Risk Manahement Essay Example | Topics and Well Written Essays - 1500 words

Risk Manahement - Essay Example These strategies are forward contracts, futures contracts, swaps, call options, collars etc. All these strategies have significant strengths and weaknesses, which needs to be efficiently balanced by firms. This paper illuminates the impact of commodity price risk on the firms as well the significance of hedging such risk. It also analyzes different hedging strategies used by companies and their strengths and weaknesses. Hedging constitutes one of the most important financial decisions of any firm. It refers to different ways through which a company can minimize its exposure to various kinds of risks. Fuel represents a crucial cost in the total airline expenditure and thus fuel price risk has a great impact on the earnings and cash flows of airlines. Any drastic increase in oil prices can adversely affect cash flows. Effective hedging strategies are imperative for airlines to minimize the variability of cash flows due to volatility in oil price (Carter, Rogers. and Simkins, 2003). This is why almost firms use various hedging strategies to protect their cash flow from variations resulting out of oil price fluctuations. Froot, Scharfstein and Stein propound that "if a firm does not hedge, there will be some variability in the cash flows generated by assets in place." (1993, p. 1630) A non-hedging airline is also likely to be greatly vulnerable to any change in fuel market price. Because of effectiveness of hedging in commodity price risk manageme... that "for a given level of debt, hedging can reduce the probability that a firm will find itself in a situation where it is unable to repay that debt." (1993, p. 1632) This is one of the greatest benefits of using hedging strategies to manage commodity price risk. These strategies assure management that even if the commodity price moves in the unfavourable direction, it will not have a great impact of firm's earnings and cash flows. Forward contracts are the most common hedging strategies used by firms. Southwest airlines managed its exposure to oil price risk in the year 2005 with the help of forward contracts and successfully enhanced its earnings. On the contrary, in the same year other airlines like Delta and United Airlines faced great difficulties. However, there is high credit risk involved in hedging strategy using forward contracts. Froot, Scharfstein and Stein elaborate that "because they are not settled until maturity, forwards can involve substantially more credit risk than futures." (1993, p. 1649) Forwards have a distinctive feature as compared to the futures contract that they cannot be settled before maturity date. Hence, on one hand forwards strategy helps firms to considerably minimize their exposure to commodity price risk, it also leads to significant credit risk. Futures contract is another most commonly used strategy that firms can use to hedge against the commodity price risk. Veld-Merkoulova and de Roon (2003) illuminate a 'nave' strategy which relies on short term futures contracts for the purpose of hedging long term position in the spot market when the size of both the positions are the same. Under this hedging strategy, the futures contract is closed on the same date as that of the spot contract if futures contract has a maturity date