Financial Risk Management - Coursework Example

Financial Risk Management of Institute As a process, economic risk management deals with uncertainties thatresult from transactions. It involves an assessment of the risks a firm faces and the development of possible strategies to cover the risks. Risk management aims at protecting a firm from any losses by use of techniques such as hedging. The most influential aspect of a commodity is the volatility of its price as it affects all economic units in the economy. Therefore, risk management becomes a pertinent issue for firms that trade in commodities. A failure to manage risks many lead to many losses. Risk management is of importance to airlines especially given the volatility of fuel prices. Hedging, especially, plays a significant role in helping a company avoid the downside of economic events such as price changes. It aims at taking advantage of the upside while shielding from the downside. Many shareholders are of the opinion that managers should not apply hedging to risks such as changes in fuel prices, which are industry-specific. The argument is that companies can easily deal with such risks through holding diversified portfolios of stock. They feel that hedging may lower earnings due to the inability of the firm to take advantage of favourable market situations. Most of the executives that are against hedging claim that risk is unavoidable regardless of the use of hedging. They further claim that since competitors do not use hedges, then there exists some level playing field (Buckley, 2003 p.231). Thus, they find justification for their opposition to hedging in that argument. For an airline, hedging does not influence the cost of operating as an airline. Instead, it forms an independent and speculative financial business. Therefore, any right or wrong speculations by the airline do not affect its competitiveness in the industry. Most airlines in the US hedge against fuel risks. Fuel hedging is the advance fixing of the price of jet fuel by an airline with an oil company. The objective is to avoid or reduce the impact of sudden changes in the spot market price of fuel. Since fuel makes up the biggest portion of an airline’s costs sudden changes in price could cause adverse consequences. Hedging against fuel prices has several advantages. First, setting a pre-determined price helps protect the airline from any sudden increase in the prices of oil. For example, if an airline hedges half of its fuel requirements at a price of $2.50 per gallon and throughout the year the spot-market price for oil does not fall below $3.00, then the airline would incur lower costs. That would be a benefit to the airline. However, to the oil company, the gains by the airline mean a loss of the same margin to them. Also, escalating oil prices may cause fare to rise as the fares have to be adjusted to take into consideration the increased costs due to price hikes (Adedeji and Baker, 2002 p.54). That would affect the operational performance of an airline. A hedged airline may be able to maintain its current fares even in times of escalating oil prices. That competitively gives them an edge over competitors who do not hedge and are hence affected by the change in prices (Aretz et al, 2007 p.436). Effective hedging, therefore, helps airlines save money on any price hikes. It protects firms from oil price shocks. Hedging may also provide a firm with an avenue to differentiate, thus giving it an edge over its competitors. It also saves on managerial costs as well as lowering distress costs that emanate from adverse situations that the company faces. In so doing, it increases the value of the firm while lowering the cost of capital. While engaging in futures or forward contracts, a firm may develop a better inventory management system (Aretz et al, 2007 p.438). Price volatility affects inventory management. Thus hedging improves the management of stock by reducing the costs related to inventory. Price volatility adversely affects revenue streams. It causes a disruption to cash-flows. With hedging, there is certainty in production processes, and hence there is continuity in cash-flows. For example, when fuel prices escalate, an airline hedging against such escalation would not have to discontinue some of its flights due to the high cost of operation. It will continue to enjoy cash-flows even under the adverse circumstances of high prices. An airline may not be able to stock large inventories of fuel as it would involve a lot of financing and storage costs. It thus becomes necessary for an airline to hedge to avoid these expenses, as well as swings in prices. Although few airlines use jet fuel hedging, those that use it have had a lot of financial benefits. For example, Southwest Airlines have reaped huge profits over the years due to their aggressive hedging strategy. On the downside, fuel price hedging may be a cause for great losses during times when prices are plummeting. When prices fall, an airline that is hedging may not be able to take advantage of the fall in prices since it already has a pre-determined price at which to buy (Campello et al, 2011 p.1617). It ends up incurring higher costs relative to the rest of the industry. For example, where an airline, through its hedging transactions, pre-determines fuel prices at $3.50 per gallon and the prices suddenly fall below $2.00 per gallon, the airline incurs losses of the magnitude of price fall. Also, an airline may be limited in its adjustment of fares in times when price of oil falls. The high fares it charges relative to competitors may work against it and hence income would also fall. Some of the Over the Counter derivatives that are applicable for hedging jet fuel include swaps, collar structures and options. However, these derivatives are quite illiquid and may not be sufficient to hedge all the jet fuel requirements of an airline. The effectiveness of the hedging function of any airline would depend on the amount the airline will hedge and the accuracy with which it predicts the future prices of oil (Bailly, Browne, Hicks, and Skerrat, 2003 p.189). A balanced hedging policy is likely to ensure that costs and losses are minimized in case of sudden rises or falls in prices. That would enable the airline to take advantage of such price movements. For example, an airline that hedges half of its oil requirements has the advantage of buying the remaining half at the spot market price when prices plummet. Thus, it does not lose out entirely on the low prices. When prices suddenly escalate, the hedged portion of their consumption protects them from excessive losses. Time also matters when it comes to hedging. Since the hedging contract is for a particular period, it becomes necessary to consider the time factor in any hedge transaction. A well calculated period may avail an airline some flexibility when it comes to taking advantage of price falls. For example, a hedge contract that is for a short period may make it possible for an airline to purchase oil at the spot prices once the contract runs out. Hedge-related losses are also dependent on the type of hedging the airline applies. Different hedges come with different options. For instance, options, which are popular with airlines, confer a right, but no obligation to the airline to purchase fuel at the pre-determined price in the future. Even with the disadvantages that an airline may face due to hedging against volatility in oil prices, the benefits still outweigh the disadvantages. An airline’s choice to hedge may have justification that the gains it achieves by such hedging strategy over several years far outweigh the losses it incurs in a given period when prices may fall below the hedge prices (Bartram, Brown, and Fehle, 2009). It is thus necessary to hedge at least part of the airline’s fuel consumption to shield it from losses that come as a result of volatility of the prices. That would ensure profitability and stability for the airline. Hedging and Corporate Value According to Miller and Modigliani, a firm’s hedging activities have no influence on the value of the firm. However, firms face many situations such as taxes, financial distress costs, information asymmetry, bankruptcy costs as well as high costs of external financing. All these cause deadweight cost to the firm and hence reduce the firm’s value (Stephen, 2001 p.97). Hedging reduces the volatility of cash flow and in so doing increases the firm’s value. When an airline engages in hedging over an extended period of time, it develops some assurance over the market price. By maintaining the prices of their inputs, they manage to keep their operating costs from rising. That enables them to plan and come up with capital formation and expansion strategies. In so doing, there is growth in capital investment. With increased capital investment, the firm’s corporate value increases. One of the most essential features of management strategy is the reduction of corporate risk. That is necessitated by market imperfections which also have the effect of reducing the value of a firm. That is so due to the volatility involved. Some of the effects of market imperfections include agency costs, financial distress costs as well as costs that relate to managerial risk aversion. All these combine to affect a firms value adversely. Hedging, therefore, enhances the value of the firm through the reduction of the costs emanating from such market imperfections. As hedging reduces costs and losses due to market volatilities, it enhances profits that increase earnings. Higher earnings improve the value of the firm. Hedging gives suppliers and customers some assurance over the company’s stability in terms of its products and services. That may be an indication of the corporate value that hedging adds to the company as it increases the confidence of the suppliers and customers (Eun and Resnick, 2008 p.55). Also, with reduced chances of financial distress and improved business stability that hedging brings, there is improved job security for the employees. A satisfied workforce improves its productivity and hence further improves the performance of the organisation. With improved performance, the company achieves better results. That increases the corporate value of the firm. Various studies have shown different results in the determination of the effects of hedging on the value of the firm. Some studies in the airline industry indicate that hedging makes it possible for airlines to expand their operations even when the industry is experiencing problems. That helps deal with the issue of under-investment, which affect the value of the firm. The studies support the proposition that hedging influences the firm’s corporate value. They suggest that fuel hedging in the airlines industry would make an airline more valuable than its competitors. However, other researches show contrary results. They indicate that the potential gains a firm may derive from derivatives is not significant when compared to the movement in equity values or cash flows. They cannot therefore have a significant effect on the company’s value. The studies indicate that other risk management activities are responsible for the changes in value of the firm (Klimczak, 2007). An example of such activity is operational hedges. The operational hedges enhance value and have a positive correlation with derivatives positions. Supporters of these latter studies argue that were hedges to increase the value of the firm, then all companies would be operating at an optimum. From the differing results from different studies, one can conclude that the value of a firm is not just a result of hedging. Rather, various factors play a role in influencing firm’s value. Although hedging may improve the operations and performance of a firm, it may not be able to influence the value of a firm on its own. It works with other factors to bring such an effect. All in all, the studies agree that hedging may provide a firm with an advantage when it comes to operational costs as it lowers risks. References Aretz, K., Bartram, S.M. and Dufey, G., 2007. Why hedge? Rationales for corporate hedging and value implications. The Journal of Risk Finance, 8 (5), p.434–449 Campello, M., Lin, C., Ma, Y. and Zou, H., 2011. The Real and Financial Implications of Corporate Hedging. The Journal of Finance, 66 (5), p.1615-1645. Buckley, A., 2003. Multinational Finance. Financial Times Management. Stephen, J.J., 2001. Managing Currency Risk: Using Financial Derivatives. New York: Wiley Eun, C. and Resnick, B., 2008. International Financial Management 5th edition. McGraw-Hill Adedeji A, Baker R., 2002. Why firms in the UK use interest rate derivatives. Managerial Finance, 28 (11), p.53-74 Klimczak, 2007. Risk Management Theory; A Comprehensive Empirical Assessment. MPRA paper no 4241 November 2007 Bailly, N. Browne, D. Hicks, E. and Skerrat, 2003. UK Corporate Use of Derivatives. European Journal of Finance, 9, 163-193. Bartram, S. Brown, G. and Fehle, F., 2009. International Evidence on Financial Derivative Usage. Financial Management, Spring 2009. Read More