Foreign Exchange, Risk Management and Risks Related to Expansion and Growth: A Case of Euro Jet - Coursework Example

? Foreign Exchange Risk Management and Risks Related to Expansion and Growth- A Case Study of Euro Jet Name] [Date] Foreign Exchange Risk Management and Risks Related to Expansion and Growth- A Case Study of Euro Jet Introduction Euro Jet’s operations are spread to different parts of the Europe and the airline is the largest European airline in terms of seat-miles flown per annum. One of the major challenge the company faces is risk associated with foreign exchange exposure. In this report, a comprehensive evaluation of the foreign exchange risk associated with Euro Jet’s operations has been carried out and approach for managing the same has been put forward. In addition to this, as has been noted in the case study that the company plans to opt for one of the two options for expansion, which include expansion of network to intercontinental destinations and growth of existing network, the report also provides an evaluation of the risks associated with these two options in terms of foreign exchange risk and international environment risks. Besides this, a critical review of the literature pertaining to foreign exchange risk has been provided in the appendix at the end of this report. Management of Foreign Exchange Risk Having noted the fact that Euro Jet is faced with a risk of foreign exchange exposure due to fact that its revenues are earned under different currencies’ denominations, it is therefore pertinent to understand first that what is foreign exchange exposure risk and how it influences a company’s revenues. Moreover, the understanding of different risks and methods to manage them is likely to result in determining an approach which is more suited to the needs and requirements of Euro Jet. Foreign Exchange Exposure Risk The foreign exchange exposure risk refers to the expected gain or loss incurred due to fluctuations in the exchange rate (Arnold & Kumar, 2008; Moles et al., 2011). The foreign exchange risk resulting from fluctuations in the exchange rate may impact the overall cash flows, revenues, assets and liabilities and other items of financial statements of a company. In other words, the changes in foreign exchange rates result in the changes in a firm’s value, which may be favourable or an unfavourable change (Madura, 1989). Companies having operations in more than one country, like Euro Jet, are projected to risks associated with foreign exchange fluctuations. The risks associated with foreign exchange fluctuations may be categorised into three main types, which are as follows: Transaction Risks This risk relates to the risks associated with cash flows, i.e. the impact of changes in the exchange rates on revenues receivable, expenses payable, and other payments to be made to shareholders and third parties (Arnold & Kumar, 2008; Moles et al., 2011). Translation Risks This risk refers to the impact of change in foreign exchange rates on the value of a company. The impact of changes in foreign exchange rates is translated and reflected in the balance sheet of the company (Arnold & Kumar, 2008; Moles et al., 2011). Economic Risks This risk relates to the exchange rate fluctuations translated in the present value of operating cash flows to earned in future by a company. In other words, this risk relates to impact of changes in foreign exchange rates on the earnings of a company (Arnold & Kumar, 2008; Moles et al., 2011). Keeping in view this discussion of the foreign exchange risk and its various types, the approaches for managing foreign exchange exposure risk can be discussed as under. Approaches for Managing Foreign Exchange Exposure Risk In order to manage foreign exchange exposure risk, the most common and widely applied approach by both financial and non-financial business entities is the use of hedging. However, hedging has also various types and therefore various hedging approaches can be followed by business entities, and particularly by Euro Jet. Hedging refers to dealing with risk for a company resulting from exposure to foreign exchange fluctuations while transacting internationally or in international currencies. Hedging is carried out by using either cash flow method or on the other hand by considering fair value method (Papaioannou, 2006). Hedging Strategies Keeping in view the fluctuations expected in the future, business entities may consider hedging transaction risks to ensure obtaining certain cash flows or earnings. This strategy is often referred to as tactical hedging, which is mostly used by businesses to manage transaction risks pertaining to short term transactions. On the other hand, for long term transactions’ management, hedging techniques used are termed as strategic hedging. In addition, another strategy to hedge foreign exchanges currency rates risk is passive hedging. In this type of hedging no forecasting of currency fluctuations are taken into consideration, but in fact a constant hedging is carried out over a period of time (Arnold & Kumar, 2008; Moles et al., 2011; Papaioannou, 2006). Hedging Benchmarks and Performance According to Jacques (1996), while hedging for risks, the risk is sometimes denoted as the VaR (Value at Risk), which is considered as in accordance with the performance measures. In order to determine the most efficient hedge against exposure to a particular currency, hedging optimization models are used. Therefore, performance and benchmarks (VaR) are considered for determining the most efficient rate for hedging. In this way, the most effective hedging strategy is considered by ascertaining the risk which can be taken by the business entity (Arnold & Kumar, 2008; Moles et al., 2011; Papaioannou, 2006). Empirical Support for Hedging as an Effective Risk Management Technique The empirical evidence obtained by researchers in the past have noted that hedging strategies are effective in managing risks associated with foreign currency exchange exposures. As for instance, Allayanis and Weston (2001) conducted their study to determine how hedging enabled large non-financial business entities operating in the United States to safeguard themselves against fluctuations and exposures in the market. Their findings concluded that there was on average 4.87 percent higher value of firm indicated by company using hedging as compared to those business entities which did not use any type of hedging strategies. Similarly, in their study, Carter, Rogers and Simkins (2003) also followed the same research model as used by Allayanis and Weston (2001). The objective of the research work conducted by Carter et al.’s (2003) was also the same, which was to investigate the impact of hedging regarding fuel price changes for airline companies. The researchers concluded that those airline companies which made use of hedging strategies were able to report lower costs and higher profits as compared to those airline companies which did not do so. Similarly, Rao (1999) also concluded in his study that hedging is beneficial for airline companies. Foreign Exchange Risk Management Approach for Euro Jet In order to manage its foreign exchange risk, a company needs to identify and understand the particular type of exposure, methods and instruments available to be used for managing such risks and the possible impacts of hedging strategies. Having considered the financial statements of Euro Jet and the accompany notes and disclosures, it can be stated that the revenues and expenses earned and incurred by the company are exposed to different currencies. As a result of this diversity in currencies in which Euro Jet’s revenues and expenses are dealt with, it is important to understand that the risks pertaining to the company are also of varying degree and nature. Following table reiterates the proportion of Euro Jet’s revenues and expenses incurred in different currencies: Currency Operating Revenue Breakdown by Currency Fuel and Oil Contracts to the Airline Airport and Handling Charges Aircraft Rental Charges Sterling (?) 40 % - 48 % - Euro (€) 45 % - 44 % - Swiss (CHF) 7 % - 4 % - US Dollars and Others 8 % 100 % 4 % 100 % Reviewing the information provided in the above presented table, it can be noted that revenues and airport and handing charges are mostly in Sterling (?) and Euro (€). On the other hand, most of the fuel and oil contracts to the airline and aircraft rental charges are denominated under US dollars and other currencies. In addition, 65 percent of the interest charges for loans obtained by Euro Jet are denominated under US dollars. This diversified denomination of revenues and expenses in various currencies project Euro Jet to significant foreign exchange currency risks. Apart from considering these important facts, it is also important to know that the company’s financial statements are denominated under Euro (€). Keeping in view these facts, it is recommended that the company shall manage its risk pertaining to foreign exchange exposure by introducing hedging policies and strategies. In this regard, the company shall determine the hedging rates by following a hedge benchmark and profitability method. Apart from this, as far as recording of transactions in currencies other than Euro is concerned, it is recommended that the company shall initially record by translating all foreign currencies to Euro on the basis of spot exchange rate prevailing on the original date when transaction was carried out. In addition to this, all other balances denominated under foreign currencies shall be translated to Euro and presented in the financial statements by considering the currency exchange rates on the date presented in the balance sheet of the company. Apart from this, profits and losses relating to the airline’s operating shall be translated into Euro on the basis of average currency rates during the period for which financial statements are being made. In case there are differences resulting from calculations, the same shall be carried to the equity section of the balance sheet in the form of a separate component. Foreign Exchange and International Environment Risks As has been noted in the case study, the company aims at expanding its operations by opting for one of the two options in this regard. The first option is to expand its operations to intercontinental level by offering its airline services to Miami, New York, Moscow and St Petersburg. The second option on the other hand is to go for network expansion keeping in view the opportunities present for growth. Risks Related to Intercontinental Operations The fact that the Board aims at implementing its low cost airlines operation model to destinations in other continents can be evaluated by considering the risks which may emerge from foreign currency translation. The intercontinental operation plan, although is planned to follow the same “very low cost business model”, may give rise to a further exposure of the company to foreign exchange translation risks. In addition, apart from the fact that market conditions are reflective of an increase in the customer base, the fact that whether this additional customer base bring in additional profits for the company or it adds to the losses incurred due to foreign exchange translation, shall be evaluated thoroughly. Risks Related to Expansion of Existing Network The second option available for Euro Jet’s Board is expansion of its network in the existing region of operations. The expansion of its services will require acquisition of additional 150 aircrafts to augment the existing fleet of 300 Boeing 737, and an addition of 50 more to replace depreciated airplanes. Upon exercising this option, the additional aircrafts will be acquired over a period of 10 years. The evaluation of this option can be considered while taking into account the fact that the company has two possible suppliers of the additional aircrafts, with a considerable difference in their prices. The following table details the offers of the two suppliers: Name of Supplier Cost of Acquisition Boeing 737 (US) US $ 21,600 million China Aircraft Company (CACo) (China) 116,307.5 million Renminbi The evaluation of the two options and risks associated with them can be considered by comparing the two options. First of all, the comparative analysis of the costs associated with the two options reveals that acquiring aircrafts from China Aircraft Company (CACo) for 116,307.5 million Renminbi will be more cost effective in comparison with Boeing 737 aircrafts. Following table shows the exchange rates for the two currencies Exchange Rates US Dollar 1 = 6.12287 CNY ? 1 = US Dollar 1.59686 ? 1 = € 1.19683 Now, by translating the two options into Euros, the comparison of costs can be made, which shows the impact of translation from one currency to another. Following table shows the translation of costs: Boeing 737 - Translation of Cost from US dollars to Euro   Cost Denominated in Currency of Offer Cost Denominated in Sterling Cost Denominated in Euro Boeing 737 (US) $ 21,600 ? 13,526.55 € 16,188.98 China Aircraft Company (CACo) - Translation of Cost from CNY to Euro   Cost Denominated in Currency of Offer Cost Denominated in US Dollars Cost Denominated in Sterling Cost Denominated in Euro China Aircraft Company (CACo) (China) CNY 116,307.5 $ 18,995.59 ? 11,895.59 € 14,236.99 As per the calculations presented in the above two tables, there is a considerable difference in the amount of money the company will be eventually paying to aircraft suppliers. Apart from the fact that the option of purchasing aircrafts from Chinese company is cheaper than going for Boeing 737, there is another benefit in relation to opting for Chinese supplier. This benefit relates to exposure of currency to changes in foreign exchange markets. As for instance, if Euro Jet selects the first option, i.e. Boeing 737, the company will have to pay for the amount of aircrafts paid in US dollars. The exchange rate between US dollar and Euro can change as there is no hedging between these currencies and therefore there is a risk that the company may eventually pay more than the offered price if a weak Euro exists against dollar at the data of agreement. On the other hand, Chinese Renminbi is hedged against the US dollar and therefore if translated through US dollar there is a minimal risk relating to foreign currency exposure for the airline. Therefore, on these grounds it is suggested that the company shall opt for purchasing additional planes from China Aircraft Company (CACo). Summary In this report, foreign exchange risk, currency risk management strategies and recommendations for Euro Jet have been presented. Based on the review of exposure of the company’s revenues and expenses, and considering various models and techniques for safeguarding against risk relating to foreign exchange exposure, it has been recommended that the company shall opt for hedging strategies and shall follow the hedge benchmark and profitability method. In addition to this, the options presented to the Board of the company regarding expansion of its operations to intercontinental destinations or to grow its network within the region in which it is presently operating have also been reviewed. The review of these options have revealed that the company will be subject to further risk relating to foreign currency exposure if it expands its operations to intercontinental level. On the other hand, it has been noted that among the two options to acquire aircrafts from Boeing and Chinese based company, the Chinese option is more suitable. This suitability is based on the fact that it is not only a cheaper option but it also provides better safety against the risks related to foreign currency fluctuations’ exposure. Appendix A Critical Review of the Literature The main body of the report includes various references to the literature pertaining to management of foreign currency risk exposure for a business entity. In the main body of the report, it has been recommended that the airline operator, Euro Jet shall consider hedging strategies to safeguard its financial statements and performance indicators against exposure to risks emerging from foreign currency fluctuations. Although recommendation has been made regarding management of the foreign exchange risk exposure, but it is also important to critically review the impact of hedging and how it is considered as a useful tool for managing the said risk. There is a wide literature which relates to the management of risk arising from dealing in foreign currencies and being exposed to fluctuations in the foreign currency exchange market. In this regard, most of the criticism relates to the adoption of hedging strategies by firms in order to safeguard against the exposure to fluctuations in foreign exchange markets (Stulz, 1996). Hedging has also been considered and proven to be an effective method of managing foreign exchange risks. In this regard, majority of the studies for airline industry have been carried out to test how hedging influences the value of firms when they set strategies to safeguard their respective earnings against changes in fuel prices (Morrell & Swan, 2006). As for instance, Allayanis and Weston (2001) conducted their study to determine how hedging enabled large non-financial business entities operating in the United States to safeguard themselves against fluctuations and exposures in the market. The findings obtained from the study concluded that there was on average 4.87 percent higher value of firm indicated by company using hedging as compared to those business entities which did not use any type of hedging strategies. Keeping in view these results, it can be argued that there may not be one factor, such as hedging and the resulting protection against market risks, but in fact other factors may also have contributed in improving the firm value for those which opted for hedging. This argument can also be justified by the fact that the researchers themselves noted in their study that they were “not able to take into account the difference between those firms that might have hedged 100% of their currency needs one year ahead, and those that only hedged 20% of needs; and second, between those that hedged three months out and those that hedged two years out.” (Morrell & Swan, 2006, p.15). However, the conclusions reached by other researchers in relation to similar research works actually corroborate the findings obtained by Allayanis and Weston (2001) in their study. As for instance, in their study Carter, Rogers and Simkins (2003) applied the same research model as used by Allayanis and Weston (2001). The objective of Carter et al.’s (2003) study was also the same, i.e. to determine the impact of hedging regarding fuel price changes for airline companies (Basher & Sadorsky, 2006; Daley & Scott, 1998). The researchers concluded that those airline companies which made use of hedging strategies were able to report lower costs and higher profits as compared to those airline companies which did not do so. Similarly, Rao (1999) also concluded in his study that hedging is beneficial for airline companies. Although hedging is not only used for fuel prices and in this report, the primary focus is to understand the applicability and significance of hedging in relation to currency risk exposure, it is still useful to evaluate the role of hedging in the management of risks relating to fuel prices fluctuations. Commenting about hedging and in fact commenting against it, the Chief Executive Officer of the British Airways noted that “a lot is said about hedging strategy, most of it is well wide of the mark. I don’t think any sensible airline believes that by hedging it saves on its fuel bills. You just flatten out the bumps and remove the spikes.” (AFX News, 2004) Not only this, the Chief Executive also pointed that in fact hedging against risks is not required entirely, he said, “When you hedge all you do is bet against the experts of the oil market and pay the middle man, so you can’t save yourself any money long term. You can run from high fuel prices briefly through hedging but you can’t run for very long.” (AFX News, 2004). But the comments of British Airways’ Chief Executive can be considered not in line with what empirical evidences state. In fact, evidences and conclusion reached by Carter et al. (2003), Allayanis and Weston (2001) and Rao (1999) are all against the statements noted by the Chief Executive. Moreover, Cobbs and Wolf (2004) rejected the statements of the Chief Executive and reiterated the conclusions reached by researchers like Allayanis and Weston (2001). Similar to hedging practices for avoiding risks associated with fluctuations in fuel prices, researchers on the basis of their empirical investigations have also recommended the same to be adopted for safeguarding against the risks associated with fluctuations in the foreign exchange market. It has been argued that hedging against foreign exchange exposure risks can be considered as highly effective in forecasting the cash flows to be generated by the firm. Moreover, when business entities make use of hedging practices, it also enables them to even out their income and profits and thus providing a more convenient and convincing financial information for financial market players (Froot, Scharfstein and Stein, 1994). Critics of the hedging practices in relation to foreign exchange exposure risks also regard hedging to be a more expensive option. As for instance, Hagelin and Pramborg (2004) have noted that the expenses incurred on hedging can be more than the losses actually aimed at to be covered by the hedging strategies. Having considered this review of the literature, it can still be stated that hedging practices are considered as effective and efficient means by business entities world over and considered it as a means to safeguard against the risks associated with currency fluctuations in the international market. List of References AFX News, 2004. BA says fuel requirement 45% hedging in current year. AFX News, 17 May. Allayannis, G. & Weston, J.P., 2001. The use of foreign currency derivatives and firm market value. The Review of Financial Studies, 14(1), pp.243-76. Arnold, G. & Kumar, M., 2008. Corporate Financial Management. New Delhi: Pearson Education India. Basher, S.A. & Sadorsky, P., 2006. Oil price risk and emerging stock markets. Global Finance Journal, 17, pp.224-51. Carter, D.A., Rogers, D.A. & Simkins, B.J., 2003. Does fuel hedging make economic sense? The case of the US airline industry. Journal of Finance website. Cobbs, R. & Wolf, A., 2004. Jet fuel hedging strategies: options available for airlines and a survey of industry practices. Finance, 467. Daley, W.M. & Scott, D.T., 1998. Impact of Changes in Foreign Exchange Rates and Other Risks. New Providence: UNZ & Co. Froot, K., Scharfstein, D. & Stein, J., 1994. A Framework for Risk Management. Harvard Business Review. Hagelin, N. & Pramborg, B., 2004. Hedging Foreign Exchange Exposure: Risk Reduction from Transaction and Translation Hedging. Journal of International Financial Management and Accounting, 15(1). Jacques, L., 1996. Management and Control of Foreign Exchange Risk. Norwell: Kluwer Academic Publishers. Madura, J., 1989. International Financial Management. St. Paul: West Publishing Company. Moles, P., Parrino, R. & Kidwell, D.S., 2011. Fundamentals of Corporate Finance. West Sussex: John Wiley & Sons Limited. Morrell, P. & Swan, W., 2006. Airline Jet Fuel Hedging: Theory and practice. Transport Reviews, 26(6), pp.713-30. Papaioannou, M., 2006. Exchange Rate Risk Measurement and Management: Issues and Approaches for Firms. IMF Working Paper. New York: International Monetary Fund. Rao, V.K., 1999. Fuel price risk management using futures. Journal of Air Transport Management, 5, pp.39-44. Stulz, R.M., 1996. Rethinking Risk Management. Journal of Applied Corporate Finance, 9(3), pp.8-24. Read More