Airline Financial Management - Essay Example

Running Head: Airline Financial Management Airline Financial Management: Internal Audit of the of the Airline Financial Management: Internal Audit A firm's internal risk management process is the process by which the firm tries to ensure that the risks to which it is exposed are the risks to which it thinks it is and needs to be exposed in order to maximize security holder welfare. Risk management as a process can fail for a variety of reasons other than the occurrence of losses. First, risk management can fail to disseminate the right information to the right players. Closing the gap between actual risk and desired risk would be possible when the right people in the organization are evaluating that gap with the right information. Hence, in order to ensure the integrity of the company's systems and financial operations and minimize the possibility of loss through mismanagement or fraud, the treasury department of the corporation can come to help. Through the formulation and implementation of a through risk management process, the likely and not very likely, both kind of unpleasing events can be avoided, and/or their damage minimized. The primary objective of the treasury department would be to minimize and provide for the various types of risks confronted to the company. This main objective can be broken down in smaller aims and objectives, all forming elements of the broader risk management process. Risk management as an organizational process can be separated into five general activities: identify risks and determine tolerances; measure risks; monitor and report risks; control risks; and oversee, audit, tune, and realign the risk management process. Identify Risk and Determine Tolerances Risk identification is the process by which a company recognizes and, in some cases, detects the different financial risks to which it is exposed through the normal course of conducting its business. Risks can be left unidentified for reasons ranging from poor internal controls that allow the unnoticed booking of risky financial transactions to basic oversight of fundamental exposures. The process by which members of a company review, analyze, and discuss their risk profiles is an indispensable means by which risks can be identified, and, hence, managed. Our airline company transports passengers from the United States to Europe and back. The obvious risks faced by the company include the risk of plane crashes, maintenance-related delays, equipment damage from fire, and a loss of customers. Less obvious but perhaps equally significant are also the financial risks to which our company may be subject, such as the risk of rising jet fuel prices or the risk of fluctuations in the euro/dollar exchange rate. Without a systematic process to analyze these different risk exposures, our company's shareholders may never realize fully the different avenues through which the value of their capital can be adversely affected. Given the risks the company has identified, senior managers and directors must agree on tolerable levels of those risks required for the operation of the firm's primary business. This determination should be made explicitly by the firm's key stakeholders, including senior managers, the board of directors, and sometimes major creditors. Measure Risks Risk measurement involves the quantification of certain risk exposures for the purpose of comparison to company-defined risk tolerances. The process by which different risks are quantified is a critical component in an organization's broad risk management program. Without a good measure of risk, a determination can be hard to reach about whether the company is taking too much of some types of risks-or, conversely, not enough of another. Monitor and Report Risk A third component of the risk management process is risk monitoring and reporting. The risks to which a firm is subject can change for two reasons. The first is a change in the composition of a company's assets or liabilities. To monitor changes in risk arising for this reason, firms generally rely on simple tools such as open position reports, statements of current payables and receivables, and the like. But the risks affecting a firm may also change simply because the factors affecting the cash flows on its assets or liabilities (or the discount rates for those cash flows) fluctuate. In the case of our company, the jet fuel risk profile could change either because additional fuel must be purchased above the company's baseline natural risk exposure estimate or because rising prices increase the cost of existing purchase requirements. Our company, however, may monitor its jet fuel risks significantly less often. Not only does the risk profile of the airline change more slowly, but the firm may not be willing to incur the costs to control its risks more often than, say, monthly or quarterly. Control Risks Closely related to risk monitoring is risk control, or the actions our firm may take to keep its actual risk profile at or below its risk tolerance. Sound risk control decisions are only possible when the measurement and risk monitoring/reporting parts of the process are working properly. In other words, unless our firm can compare its actual risks to its risk tolerances, we cannot determine whether actions should be taken to reduce those risks except on a purely ad hoc basis. In some cases, a company's risk control response to a divergence between actual and desired risk exposures may be to take no action. If the cost of closing the gap is larger than the gap, for example, hedging would end up costing shareholders. Consequently, a well-functioning risk management process does not always yield actions that change the risk profile of the company. But if the risk profile of the company can be changed in a manner by which the marginal benefit of the change in exposure is equal to its marginal cost, risk management products are the means by which this is possible. Risk control can be undertaken ex ante or ex post. The former usually involves internal controls on risk-taking activities that prevent actions from being taken ex ante that would increase the risk of a company beyond its tolerance. Market and credit risk limits are typical such controls, and may require, for example, that traders seek advance approval before executing a contemplated deal that would push the firm's actual risks above its tolerance level. Risk management products like position-keeping and monitoring systems are often essential support systems for a sound system of internal controls on financial risk. Risk transformation products are also essential components of the risk control process. The company can use trading, clearing, and insurance products to close the gap between actual risk exposures and the target ex post. Purchasing fire insurance, for example, is a risk control action taken to address the natural exposure of the firm to the operational risk of fires. Similarly, our company must somehow reduce its annual natural exposure to jet fuel price increases on .5X gallons of its fuel purchases. This exposure reduction can be accomplished by going long .5X gallons of fuel using derivatives such as futures, forwards, options, or swaps. If our company opted instead to define a loss-based target to ensure that the net margin of its fuel purchases is locked in rather than a quantity of fuel, the risk management products used would still likely consist of futures, forwards, options, and swaps. In that case, however, the tactical implementation of the hedge (i.e., hedge ratio, rebalancing frequency, instrument mix) would differ from the quantity-matched hedging case. Oversee, Audit, Tune, and Realign The final component of a properly functioning risk management process is risk audit and oversight and the fine tuning of the risk management process itself. This includes everything from external audits of risk management policies and procedures to internal reviews of quantitative exposure measurement models. In essence, risk audit and oversight is the process by which the firm addresses whether or not its risk management process is working properly and efficiently. This final step in the risk management process, feeds back into the first step of risk identification and determination of risk tolerances. In other words, the risk management process is a dynamic one, with each repeated iteration involving the incorporation of information obtained in previous implementation of the process. The passage of time throughout the evolution of the risk management process is not instantaneous and can create significant differences between the expectations of senior managers and the actual implementation of the risk management process. Especially if the risk management process is time-consuming to implement initially, this stage of the process provides the critical opportunity for managers and directors to realign their goals and try to ensure that the design of the risk management process matches the current needs of the corporation. A final business process that plays a critical role in determining how well a company can leverage its internal risk management process into efficiency gains and externally supplied risk transformation products is knowledge management. Many of the risk management tools, systems, and models used by a firm in its internal risk management can be used to develop financial products, as well as supply advisory services and systems solutions to customers. But this requires careful attention to the management of information and knowledge between the various parts of the company. The need to provide some form of education in treasury matters to senior managers is imperative. The ideal credit scoring model, for example, will be of limited use if business line managers do not understand its uses and applications. Similarly, a credit scoring model developed by an internal risk manager with no input from business line managers may lack many of the features that would enable the line approval process to become more standardized and automated. To optimize the knowledge management issues related to risk management, our firm must address four dimensions simultaneously: content, process, culture, and infrastructure. Content Any approach to enhancing knowledge management must start by asking which knowledge is relevant for strategy and ongoing operations. Process Knowledge management must be institutionalized. Processes like defining and redefining objectives, creating and updating knowledge, storing and disseminating knowledge, and applying knowledge thus must become part of the standard operating procedures of the organization. Culture The definition and design of a knowledge base in terms of content and technology is often the easiest part in enhancing knowledge management. However in order to ensure that the corporate culture supports the creation and exchange of knowledge, the barriers that oppose the exchange of knowledge in the company must be assessed, especially in the context of the firm's past experience. The corporate culture must then be evaluated and possibly reframed to ensure the proposed exchange of knowledge can be supported. A key challenge for a corporate treasury that wishes to provide financial management products and services to both internal business lines and external customers is establishing the risk control parameters for how much risk the treasury will take. The role of governance in this case will be to ensure that by offering a wider range of products and services, the treasury does not assume interest rate risks that the company is unprepared to bear. At the same time, attention to knowledge, customer, and product management are necessary if the treasury is to exploit its knowledge and systems in the risk management area to serve customers through enhanced relationship management and product offerings. Incidentally, deviations between actual and tolerance risk levels may arise without any failure in the risk management process and without any change in stakeholder risk tolerances. Deviations between actual and desired exposures may change purely as a result of unexpected market movements. Changes in financial markets can also precipitate changes in the behavior of prices, correlations, corporate credit spreads, and other variables that may cause actual market behavior to deviate from what a firm earlier assumed about market behavior in its risk measurement and monitoring, capital allocation, and performance evaluation processes. Derivatives have in all probability been around for as long as people have been trading with one another. Forward contracting dates back at least to the twelfth century, and may well have been around before then. Early forward contracts were economically no different from the ones used today. Merchants entered into contracts with one another for future delivery of specified amounts of commodities at specified prices. Merton refers to this as the "financial-innovation spiral," which he defines as follows: "As products such as futures, options, swaps, and securitized loans become standardized and move from intermediaries to markets, the proliferation of new trading markets in those instruments makes feasible the creation of new custom-designed financial products that improve "market completeness"; to hedge their exposures on those products, their producers, financial intermediaries, trade in these new markets and volume expands; increased volume reduces the marginal transaction costs and thereby makes possible further implementation of more new products and trading strategies by intermediaries, which in turn leads to still more volume. Success of these trading markets and custom products encourages investment in creating additional markets and products; and so on it goes, spiraling toward the theoretically limiting case of zero marginal transactions costs and dynamically-complete markets." (Merton, 1993) The risk management process will fail if there is a lack of mutual understanding between stakeholders of the firm, the owners of the risk management process, and risk owners themselves. Consider, for example, the firm has senior managers' and directors' approval to engage in a long-term commodity sales project and uses futures to hedge its major exposure to financial catastrophe, for example, spot price risk. At the same time, suppose the firm-again with the approval of senior managers and directors-attempts to exploit a perceived comparative informational advantage in the basis and thus opts for a hedge that is designed to maximize the gains from basis trading while simultaneously protecting the project from spot price risk. The managers of the commodity program may believe they have the commitment of managers and directors to fund all the margin calls that might occur on the hedge in the short run. If large margin calls occur early in the life of the program and are accompanied with basis trading losses, management may fail to produce the funds required to sustain the program and pull the plug on the hedge. Such a situation could arise either because senior managers thought they understood the risks and business objectives of the program but did not or because the managers of the commodity program failed to articulate all the dimensions of the risk of the program to managers ex ante. Either way, the result of the premature hedge liquidation is a major unexpected unhedged long-term commodity price exposure. (Culp and Miller, 1995a, b) References Culp, C.L., and M.H. Miller (1995a) "Blame Mismanagement, Not Speculation, for Metall's Woes" European Wall Street Journal. Culp, C.L., and M.H. Miller (1995b) "Hedging in the Theory of Corporate Finance." Derivatives Quarterly, 8, 1. Merton, R.C. (1993) "Operation and Regulation in Financial Intermediation: a Functional Perspective." Working Paper 93-020 (Harvard Business School). Bibliography Culp, C.L., and M.H. Miller (1995a) "Blame Mismanagement, Not Speculation, for Metall's Woes" European Wall Street Journal. Culp, C.L., and M.H. Miller (1995b) "Hedging in the Theory of Corporate Finance." Derivatives Quarterly, 8, 1. James Barrese, Nicos Scordis (2003) "Corporate Risk Management" Review of Business. Volume: 24. Issue: 3. Publication Year: 2003. Page Number: 26+. COPYRIGHT 2003 St. John's University, College of Business Administration; Merton, R.C. (1993) "Operation and Regulation in Financial Intermediation: a Functional Perspective." Working Paper 93-020 (Harvard Business School). William L. Ferguson, Michael Theil "Risk Management as a Process: An International Perspective" Review of Business. Volume: 24. Issue: 3. Publication Year: 2003. Page Number: 30+. Read More