Risk Management in the Airline Industry of EasyJet and British Airways - Case Study Example

Risk Management in the Airline Industry Case Study of EasyJet and British Airways Introduction. The objective of this paper is to analyse risk management in the Airline Industry. This will be done by analysing EasyJet Plc and British Airways Plc. Particular attention will be on the exposure to and management of fuel price risk, foreign exchange rate risk, interest rate risks and other risks related to Airline companies. The rest of the paper is organised as follows: section 2 looks at the risks associated with Airline companies as well as the risk management strategies commonly employed; section 3 looks at EasyJet and British Airways’ risk exposure and the approaches used in mitigating these risks; and section 4 provides some conclusions and recommendations. 2. Risks Associated with Airline Companies. Airline companies are exposed to a number of risks including fuel price risk, interest rate risk, foreign exchange rate risk and operational risks. Fuel price risk is one of the most important risks that affect airline companies. When fuel prices rise airline companies face an increase in operating cost and thus a decrease in gross profit which in turn translates into low net profit margins, low return on equity, and low return on assets etc. shareholder value also reduces in turn. Moreover, it is difficult to determine whether the rate of decline will be higher than or lower than the rate of increase. Also, it is difficult to determine whether the time period covered by a downward trend will exactly equal the time period covered by an upward trend and whether the positive impact of a decline will exactly equal the negative impact of an increase. Figure 1: Source: Caneiro (2007). Figure 1 above shows the movement in oil prices over the period 1861 to 2006. One can observe from the figure above that oil price variability has been poorly predicted and that it is difficult to separate out temporary fluctuations from trends. This indicates that it is difficult to predict what will happen to oil prices in future. (Caneiro, 2007). This volatility in oil prices poses significant risks to airline companies. As the price of crude oil rises, fuel prices also rise which in turn increases the operating costs of airline companies. Apart from fuel price risk, airline companies face interest rate risks with regards to the long-term debt commitments. They run the risk that interest rates may change prior to paying their debt or receiving the outstanding receivables. In addition to interest rate risk, they also face exchange rate risk which is the risk that exchange rates may change before they receive or pay their receivables and payables that are denominated in foreign currency. All these risks may have an adverse effect on the company’s cash flows and operations. To hedge against the above risks, airline companies use a number of derivatives. There are different types of derivatives including options, forwards, futures, and swaps (Carter et al., 2006). Options are derived from an underlying security. There are two types of options: call options and put options. A call option gives the holder of the option (the long side party to the contract) the right but not the obligation to buy the underlying security from the writer of the option (the short side party to the contract) at a specified price known as the exercise price at a specified maturity date. (Bodie et al., 2005; Shapiro, 2006; Myers and Brealey, 2002). A put option on the other hand gives the long side trader the right but not the obligation to sell the underlying instrument at the exercise price to the short side trader on a specified date known as the maturity date. (Bodie et al., 2005; Shapiro, 2006; Myers and Brealey, 2002). A forward contract represents an agreement between two knowledgeable willing parties whereby one party agrees to buy the underlying instrument at a specified price and date and the other party agrees to deliver the instrument at the specified price and date. (Bodie et al, 2005; Shapiro, 2006). Unlike options contracts where the long is not obliged to fulfill the terms of the contract, both parties to a forward contract have fiduciary duty to comply with the terms of the contract. a futures contract is similar to a forward contract. in all material respects except for the fact that futures contracts trade on standardized exchanges whereas forwards trade in over-the-counter markets. Moreover, forwards can be customized to meet the needs of the traders whereas futures are standardized. Another important difference between futures and forwards is that there is more liquidity in futures trading and default risk is low as opposed to trading in forwards. (Bodie et al., 2005; Shapiro, 2006; Chance, 2008). A swap contract represents a contract between two parties to exchange cash flows. This may either be the exchange of cash flows designated in different currencies or the exchange of cash flows designated at two different types of interest rates (floating and fixed interest rates). (Chance, 2008; Shapiro, 2006; Allayannis and Weston, 2002 ). 3. Risk management at EasyJet and British Airways 3.1 EasyJet EasyJet Faces Fuel Price currency risks. These are described as sudden and significant changes in foreign currency exchange rates or sudden increases in jet fuel prices. The potential impact of the risk on the company is that it can have a material adverse effect on its financial performance. To hedge against this risk, the company has a policy to hedge within a percentage band for rolling 24 months (EasyJet Plc, 2009). The company uses a limited range of derivatives that trade in over the counter markets. It enters into a number of forward commitments with a number of approved counterparties. The company also faces financial and interest rate risk. All EasyJet’s debt is asset related reflecting the capital intensive nature of the airline industry. The potential impact on EasyJet of these risks is that market conditions could change the cost of finance which may have an adverse effect to the financial performance. The company’s group interest rate management policy aims to provide certainty in a proportion of its financing. The company’s operating lease rentals are a mix of fixed and floating rates. A significant portion of U.S dollar mortgage debt is matched with U.S dollar cash deposits (EasyJet Plc, 2008). EasyJet also faces liquidity and investment risk. The company continues to hold significant cash and liquid investments to mitigate the risk of business disruption events. A lack of liquid funds could result in the business being unable to meet its debts and aircraft financing commitments as the fall due. This would have a material adverse effect on the company’s performance and restrict future growth. To mitigate against these risks, the company has a number of funding facilities. As at 30th September 2008, the company had committed undrawn facilities totaling $1,135 million comprising $885million of aircraft financing and a $250 million standby facility. The board has a policy that requires the maintenance of an absolute minimum level of free cash and deposits. Surplus funds are invested in high quality short-term liquid investments usually money market funds and back deposits. The company invests only in the securities of highly rated issuers such as those with an AAA ratings (EasyJet Plc, 2008). 3.2 British Airways Like EasyJet, British Airways is exposed to a variety of risks, including market risk, credit risk and liquidity risk. Its overall risk management programme focuses on the unpredictability of financial markets and seeks to minimise potential adverse effects on our financial performance. British Airways is s exposed to a variety of financial risks: market risk (including foreign currency risk, interest rate risk and fuel price risk), credit risk and liquidity risk. To hedge against these risks, it enters into derivative transactions in order to manage certain market risks. All such transactions are carried out within guidelines approved by the Board. Financial risk management is the responsibility of the Group Treasury which is governed by the Board of Directors. The treasury is responsible for the identification, evaluation and hedging of financial risks. The Board provides written principles for overall risk management, as well as written policies covering specific areas, such as foreign exchange risk, interest rate risk, credit risk, use of derivative financial instruments and investment of excess liquidity. Fuel price risk Like EasyJet, British Airways is exposed to fuel price risk. Its fuel price risk management strategy aims to provide the airline with protection against sudden and significant increases in oil prices while ensuring that the airline is not competitively disadvantaged in a serious way in the event of a substantial fall in the price of fuel. In meeting these objectives, the fuel risk management programme allows for the judicious use of a number of derivatives available on the Over The Counter (OTC) markets with approved counterparties and within approved limits (British Airways Plc, 2008). The following table demonstrates the sensitivity of financial instruments to a reasonably possible change in fuel prices, with all other variables held constant, on profit before tax and equity (British Airways Plc, 2008): Source: Birtish Airways Plc (2008) Annual Report and Accounts Source: Birtish Airways Plc (2008) Annual Report and Accounts Foreign currency risk British Airways is exposed to currency risk with respect to its sales, debt, and loans that are denominated in foreign currency. The currencies in which these transactions are primarily denominated are euro, US dollar and Japanese yen. The Group generates a surplus in most currencies in which it does business. The US dollar can be an exception as capital expenditure, debt repayments and fuel payments denominated in US dollars can create a deficit. Sudden changes in foreign exchange rates can have a material adverse effect on the company’s performance. It manages foreign exchange exposures arising from transactions in various currencies through a policy of matching, as far as possible, receipts and payments in each individual currency. (British Airways Plc, 2008). Surpluses of convertible currencies are sold, either spot or forward, for US dollars or sterling. The Group has substantial liabilities denominated in yen and US dollars. The Group utilises its yen debt repayments as a hedge of future US dollar and yen revenues. Forward foreign exchange contracts and currency options are used to cover near-term future revenues and operating payments in a variety of currencies (British Airways Plc, 2008). Interest rate risk The Group is exposed to changes in interest rates on floating debt and cash deposits. There was no impact on shareholders’ equity. These changes are considered to be reasonably possible based on observation of current market conditions. Credit risk The Group is exposed to credit risk to the extent of non-performance by its counterparties in respect of financial assets receivable. However, the Group has policies and procedures in place to ensure credit risk is limited by placing credit limits on each counterparty. The Group continuously monitors counterparty credit limits and defaults of counterparties, incorporating this information into credit risk controls. It is the Group’s policy that all counterparties who wish to trade on credit terms are subject to credit verification procedures. Liquidity risk Prudent liquidity risk management includes maintaining sufficient cash and interest-bearing deposits, the availability of funding from an adequate amount of credit facilities and the ability to close out market positions. Due to the dynamic nature of the underlying business, Group treasury maintains flexibility in funding by maintaining availability under committed credit lines. 4. Conclusions Based on the foregoing discussion, it can be concluded that both EasyJet and British Airways are exposed to the same type of risks. Both companies use the same techniques to manage these risks. The techniques used are in line with those proposed in the theory such as using derivatives and matching liabilities with assets. Bibliography Allayannis G., Weston, J. P. (2001), “The Use of Foreign Currency Derivatives and Firm Value”, The Review of Financial Studies, vol. 14, No. 1, pp. 243-276. Bodie Z., Kane A., Marcus A. J. (2005). Investments. Sixth Edition. McGraw-Hill. Carter, David A., Rogers, Daniel A. and Simkins, Betty J.,Does Hedging Affect Firm Value? Evidence from the US Airline Industry. Financial Management, Vol. 35, No. 1, Spring 2006. Available at SSRN: http://ssrn.com/abstract=909669 Shapiro, A. C. (2006). Multinational Financial Management. Eight Edition, Wiley and Sons Inc. EasyJet Plc (2008), “Annual Report and Accounts”, available online at: http://corporate.easyjet.com/~/media/Files/E/easyJet/pdf/investors/result-center/easyJet_ar081.pdf British Airways Plc (2008), “Annual Report and Accounts”, available online at: http://www.britishairways.com/cms/global/microsites/ba_reports/pdfs/BA_Report_2007_08.pdf Read More