This paper examines EasyJet's use of financial derivatives as a risk management tool, focusing on its forward contract programs for jet fuel, U.S. dollar, and euro exposures. It begins by defining derivatives and explaining why firms hedge to achieve cash flow certainty rather than to speculate. Using EasyJet's 2011 Annual Report as its primary source, the paper traces the evolution of the airline's hedging program from its 2003 launch through its mature multi-currency structure, assesses governance and monitoring practices, and evaluates ex-post outcomes — including the £330 million fuel hedging loss in FY 2009 and the net gains visible at early 2012 spot rates. The paper concludes that the value of a hedging program lies not in "winning" individual trades but in enabling better operational and pricing decisions.
Firms use derivatives in order to manage the financial risk associated with maintaining open positions in either currencies or commodities. As a result, the firms that most commonly utilize derivatives are those that operate internationally or deal extensively with key commodities. EasyJet is one such company: it uses crude oil hedges on the price of jet fuel and currency hedges to manage its exposure to the euro and the U.S. dollar. This paper discusses the use of derivatives as a risk management tool, using EasyJet as an example firm.
Derivatives are instruments whose price is tied to the price of an underlying asset. Some of the more common derivatives in use are futures contracts, forward contracts, options, and swaps (Investopedia, 2012). The choice of derivative depends on a number of factors, including the needs of the firm, the availability of the instrument, the degree to which a specific derivative can hedge exposure, and its cost. Firms must therefore always be aware of the different characteristics of available derivatives in order to find the one that best meets their needs.
The first step in determining what, if any, derivative strategy needs to be adopted is to understand what the company requires from its derivatives. In general, the value of derivatives to a company is to hedge exposure. When a company is exposed to a commodity or currency, fluctuations in that commodity or currency can change the value of a transaction. This can be positive or negative, but for many companies that uncertainty is something they prefer to avoid. This is a reasonable response — if a CEO wants the success or failure of the company to depend on a gamble, he or she should sell the assets and go to Las Vegas. Most firms do not wish their profits or losses to depend on the movement of a currency or commodity; it is easier to derive long-term shareholder value by tying the firm's results to managerial actions. This is where hedging comes into play. With cost certainty, the company knows that its success or failure will not result from winning or losing a gamble, but rather from its own operational decisions.
At EasyJet, the company has three major derivatives programs to hedge against its three major exposures. The first is fuel. For most airlines, fuel is one of the biggest costs, if not the single largest. Jet fuel prices have been highly volatile in recent years (CAPA, 2009), representing a major risk for airlines. Discount airlines like EasyJet are especially susceptible to fuel price fluctuations because their business model relies on a high-volume, low-margin strategy. Those tight margins can easily erode with fuel price movements. While all airlines undertake some fuel price hedging, discount airlines in particular seek cost certainty, as it allows them to set prices at levels that will keep each flight profitable. Without fuel price stability, an airline will have far greater difficulty ensuring profitability, selecting routes, and pricing competitively.
EasyJet also faces foreign exchange rate risk as a UK company that does significant business in Europe and purchases a major input — jet fuel — priced in U.S. dollars. As such, EasyJet maintains hedging programs for both currency exposures. It has U.S. dollar requirements for jet fuel but does not operate in the United States, so it cannot offset those requirements with dollar-denominated sales. Similarly, the company generates a significant amount of euro-denominated revenue that exceeds its euro-denominated expenses, meaning it must sell euros every year or leave them on the balance sheet as a source of translation risk.
According to EasyJet's 2011 Annual Report, the company was hedged at 73% of its fuel needs through the end of 2012 at $950 per metric tonne, and 49% through 2013 at $979 per metric tonne. The stated aim of the policy is to reduce "short-term earnings volatility." This reveals two important aspects of EasyJet's hedging strategy. First, the company hedges long-term. Longer-term hedges provide fuel price certainty far enough into the future that the company can set routes and prices accordingly. There is a risk that prices could decline — which is why EasyJet does not fully hedge — but the price certainty it gains allows it to structure operations to ensure profitability and to raise fares on routes that would otherwise be unprofitable. Second, the hedges are denominated in metric tonnes, a direct measure for jet fuel. Many airlines hedge using crude oil because that derivatives market is more liquid; in the United States, airlines often use crude or heating oil as imperfect hedges (Cobb, 2004). If EasyJet is able to hedge jet fuel directly, it achieves better cost control than an imperfect hedge would provide.
Fuel prices represent only one element of the cost equation, since those prices are denominated globally in U.S. dollars. This means EasyJet also needs dollar hedges to manage currency exchange rate risk. Having fuel hedges settled well in advance makes the dollar hedges easier to structure, because the company is in a better position to know the timing and amount of its dollar cash flows. According to the 2011 Annual Report, EasyJet was hedged 80% six months out, 69% for the full FY 2012, and 46% for FY 2013 on its dollar requirements. The close match between the fuel hedge ratios and the dollar hedge ratios reflects the company's awareness that both exposures are fundamentally linked.
EasyJet also carries euro exposure from the revenues it generates in Europe. The company sells its surplus euros in advance. This hedge differs slightly from the fuel and dollar programs because revenue forecasting involves more uncertainty than forecasting fuel requirements. The six-month euro hedge stood at 76%, the one-year hedge at 71%, and the FY 2013 hedge at 50%. These ratios give EasyJet some leeway with respect to revenue shortfalls, so that it would not need to buy euros on the open market to cover those shortfalls. Nonetheless, the degree of hedging is substantial, reflecting the company's view that revenue certainty is just as important as cost certainty.
"Evolution of hedging program since 2003 launch"
"Finance department oversight and forecasting processes"
"2008–2009 losses and 2012 spot-rate gains assessed"
Almost all airlines utilize some form of derivative to hedge their fuel exposure, if not their currency exposure. Most use forward contracts, but many rely on imperfect hedges for their jet fuel exposure. The key to an effective hedging program is that the program's objective must align with the company's overall strategy. Price volatility for currencies and commodities is a given, so prices will move in one direction or another. Any company that hedges simply to gamble on a directional move is doing exactly that — gambling. The key to sound derivatives use is to buy the company cost certainty and, where applicable, revenue certainty. For EasyJet, that certainty enables better decisions about pricing and route selection.
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