In early 2005, Delta Air Lines said it had stopped hedging fuel expenses. Because jet fuel is a significant and volatile cost, airlines routinely enter into contracts that set floors and ceilings for the fuel prices they will pay in the future. It appeared to be an odd time for Delta to eliminate its hedges: its credit ratings were sliding, indicating that it was vulnerable to a financial shock. The previous year, its fuel expenses had jumped more than 50% due to a spike in oil prices.
Delta's decision contradicted a longstanding assumption of academic business theory, that financially constrained companies managed their risks more tightly, because they can't afford a big unexpected loss. Delta would be expected to hedge more, recognizing that unplanned expenses could push it into bankruptcy.
But its action illustrates the research findings of Chicago Booth Professor Amir Sufi and Duke University's Adriano A. Rampini and S. Viswanathan, who believe that troubled companies can't afford to manage their risks as well as healthy ones can. Their work could upend theories of risk management and help investors and managers better understand the choices facing distressed businesses.
Sufi and his collaborators examine airlines because the companies explain their hedging decisions in annual 10-K filings to the US Securities and Exchange Commission, and because fuel typically makes up 20% of an airline’s operating expenses, and as much as 30% or more when oil prices are high.
Previous research indicated that larger airlines hedge more than smaller ones, and airlines with less debt and higher credit ratings hedge more than those that are financially strapped, but those studies didn’t examine the hypothesis that risk management involves financing tradeoffs. “The most important insight is that hedging is not free,” Sufi says. “It’s actually quite expensive, because it forces you to use very valuable collateral to pledge against that hedge.”
The researchers develop a model that predicts that when a company’s net worth is low and the marginal value of its internal resources is high—in other words, when the company needs all the cash it can find to keep operating—firms choose to finance investment, or downsize less, at the expense of hedging.
To test their model, the researchers look at 10-K filings from 23 US airlines from 1996 through 2009. The filings allow them to measure variations in fuel hedging across the industry, as well as changes at the same airline from year to year. They believe they are the first to look at changes in airlines’ risk management over time, ruling out the possibility that hedging is solely based on size, with bigger airlines hedging more. Instead, Sufi and his coresearchers find a strong correlation between changes in net worth and the fraction of the next year’s fuel expenses hedged by the airline.
They also test their model using 10 situations of airlines in financial distress. During the two years before the airlines become distressed, their hedging declines from about 30% of the airlines’ total expected fuel expenses to about 25%. As the airlines become distressed, hedging drops to less than 5% of those total expected fuel expenses. In the two years following distress, when the airlines begin to recover, hedging returns to almost 20%.
Although the researchers didn’t study Delta’s case, their findings could explain its actions in 2005. Delta’s lenders and the counterparties to its hedging agreements required the airline to post collateral. As the airline’s cash dwindled, it was forced to choose between the short-term goal of keeping the company running and the longer-term goal of hedging fuel expenses. It reduced its hedges from 65% of total expected fuel expenses in fiscal 2003 to 8% in fiscal 2004. But the risk didn’t pay off: in September 2005, Delta sought Chapter 11 bankruptcy protection, blaming debt and high fuel prices.
Sufi hopes to apply his findings to ongoing research about low-net-worth households, examining why these households don’t protect themselves from financial shocks. His work illuminates the dilemma that families and businesses face when it comes to warding off risk: those who can afford to the least are the ones who need to the most.