The Effect of Fuel Hedging in the Airline Industry on Returns, Volatility, and on the Return-to-risk Relationship Analysis

This paper begins with an investigation on the relation between airline fuel hedging and volatility and builds on this idea to consider its effect on the risk and return relationship. The evidence affirms a negative association between an airline’s fuel hedging expense and both its total volatility and idiosyncratic volatility. However, we observe a negative relationship between hedging and the Sharpe ratio, indicating that hedging reduces the return to risk performance. These relationships also appear to be nonlinear as medium or small hedgers can improve their return to risk ratio while large hedgers can reduce their total and idiosyncratic risk. Results indicate large hedgers are effective hedgers while small and/or medium hedgers may be using derivatives more for effective speculation. Employing lagged variables and instrumental variable approaches yield qualitatively similar results. JEL Classification: D81 Criteria for Decision-Making under Risk and Uncertainty & G11 Portfolio Choice; Investment Decisions