide a clearer picture because hedging benefits likely
depend on absolute oil price levels and relative volatility, both of which could be smoothed out over a 20- to 30-year time horizon (of
possibly daily observations, please note that at this point in time not even the airlines themselves have such granular data). During periods
of low volatility of input prices, airlines may not receive sufficient benefits from hedging (Allayannis and Weston, 2001). In addition, firms
take or avoid risk depending on current versus past performance (Kahneman and Tversky, 1979), which suggests the potential for
organizational learning (Rerup and Feldman, 2011) and changes in hedging behavior over time. Therefore, the period and time span of the

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empirical study may have a significant impact on hedging and risk management outcomes more generally. In the future, research based on
longitudinal analysis beyond a six-year period and at a more granular level is warranted.
Second, although it is common in research related to organizational behavior (e.g., Singh, 1986), we did not examine whether
engagement in hedging occurs at the organizational/cultural level or is an activity engaged in by proactive individuals (e.g., Glaser
et al., 2016) such as chief financial officers. Although banks or consultants may influence a firm’s decision to engage in hedging
strategies, ultimately the firm and its stakeholders must live with the risk exposure and resulting performance of the firm. How firms
manage the dilemma of allowing their employees to manage risk proactively and innovatively within the constraints of corporate
culture as well as operational and financial challenges is worth investigating in future research. We further acknowledge that specific
heterogeneity may be present, negatively affecting the robustness of the results (Hensher and Jones, 2008). Although we used GMM
and IV (2SLS) models to minimize endogeneity and unobserved heterogeneity, firm specific heterogeneity may be improperly al-
located to the random components of the regression models. Finally, and more relevant to the management context, we acknowledge
that the use of hedging dummies limits the amount of information that is accounted for. For example, operational hedging strategies,
specific financial instruments (interest swaps, collars, etc.), product time horizons and hedging volumes as well as transaction costs
related to hedging should be explored and controlled for in future research. Finally, the results of our region dummies suggest that
culture may impact on cost management and fuel hedging approaches, which presents another area worthy further investigation.

7. Conclusions

Airline management approaches to financial hedging differ substantially (as of December 2018, see Fig. 2), with some airlines
hedging substantial amounts of their future fuel requirements while many other airlines do not hedge at all. The latter could be
interpreted as either a smart move or indeed as super risky or in other words as flying without a safety net. In this paper, we re-
examined financial hedging theories in the context of corporate strategy in the global airline industry. Highly significant volatilities of
input prices, interest and foreign exchange rates leave firms exposed to substantial risks that can result in financial distress, costs and
failure, as witnessed in many markets since the global financial crisis in 2008. Particularly for the airline sector that risk is an
important, topical and pressing problem as financial hedging can go both ways as for example evidenced by Cathay Pacific’s sub-
stantial fuel-hedging losses of in 2017. Our paper is an attempt to provide management with much needed guidance on this whether
financial risk management in the form of holistic hedging can be a successful strategy as the extant literature on financial (foreign
exchange, interest rate and fuel) hedging is inconclusive and for the airline context sparse in terms of robust empirical evidence.
Building on the theoretical notion that hedging strategies can, in principle, improve profitability and cash flows (Calandro, 2011), we
have evidenced that organizational risk taking through speculative hedging is not rewarded in the form of higher airline profit margins.
However, our results also show that, in general, hedging does decrease airline operating profit margin volatility and hence results in more
sustainable/stable procurement, operations and financial outcomes. While fuel hedging has a significant and short-term impact (within
one year) on operating profit margin volatility, interest rate hedging is more relevant to long-term planning as the majority of the interest
rate hedging tools are swaps that can have a long-term effect (beyond the period under investigation in our paper) often stretching to
maturity of the liabilities being swapped. Future research should, rather than purely focusing on operating profits (EBIT margins) also
include net profits, as this may be more directly impacted by interest rate hedging. Our results further suggest that low current ratios have
a positive impact on airline operating profits, highlighting the importance of liquidity in capital-intensive industries such as the airline
sector. We therefore argue that airlines (and capital-intensive, international businesses more generally) can and should use integrated
financial hedging strategies (fuel, foreign exchange and interest rates) to gain and maintain competitive advantages.

Acknowledgments

We gratefully acknowledge useful comments of anonymous reviewers and David Hensher.

References

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