Every week there are more companies which announce that they are losing money with the hedging strategies that they are using. A lot of the strategies are bull market strategies and have unlimited loss if prices drop. With commodities, commodities currencies, equities–essentially all asset classes–collapsed in the past month, it is not surprising to see companies announcing to public that they have suffered serious derivative losses.
According to newspaper, Cathay uses zero cost options to hedge fuel costs. They long a call option so that they will earn money from the option if fuel price goes above the strike. Also, in order to have zero cost strategy, they sell a put option is to offset the entire cost of buying a call option. At the same time, this short put creates an unlimited downside to the company. When fuel price drops below the strike price, the company will need to purchase fuel at the strike price which is higher than the current price.
By using this strategy Cathay does not need to worry about fluctuation in fuel price. They have probably set a fixed price for fuel in their business projection and having a fixed fuel price definitely makes planning much more easy. Unfortunately this created an unintended side effect of creating big financial loss when the hedge goes the wrong way.
With what has happened in this financial crisis and all this negative publicity surrounding derivatives and structured products, companies will definitely be very cautious when bankers sell them all these hedging solutions. From now on, they will very likely resist all hedging solutions with possible unlimited downside!
