Does Hedging Affect Firm Value? Evidence from the US Airline Industry

By Carter, David A.; Rogers, Daniel A. et al. | Financial Management, Spring 2006 | Go to article overview

Does Hedging Affect Firm Value? Evidence from the US Airline Industry


Carter, David A., Rogers, Daniel A., Simkins, Betty J., Financial Management


Does hedging add value to the firm, and if so, is the source of the added value consistent with hedging theory? We investigate jet fuel hedging behavior of firms in the US airline industry during 1992-2003 to examine whether such hedging is a source of value for these companies. We illustrate that the investment and financing climate in the airline industry conforms well to the theoretical framework of Froot, Scharfstein, and Stein (1993). In general airline industry investment opportunities correlate positively with jet fuel costs, while higher fuel costs are consistent with lower cash flow. Given that jet fuel costs are hedgeable, airlines with a desire for expansion may find value in hedging future purchases of jet fuel. Our results show that jet fuel hedging is positively related to airline firm value. The coefficients on the hedging variables in our regression analysis suggest that the "hedging premium" is greater than the 5% documented in Allayannis and Weston (2001), and might be as large as 10%. We find that the positive relation between hedging and value increases in capital investment, and that most of the hedging premium is attributable to the interaction of hedging with investment. This result is consistent with the assertion that the principal benefit of jet fuel hedging by airlines comes from reduction of underinvestment costs.

**********

Recent literature in corporate finance has fostered an improved understanding of why nonfinancial firms may hedge. (1) However, very little research has focused on whether hedging achieves reasonable economic objectives. In particular, many researchers are interested in whether hedging increases firm value. Allayannis and Weston (2001) examine the relation between foreign currency hedging and Tobin's Q. They conclude that hedging is associated with higher firm value. On the other hand, Jin and Jorion (2004) find no relation between hedging and firm value for oil and gas producers.

This article contributes to the body of corporate risk management research in two important ways. First, given the conflicting results on the relation between hedging and firm value, we provide additional evidence regarding this question by studying the hedging of jet fuel price risk exposure by US airlines. The airline industry offers a unique perspective from which to analyze the value of firms' hedging activities because the industry is largely homogeneous and competitive. Further, we focus on the hedging of a single, homogeneous and volatile input commodity, jet fuel. Second, and perhaps more important, our analysis provides a better understanding of the source of potential value from hedging by airlines. To our knowledge, we are the first to find empirical evidence pointing to the source of value from hedging operations. We find that the airline industry exhibits two characteristics consistent with the general assumptions and framework developed in Froot, Scharfstein, and Stein (1993). First, the airline industry's history of investment spending is not negatively correlated with jet fuel costs, as one might expect. In fact, the relation between these two variables is largely positive. Second, airlines face significant distress costs. For example, Pulvino (1998, 1999) finds that distressed airlines are forced to sell aircraft at below-market prices. Froot et al. (1993) suggest that firms facing significant expected distress costs will choose to underinvest. The underinvestment cost is an indirect cost of financial distress (e.g., Stulz, 1996). They show that hedging is a mechanism to alleviate this underinvestment incentive. In their model, hedging is more valuable when investment opportunities display lower correlations with cash flows from hedgeable risks. Simply put, the airline industry provides an excellent sample setting because its environment conforms well to this theory of hedging.

The results show that airline firm value is positively related to hedging of future jet fuel requirements. …

The rest of this article is only available to active members of Questia

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Does Hedging Affect Firm Value? Evidence from the US Airline Industry
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Help
Full screen

matching results for page

    Questia reader help

    How to highlight and cite specific passages

    1. Click or tap the first word you want to select.
    2. Click or tap the last word you want to select, and you’ll see everything in between get selected.
    3. You’ll then get a menu of options like creating a highlight or a citation from that passage of text.

    OK, got it!

    Cited passage

    Style
    Citations are available only to our active members.
    Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

    1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

    Cited passage

    Thanks for trying Questia!

    Please continue trying out our research tools, but please note, full functionality is available only to our active members.

    Your work will be lost once you leave this Web page.

    Buy instant access to save your work.

    Already a member? Log in now.

    Oops!

    An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.