Off topic but I'm curious why Walmart employs futures traders?
In San Francisco, depending on where you go right now, tomatoes might be $20 a case or they might be $40 a case. Why is any place selling them for $40 a case? I honestly couldn’t tell you other than there was probably a problem somewhere with the tomato crop. But if you’re able to get them for $20 a case right now, it’s because that store was able to get them for a good price, and that means somewhere upstream in the supply chain, a futures contract was exchanged which made that possible by locking in the purchase price in advance for this batch of tomatoes.
This is often the case with avocados which might sell for $0.50 a piece in one place or up to $3 a piece in another. Anything can affect the price, up to and including cartels in Mexico demanding protection money from Avocado farmers recently, but pests, weather, soil problems, or whatever might limit the supply and lead to price increases.
Walmart, being Walmart which isn’t unlike being Costco or any other major supermarket of sorts where people buy food, would want to limit their exposure to shocks in the market regardless of what’s causing the shocks. So they would need to employ futures traders in order to accomplish this. Even if they lose money on some contracts, they’re probably making money on enough of them to keep their prices low when you go there to buy tomatoes, avocados, lettuce, spinach, meat, poultry, or whatever. Nobody is happy when the price of tomatoes suddenly doubles almost overnight, and especially not the customer.
On the other hand, the supplier gets money now, not some time in the future (like after harvest) and this provides a different kind of cash flow that doesn't invoke debt (usually).
And then there's trading on the contracts all around, trying to get best prices :)
During the mid-2000s, Southwest got so good at hedging and futures trading--plus was one of the only airlines that hadn't gone bankrupt so had the cash and credit and good reputation to trade on--that it was routinely called "a commodity desk that happens to fly airplanes."
To hedge or not to hedge basically comes down to US versus EU accounting rules.
In the case of airlines, they are effectively 'short' oil, in that they profit if the price of oil falls, and lose if the price rises. So the usual story is that it makes sense to hedge their oil costs. They can do this in three main ways:
1) Buy oil forward. They get to lock in the price of oil at a future time. If oil prices rise, they win. But if oil prices fall, they lose out, since competitors can now buy oil more cheaply.
2) Buy a call option on oil. They get the right to buy oil at a fixed price at a future time. If oil prices rise, they can exercise the option, and win. If oil prices fall, they can just take the cheaper price => another win. But the option itself has a cost, so if oil prices don't change much, they lose out since they had to eat the cost of buying the option.
3) Sell a put option on oil. This is the airline being paid by someone for the option to sell them oil at a fixed price at a future time. In this case, the airline wins if oil prices don't move too much in any direction (since they get paid for the put option). If oil falls in price, they will have to buy it at the higher price => they lose. If the oil price rises, they also lose since the costs have risen.
Yet, in all cases, after hedging, the airline will still either win or lose depending upon the change in oil price. No certainty has been gained.
The choice whether to hedge or not is really down to game theory. What matters is not just whether/how your airline hedges, but what your competitors do.
That’s not really true. You’re locking in the price that you’re going to pay - that’s the certainty. You might however not be getting the best price at that point in time. From a financial forecasting perspective it probably worthwhile trade off though as you’re fixing one of your costs for that time period and that’s useful even when sub optimal.
In all situations, hedging and non hedging, the oil price will determine whether you win or lose. There is no magical combination of derivatives that will ensure success. In fact, for every financial product you buy, you're paying a cost due to the margin that the bank/market charged you.
Hedging might make sense for some accounting/tax situations, but that's another issue entirely.
No. Your fares will remain competitive. It's just a hit to your profits.
edit: I see this was mentioned already in the thread.
A huge chunk of airline tickets are sold in advance. The oil futures can literally lock in the prices for only sold airfare if you're that paranoid.
Also (probably more important), the cost of oil on a given ticket is quite low and it would take a drastic change in oil prices for it to be obvious to customers comparison shopping.
Actually, yours is a rather odd take on the term 'certainity' itself! To clarify, I'll lay out the layman take & the quant take.
The layman explanation is - life is a gamble but I wear seatbelt. Because that's the certainity I won't die by being thrown off the seat. Yes, that might mean I might die in other ways. Like maybe the car dives into a lake & I couldn't get out because the seatbelt is stuck so I drown to death. But the car in lake probability is smaller than car collision probability. So I have purchased certainity in my mortal affairs by wearing the seatbelt. Atleast if my car collides with another car, I don't get thrown off for certain.
The quant problem is the same. My quant professor at UChicago always insisted "only losers buy stocks". He repeated that in so many ways that lesson stuck to all of us. Like, stocks are for losers. Quants don't buy stock, losers do. Now why did he take such a radical stand ? Stocks are a random variable so there is no certainity. That's the very definition of positive rv y(t), it can do anything on the positive y axis, because it is random. But you are not completely helpless. You can buy certainity on both the x & the y axis! And on functions of those if you are clever. So if you pay put premium on a 1 month expiry with say strike at 1 sigma, you are saying I am only willing to lose 1 sigma from my present mu within next month. If my stock falls below mu-1sigma, then some other loser better pay up. Who is that other loser ? The guy who sold me the put option. Because he holds the opposite belief, which is why he sold me the put. So I am certain I won't lose below 1 sigma. I have literally purchased my certainity by paying that put premium. The loser why sold me the put is also certain it won't go below 1 sigma, which is why he gets to collect my premium. Now, what will really happen ? Well, who the fuck knows. The stock is a random variable, so anything can happen. But neither of us have bought the stock. I have bought 1 certainity, the seller has sold another certainity. So its a win-win on the certainity axis. Because my max loss is capped at mu minus one sigma, I am certain of that. So even though underlying is random I am certain!
> No certainty has been gained. is really down to game theory.
This is simply not true. A lot of certainity has been gained, which is literally why money has been exchanged. Price of certainity is by definition the premium.
Yes, if gas prices doubled, Walmart could increase the price of their products, but consumers would likely buy a lot less, and Walmart sales would suffer.
Walmart’s focus is on “low, everyday prices”, and future can help maintain those.
Your marginal cost goes up in both cases. If you're optimising profits, you should make the same decision in both cases regardless of if you bought futures.
If you have futures to buy diesel at $2.50/gal and the diesel price skyrockets to $4.00/gal, you can keep your prices the same.
If you didn't have futures you couldn't without taking a loss.
If you have futures, your marginal cost is still $4, since now you're using an additional gallon instead of selling it at market price at $4.
Most likely the futures in question aren't being physically settled.
Regardless, the economic cost is what determines incentives to raise price for a rational actor. For my claim above to be wrong, Walmart and co would have to be irrational.
You are a corn grower and want to lock in a price 6 months from now. You are someone who buys a lot of corn and want to lock in the price 6 months from now. Futures allow you in essence to meet up in a highly liquid exchange where you can lock in those prices for the buyer/seller. Win-win for both, because they get the price security they desired.
Of course the vast majority of futures is speculative, which provides liquidity for the hedgers..
With futures you can buy the tomatoes today, to be delivered later, the farmer can get his money now and you van lock in your price now, insulated against increases in prices (with the farmer insulated against decreases).