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'Let more firms trade in futures'
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15:05, June 01, 2009

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Allowing more Chinese companies to trade in the international futures market is a better solution to protect State-owned enterprises (SOEs) from potential losses in overseas derivatives trading than simply blaming the investment banks that offer these products, experts said.

Several Chinese publications recently directed their anger at the huge losses incurred by some SOEs from overseas derivatives trading at the global investment banks that provided the products.

"I would call those products 'financial opium'," Huang Ming, a professor of finance at the Johnson School at Cornell University, was quoted as saying. One of the publications even carried a headline which said, "Complicated derivatives from abroad robbed China".

A number of SOEs suffered severe losses from their overseas derivatives trading through some reputable global investment banks. The most notable cases included Air China and China Eastern Airlines, the country's second- and third-largest carriers, losing 7.47 billion yuan and 6.2 billion yuan, respectively, from fuel hedging contracts last year.

However, as much as the investment banks were to blame, the airlines still needed to find a way to hedge the risks of fuel price fluctuations and turning to those banks was their only choice, Lin Hui, an analyst at Orient Securities Futures in Shanghai, noted.

"It's true that the products offered by those investment banks were over-the-counter (OTC) derivatives that were largely unregulated. But fuel hedging is a common practice in airlines around the world to stabilize jet fuel costs. Chinese airlines simply wanted to do the same," Lin said.

But the real problem lies in the fact that only 31 Chinese companies are allowed to trade in the international futures market and none of these are airlines, Lin added.

As a result, Chinese airlines can only conduct their fuel hedging through derivatives offered by those investment banks.

Huge losses

Furthermore, Chinese airlines were not alone in suffering huge losses from fuel hedging last year. Major airlines around the world all experienced significant losses because of the huge fluctuations in crude oil prices in 2008.

"The world crude oil price went from as high as $147 per barrel to as low as $32 in the past year. I haven't seen the crude oil price rise and fall on such a scale since the market-linked pricing system was established in 1986," said Hu Yuyue, a futures professor at Beijing Technology and Business University.

Cathay Pacific Airways, based in Hong Kong, said its year-end fuel-hedging losses in 2008 totaled HK$7.6 billion, up from HK$2.8 billion at the end of October after a sharp drop in oil prices.

Airlines including US budget leader Southwest Airlines and European giant Air France-KLM SA have suffered billions of dollars in losses on fuel hedges over recent months after the price of crude oil plunged from record highs last spring to multiyear lows.

A trader in the crude oil futures pit at the New York Mercantile Exchange

Fuel hedging is an important step for Chinese airlines to catch up with their Western peers and we can't say it's wrong just because of short-term losses, Hu added.

"If Chinese airlines can trade in the international futures market directly, it would be easier for them to make timely adjustments to their fuel hedging contacts, like most international airlines did, to reduce losses," said Lin.

Lin also pointed out that since Air China's fuel hedging contracts won't expire until 2011, it's still possible for the carrier to recover some of the losses.

Risk and opportunity

Despite the fact that some SOEs have suffered enormous losses, derivatives continue to be a very important financial instrument for large corporations around the world, including Chinese companies, to hedge business risks, Hu said.

According to the professor, a report from the International Swaps and Derivatives Association indicated that over 94 percent of Fortune 500 companies use derivatives as a tool to manage risks.


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