Application of portfolio theory to labor contract valuation : the case of the airline industry

Abstract

An analytic formula is derived in this thesis for the risk-adjusted financial value of a labor contract. The contract is modeled as a bond with a payment stream equivalent to the stipulated wages. The Capital Asset Pricing Model (CAPM) is used to determine the expected return from the bond relative to the entire financial market. The Net Present Value of the payment stream and the expected return of the bond are then combined to give the value of the labor contract. The resulting formula is a function of the contractual wage rate, the expected revenue of the firm, and the volatility of this revenue. This formula describes labor contract valuation for labor as a single group. The analysis is then extended to compare labor contract values among different labor groups within a single firm. Finally, a system dynamics model is utilized to study the impact of time delay between profitability and changes in pay. Analysis of the financial situation at nine US Major airlines reveals that in 2000, and in 2003, the wage rate at most of these airlines was higher than the optimal wage rate calculated by the model.