Does Time Have Value? an Empirical Examination of the Put Option Embedded in Refundable U.S. Air Fares

By Sturm, Ray R.; Winters, Drew B. | Journal of Economics and Finance, October 2009 | Go to article overview

Does Time Have Value? an Empirical Examination of the Put Option Embedded in Refundable U.S. Air Fares


Sturm, Ray R., Winters, Drew B., Journal of Economics and Finance


Abstract

The unprofitable history of the airline industry raises questions about how effectively airlines price their product. In this study, we use option pricing theory to examine the value of the put option embedded in refundable airline tickets. Specifically, we examine whether the time to expiration of the embedded put option is properly priced. Compiling daily real-time ticket price data for Delta and Southwest over 3.5 months, we find little evidence to suggest that airlines price the value of time in the embedded put option. However, we do find evidence suggesting that options are priced higher on business-dominated routes than on vacation-dominated routes.

Keywords Options * Airlines * Contingent claims * Ticket pricing

JEL Classification G13 * G19

1 Introduction

The time value of money is a fundamental tenet of finance. Specifically, under any positive discount rate, a dollar today is unambiguously worth more than a dollar tomorrow. Equally unambiguous is the value of time in the price of an option. Specifically, all standard put and call options increase in value as the time to expiration increases. In mis paper, we examine ticket pricing in the airline industry and argue that the price of a refundable airline ticket consists of two components - the price of a nonrefundable ticket plus the price of a put option. The refundable ticket is obviously more valuable than the nonrefundable because the put option component gives the owner the right to sell the ticket back to the airline at its original cost.1 Accordingly, we apply the standard relationship between time to expiration and the value of an option developed in option pricing theory to determine whether airlines price the value of time to expiration in the put option embedded in refundable ticket prices in a manner consistent with theory.

Option pricing theory has been applied in many different areas of modem finance beyond simply pricing an option contract with the following providing just a few examples of the other uses. Capel (1992) uses option theory to obtain some guidelines for a firm's economic exposure management. Lint and Pennings (1998) argue that cash flow methods for making R&D investment decisions cannot properly capture the investment's value due to market and technological uncertainties and suggest that option theory effectively captures jumps or business shifts in market or technological shifts. Berger et al. (1996) investigate whether investors price the option to abandon a firm at its exit value and Kau et al. (1993) use option theory to value adjustable-rate mortgages in the presence of default. We extend this body of literature by using option pricing theory to examine the value of the put option embedded in refundable airline tickets.

We believe that examining the value of the option embedded in airline ticket prices is a rich research environment because the unprofitable history of the airline industry raises questions about airlines' ability to properly price its product while the use of derivative contracts for fuel hedging suggests at least a basic understanding of derivative contract pricing.2 We acknowledge that many variables: including the airline's labor costs, operating costs and strategies, and capacity planning, contribute to the unprofitable history of the industry. In this study, we focus narrowly on ticket pricing and argue that airlines have a cost structure that can be managed through the use of derivative contracts. For example, during 2004 and 2005 Southwest Airlines hedged more than 80% of its fuel usage per fiscal quarter which often created savings in excess of $100 million per quarter.3 Accordingly, we expect that airlines are knowledgeable about the pricing of derivatives, in general, and options, specifically. However, while Southwest was hedging more than 80% of its fuel usage Delta was only hedging between 0% and 34% of its usage. This suggests that the skill and knowledge in the use of derivative contracts to hedge may vary widely across airlines. …

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