Risk Management of Airline Companies - Coursework Example

Topic: Risk Management Risk management in big companies is a strategy to minimise the financial losses and increase profits; hedging is a risk managing tool, practiced by corporations as well as governments, big and small, so that companies don’t become bankrupt due to losses and governments’ foreign exchange resources are not drained, affecting the whole economy. Airlines can practice hedging techniques by trading in risk minimizing instruments like futures, swaps or options. Hedging is like insurance -- insuring against negative happenings. It is practiced in almost all industries. Negative occurrences happen but their impact is minimised. Hedging techniques minimise airline risks, but in financial markets it is not as simple as insurance, as instruments in market are used to set off the risks of negative price tendencies. Hedging, in technical terms, is investing in two securities with negative correlations. Of course, it comes by paying in some form or the other. We can not save ourselves from risk-return tradeoff, as hedging is not a technique of making money but a way of minimising future losses. Mostly, hedging techniques require the usage of complicated financial instruments, known as derivatives; options and futures are the most commonly used derivatives. With these instruments, trading strategies are developed whereby a loss in one investment is compensated by profiting in a another. Risk issues Taking the example of Southwest Airline’s hedging techniques in mid-2005 when oil prices rose to more than $60 per barrel, giving huge profits to the company because it had entered into a contract of commodity hedging for 85% of its oil needs at the rate of $26 per barrel. Had the company not entered into commodity hedging, it would have incurred heavy losses. The Southwest Airline saved $34 per barrel and not only covered the risks involved in the scenario of $60 per barrel but solidified its market position. Other American airlines like Delta had no long term contract and in the year 2004 had to sell its supply contracts to arrange cash for paying debts. It shows how difficult it is to survive in the volatile oil market without practicing some risk minimising techniques. Similarly, another airline – United Airlines – had filed for bankruptcy protection in December 2002 -- could hedge 30% of its fuel requirements in 2005 at the cost of $45 per barrel. One can understand the compulsions behind different strategies adopted by these airlines, as their financial standings are also different. Risk depends on the upward or downward movement of commodity reference price. As it happened in the case of Southwest Airline, oil price reached $60 per barrel and the airline benefited because of commodity forward contracts and was able to hedge the risks involved. Had the commodity reference price gone below $26, the airline had to pay the bank the cash settlement amount – the difference between the fixed price and the commodity reference price. It involved the risk of foregoing of cash settlement amount equal to the difference between the fixed price of $26 per barrel and the reference price multiplied by the total quantity of oil. Another scenario would have been least risky in case the reference price and the fixed price had been same. It would be wrong to say that commodity hedging is always beneficial in increasing profits. Commodity hedging manages risk with a Commodity Futures Hedging Strategy like an insurance policy against risks related with price variations. Success in reducing the risk of this significant commodity becomes crucial for remaining in business for a company. Managing risks is very important to remain in business. More than that, it is important to take the services of reputed international banks as volatility of market requires experts’ services to know the movement of prices and choose the best hedging alternative. There are benefits arising out of hedging practices by corporations. They lower tax liability, minimise the estimated cost of financial losses, decrease confrontation between shareholders and bondholders, develop coordination between financing policy and investment policy and increase the value of manager’s wealth portfolio. Hedging techniques: Swap – a hedging technique -- provides the security of a fixed price. Suppose an airline requires swapping of its one year requirement of fuel. It will agree to pay a fix price on its requirement. There is a market forecast of increase in the price of fuel and the price increases by the time it purchases its quota of fuel. Strength & weakness of Swap - Swap guarantees the price when the airline purchases its fuel and also saves on increase in price. Weakness – Airline won’t be able to take the benefit of future further fall in the price of fuel with the bank for the whole year if it has swapped on a particular price. Future Contracts -- Other than swap, companies opt either for futures contracts on fuel or go for cross hedging jet fuel with using gas oil or heating oil. There are no future contracts on oil in most exchanges except Tokyo exchange. For such companies working outside Japan, hedging jet fuel becomes a problem of managing foreign exchange risk. As complete hedge is impossible due to technical problem of not having futures contract on the exchange rate with the Japanese Yen or US dollar, cross hedge that reduces the risk, is the alternative. Cross hedging techniques – Weaknesses: Hedging through futures contracts is complex because of mismatch of maturity date or specified asset or both. Mismatch of maturity date causes delta-hedge; mismatch of asset causes cross-hedge, and when both are in order, it leads to cross delta hedge. It is still not decided which of the hedging techniques is better than the other. The two main classes of cross-hedging examples are: commodity cross-hedging and currency cross-hedging. It is possible to cross-hedge commodity with currency and currency with commodity by taking the example of two markets from the same class: a futures market and a spot market with different but correlated underlings. Cross-hedging commodity – strengths and weaknesses In cross-hedging commodity, basic principle of hedging can be used for commodities, for which no futures contracts is possible, as mostly, they are same to the traded commodities. Jet fuel could be hedged by using heating oil futures contracts. Plus point of jet oil is that crude oil and its associated refined products’ prices are mixed and merged. But its weak point pertains to causes like transfer cost, storage costs and location, which may create problems in cross-hedging. Currency cross-hedging -- strengths and weaknesses Cross-hedging currencies happen due to four times a year maturity of currency futures, resulting in co-incidental perfect hedges. It is not easy to manage risks because of complexities of the commodity in question – jet fuel. There are different methods of cross hedging currencies. Spot and futures prices levels is a method to analyse currencies but price change level is preferred to price level method, so that it doesn’t disrupt the Ordinary Least Square (OLS) assumptions because of correlation of error terms in regression model. A simple OLS regression model over a long period of time can alter the steadiness of regression slope coefficient. Another method is Random Coefficient Model (RCM) to test the optimal hedge ratio by “overlapping” regression procedure with the purpose of checking shifts in coefficient overtime. Results are not same with countries as there is a complex relation due to open interest, volume of contracts traded, stability of the hedge ratio and the measure of hedging effectiveness. Out of different strategies to derive an optimal hedging based on a portfolio of n-currency spot portfolio, RCM may perform relatively better but it supports the idea of inter-temporal instability of minimum regression coefficients describing the portfolio effect. Another method is generalized method of moments (GMM) to measure the performance of five major currencies futures for cross-hedging local currency with US exchange rate. Empirical evidence shows that minimum variance cross hedge outperforms an unhedged position. Using a portfolio of futures contracts, it over performs in some countries and underperforms in other countries. And currency returns can take unexpected twists. Another hedging alternative is based on non-deliverable forwards contracts – volatility of currency can be traded using covariance swap but generally variance and covariance of different currencies are not stable over time. As it is common for companies to hedge 75-85% of their foreign exchange exposure, whenever it is possible, forward and futures contracts are replaced by options, which provide guarantee against adverse market movements but still there is scope for profits from positive price movements. Basket currency options for hedging and meeting revenue targets are a popular corporate strategy, as risks are managed on centralized basis – a way out to hedging net income and avoiding shocks from the volatile behavior of currency. It is found that hedged positions are riskier than unhedged positions. Cross-hedging is quite useful risk minimizing hedging technique but for a single currency cross hedge, it is important to readjust the hedging from time to time to overcome the problems of inter-temporal instability of the co-efficient. Data analysis on cross-hedging jet fuel indicates correlations between spot prices and future prices for different proxy oil products. There are limited instruments and no straight forward technique to guide the risk manager to hedge the cash flow, required to manage the commodity – fuel. Perfect hedge is a far away thing; only target achievable is minimising the risk, which is being practiced by emerging companies and nations. It is evident from the recommendations made by the Central Bank of Sri Lanka to the government to enter into hedging arrangements through international banks to minimise the negative effects of oil prices on its economy. References: A beginner’s guide to hedging. (2003). Retrieved Monday, April 9, 2007 from http://www.investopedia.com/articles/basics/03/080103.asp Commodity hedging. (2005). Retrieved Monday, April 9, 2007 from http://smh.com.au/.../2005/08/15/1123958005159.html Judge, Amrit. (2003). Why do firms hedge? A review of the evidence. Retrieved Monday, April 9, 2007 from http://mubs.mdx.ac.uk/Research/Discussion_Papers/Economics/dpap%20econ%20108.pdf. SLNF (2006). Central Bank advises Govt. to hedge oil prices. Retrieved Monday, April 9, 2007 from http://www.weerawila.com/Financial/103.html Sugar swap for consumers. (2007). Commonwealth Bank of Australia. Retrieved Monday, April 9, 2007 from http://commodities.commbank.com.au/commodities/0,2023,CH2944,00.html Tunaru & Tan. Minimizing risk techniques for hedging jet fuel: An econometrics investigation. Retrieved Monday, April 9, 2007 from http://mubs.mdx.ac.uk/Research/Discussion_Papers/Accounting_and_Finance/dpapa&fno23.pdf. . Read More