Think of hedging as insurance. The goal is to protect against a financially adverse event. There are several factors to consider if you're going to hedge, many of them included in the article on page 36 of this issue. Since hedging is complicated, ask yourself if the benefit received is worth the investment.

If the answer to that question is "yes," you then have to decide which hedging instrument to use. Two of the most common hedging instruments are swaps and options. Buying a swap is an obligation to buy a commodity at an agreed upon fixed price at some point in the future, regardless of the market price at that time. If the market price is above the agreed upon fixed price of the swap, the buyer of the swap has a gain. If the market price is below the agreed upon fixed price, the buyer of the swap incurs a loss. Selling a swap is the opposite of buying a swap. It creates an obligation to sell a commodity at an agreed upon fixed price at some point in the future, regardless of the market price at that time. Since it's the opposite of buying, in this case if the market price is below the agreed upon fixed price of the swap, the seller of the swap has a gain. If the price is above the agreed upon fixed price, the seller of the swap incurs a loss.

There are two primary types of options. The first is a call option where a buyer makes an up-front premium payment, giving the buyer the right (but not the obligation) to buy the commodity at an agreed upon price (strike price). If the market price is above the strike price of the call, the buyer of the call would exercise the option and receive a gain on the call (minus the cost of the option). If the market price is below the strike price, the buyer lets the option expire with no value. With this instrument, the buyer pays an out-of-pocket expense, but he is able to participate in lower prices, should prices fall.

The second type is a put option where a buyer makes an up-front premium payment, giving the buyer the right (but not the obligation) to sell the commodity at an agreed upon price. If the market price is below the strike price of the put, the buyer of the put would exercise the option and receive a gain on the put (minus the cost of the option). If the market price is above the strike price, the buyer lets the option expire. With this instrument, the buyer pays an out of pocket expense to establish a floor price while he is still able to participate in higher prices should prices increase.

There are more complex hedges that incorporate some or all of these instruments. You have to understand which instruments will work best for your situation. Caution: Don't hedge with intentions of making a profit or speculating on the market.

Jet fuel prices may fluctuate relative to the price of crude oil since it is derived from crude oil. Jet fuel expense is approximately 30% of American Airlines' operating expenses. Put another way, a 1¢ increase in the price of jet fuel increases our annual expenses by approximately $30 million. We began our fuel hedging program in 1993. We have a hedging committee comprised of representatives from purchasing (fuels management) and treasury who meet on a regular basis to review our hedging program. The hedging committee makes recommendations to our senior management and they have final approval of the hedge positions and instruments.

The goals of our fuel-hedging program are to protect against the potential for dramatic fuel price spikes and to reduce the chance for volatility in earnings. We hedge primarily in jet fuel and other commodities using primarily options. We add hedges on a regular basis and we do not speculate on the market.

Hedging can be complex and challenging. So, if you're going to hedge any commodity that your company needs, make sure you consider all the factors mentioned here and on page 36 before you participate in this activity.