CROSS-HEDGING AVIATION FUEL PRICE EXPOSURES WITH COMMODITY FUTURES: EVIDENCE FROM THE INDIAN AVIATION INDUSTRY

The Indian aviation industry is characterised by steep competition, steady growth, and high and variable fuel prices, all of which contribute to the precariousness of the financial condition  of airline companies. Though cross-hedging ATF price exposures using petrol and petroleum products is a common practice in many countries, Indian firms are yet to adopt this practice. This paper first sets out the background by discussing the state of the industry along with the difficulties it is facing. The subsequent analysis of the financial outcomes of commodity cross-hedging of ATF price exposures considers crude oil and Brent crude oil futures for cross-hedging. Two alternative prices of domestic and imported ATF are considered, and hedge coefficients are estimated by applying three econometric techniques, namely, ordinary least square (OLS), error correction models (ECMs), and OLS or ECM with heteroskedastic errors. Following the naïve approach that is traditionally suggested in the extant literature of considering R-square as a measure of hedging efficiency, Brent crude oil futures are found to yield the highest cross-hedging efficiency for both ATF prices. However, further estimates of encompassing models indicate that crude oil futures have additional information that could explain variations in basis risk, over and above what Brent futures can explain. Therefore, a composite cross-hedge with crude oil and Brent oil futures is estimated and tested for efficiency in terms of the variances of the profit and loss (P&L) series associated with alternative hedging strategies. For domestic operations, hedging appears to be redundant. Composite hedging was found to be the optimal hedging strategy for ATF import prices, with an even lower value at risk (VAR) compared to domestic operations, hedged and unhedged. We conclude that importing ATF and cross-hedging it with a combination of crude oil and Brent oil futures might result in better financial performance of Indian airline companies.