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The aviation industry has experienced tremendous growth over the last 5 decades. It is responsible for transformation and shaping of the world economies in great frontiers. Individuals, corporate investors and governments have spent billions of dollars in it development and sustenance. With the world economies and globalisation taking centre stage, it is a critical industry which rakes in billions of dollars in revenues. Being a high investment venture, it is also exposed to numerous risks in terms of losses. It is associated with high expenses which can bring about losses in business if stringent and strategic measures are not taken. Many airlines have fallen victim to huge losses that have seen eminent closure. Success of the industry is subject to diverse issues which affect its dynamics in different regions where it operates .For instance the status the world economy is critical in determining revenue channels that airlines utile to stay afloat and in business. For instance, during the 2008 global economic crisis, some airlines were hard hit which led to dwindling revenues and profits as well. Income flows cannot b guaranteed and hence critical measures have to be taken to protect the industry (Pierson & Sterman, 2013, . Hedging in the industry is one way which the industry utilises in ensuring continuity during times of high risk. The industry is associated with high costs in inputs and maintenance. It is further subjected to international regulations which are meant to maintain sanity in the industry. Estimated future cash flows in the industry are affected by these risks which make edging necessary in order to achieve expected goals. Different hedging products are used to cater for different risky situations. This report seeks to identify such products and their applicability in different aspects of the industry.
To avert losses that may be caused by different dynamics of the industry, different hedging mechanisms have been developed to protect the industry
The petroleum industry is a volatile industry which determines how many industries run in the world. World dependence on oil and oil products has been on the increase. The volatility of the industry has affected the aviation industry great heights. Fluctuation in prices has been constant and unpredictable. Jet fuel accounts for a significant percentage of recurring costs for the aviation industry. Constant fluctuations are therefore unhealthy for the industry. In order to keep up with the volatility, it would require airlines to adjust their pricing mechanism from time to time which is not only inconvenient but impractical. Airlines have no control over the pricing and hence have to adjust accordingly to fluctuations. Fuel hedging is carried out in different ways where the most beneficial strategies are chosen. In this regard strategies such as over the counter and exchange traded derivatives are used. Collar structure, primary derivatives and swaps are also used due to their customizable nature (Lucey & Berghöfer, 2013, 129). They are traded with financial institutions such as commercial banks where counterparty risks are considered. As a result, more than one financial institution is normally used in order to spread the risk probability evenly. Such hedging is based on the presumption that the oil industry follows a reverting cycle and is not single directional. It is therefore critical to have an understanding of the cycles in the industry in order to create optimum hedging measures. The intention is to lock in prices when they are at low points and avert high costs when they sore. Where derivatives are not possible future contracts can be used instead. This means that contracts are drawn to supply oil and its products to airline companies based on a fixed price despite fluctuations that may occur within the time of the period of the contract. Complex numerical and statistical are used when coming up with pricing mechanisms to be used over the contract period (Shapiro, 2008, 16).
Exchange Rate Risk Hedging
Apart from fuel expenses, the aviation industry is also faced with volatility associated with operating on an international frontier. This means that materials and equipment has to be sourced from foreign countries which exposes exchange rate risk. The foreign currency exchange rates are dependent on individual mechanisms and economic abilities of the countries. This has the potential of affecting foreign trade when fluctuations occur unexpectedly. The aviation industry therefore relies on mechanisms applied by their trading partner, which they have no control over. Assumptions and forecasting is dependent on the stability of trading patterns which is not guaranteed. This necessitates hedging in order to protect against losses that may accrue from such fluctuations. Dealing with multiple foreign currencies calls for accurate oversight and strategies for individual currencies. Revenues are also affected when exchange rates fluctuate; which may lead to lower profits in the long run even with constant pricing. In order to curb this, airlines use the most stable currencies in their valuation and ticketing strategies. In this regard, consumers are required to use stable currencies such as the US dollar, the Sterling pound or the Euro (Morrell, 2013). To hedge against exchange rate fluctuations, forward contracts are used where stranded pricing is used for commodities to be delivered in future. Cash backs are also accommodated in case fluctuations reach certain levels according to signed agreements. This means that the industry is compelled to take measures in their supply chain and logistical mechanisms that allow for reasonable and constant pricing over specified periods of time. Other exchange rate hedging strategies used include foreign exchange options where the players in the industry can acquire goods and services at a predetermined and agreed exchange rate within a specified period of time. Premiums are however, paid in order in order to access such privileges. Further currency swaps between different trading partners are used in order to facilitate business between them. International banking associations play a critical role in the hedging exchange rate hedging strategies as facilitators, advisors and implementers.
Interest Rate Risk Hedging
Due to the vast nature of financial requirements in the aviation industry, organisations rely heavily on loans in order to finance their operations. Different financial tools are used and are sourced from different institutions both locally and internationally. Such financing options are both on long term and short term basis. Fluctuation in interest rates could render losses to aviation organisations especially on long term agreements. Lower interest rates are favourable for the industry while rising rates are unfavourable. As a result, hedging in this perspective intends to prevent a rise in future interest expenses that may accrue. Due to the nature of credit advanced to aviation organisations, financial institutions also risk losing if interest rates were to go too low. A balancing compromise is necessary for involved parties in order to minimise losses either way. Fluctuations in interest rates are usually accompanied by fluctuations in exchange rate as well. Therefore, hedging in interest rates goes hand in hand with foreign currency hedging exchange risk. Forward contracts are basically used to hedge against interest rates fluctuations. A fixed interest rate is paid and a floating rate equivalent to the reference rate is received (Weiss & Maher, 2009, 362). Credit repayment is based on a notional principal amount which is made at reasonable intervals as determined by the parties. Short term credit is also used where hedging is not necessary. The total principal amount is divided into several periods where principal plus amount is repayable at a slightly higher rate which is meant to cater for the cost of hedging. Interest rate swap are also used where parties agree to exchange future cash flows by paying fixed interest rates and getting floating rates.
Due to the volatility and dynamism of the aviation industry, hedging is critical in safeguarding investor interest and maintaining sustainability as going concern ventures. Fuel costs are ranked second in terms of recurring expenditure for airlines. The volatility of the petroleum industry poses threats to increase in production costs which translate to low profitability or even losses. Oil prices which are regulated by oil producing countries under the umbrella of OPEC are subject to fluctuations which affect the industry on a regular basis. In this regard, fluctuation of oil prices is a major issue that airlines have to deal with in their conduct of business. When oil prices are low, airlines experience massive reduction in costs which enables them to prepare for fluctuations in future. Reserves retained during this period come in handy when prices are high. For instance Southwest Airlines was experiencing dwindling profitability attributed to high cost of fuel. The trend continued for close to two years and the airline was facing an eminent financial crisis as it had to meet other financial obligations as well. The airline experienced a 44% increase in fuel per available seat-mile. The airline at this time did not employ any hedging measures against fuel prices. Rival companies that applied hedging strategies were protected during this period as oil prices rose by over 200%. At this juncture the airline was experiencing a rise from $0.5 to $ 0.8 per gallon which was the highest since 1984 for the company (Heskett & Sasser, 2010, 1910).The company was direly hoping for the prices to come down but they could not be certain about the future, especially regarding oil prices. Further to this detriment, most of the world oil resources are located in the Middle East which is a highly volatile and politically unstable region. Further increase in costs would have seen a fully fledged financial crisis for the airline. However, an intervention program through hedging was developed to avert further losses. In this scenario vanilla swap where a floating price argent with suppliers over a specified period of time would have corrected the situation. In this case, a specified amount of fuel would be delivered at a specified price during the agreement period. Differential swaps could also be used on heating oil against jet fuel (Heskett & Sasser, 2010, 1911). Given the dynamics of pricing Southwest Airlines could also have used a call option where it would order for quantities of oil at specified favourable prices over a given period and pay the cost of such agreement.
In the wake of the 2007 2008 global financial crisis, many airlines were hard hit due to rising costs and declining passengers and cargo. Profitability in this period was minimal with immense losses being realised. Airlines with huge debts were especially hard hit due to the burden of financing credit at higher interest rates which became the norm. In this regard, airlines required more cash flows in order to come out of the situation. With high credit costs, at the time, it became even more difficult to access such credit. Lending institutions became sceptical and employed stringent measures during the period. This was due to the high rate of default that was being experienced then. Analysts asserted that the situation was temporary and would improve over time. As a result interest rates were expected to normalise over time but financing was urgently required in the aviation industry. In such situations, it was critical for airlines to negotiate interest rate hedging agreements that would see them avoid paying high interest rates for long term credit (Zeidan, 2012). In this view, capped repayment agreement was a viable solution which could see airlines get the financial assistance and repay at reasonable rates
Hedging Event and Profitability
American Airlines is one of the largest carriers in the world. In 2014 the airline took a huge risk in buying fuel for its airlines through a hedging strategy. The company reported 115% rise in profitability which was mainly attributed to sourcing cheaper fuel through the period. With falling oil prices, the company had entered into an agreement with supplier which saw it acquire the product cheaply for its operations. The hedging strategy enabled the airline to get oil cheaply than its major competitors. In this case, the airline was able to get oil at lower market prices in comparison to airlines that had locked in higher prices. The profitability that accrued from this was estimated to be over $ 600 million (Martin, 2015). This was one of the best performing years for the airline which sought to reinvest the proceeds in order to cater for future fluctuations which are uncertain. From this instance, the advantages of hedging or failing to hedge are drawn.
Ideal Hedging Strategy
As discussed earlier, the airline industry is a critical one where huge investments are at risk of losses due to volatility of the dynamics affecting it. In the contemporary environment, hedging is not only critical but necessary. The risk of not hedging is high and has the potential of leading airlines to bankruptcy in the long run. Airlines can choose not to hedge and gain tremendously from so doing. However, such benefits are short lived and can easily be wiped out when cost sore to unmanageable levels. Second from labour costs, petroleum costs account from the highest expenditure in the industry. It is therefore critical that forecasting is done reading fuel costs and appropriate hedging implemented. Though hedging is expensive for airlines, not having it altogether is more expensive. Accuracy in trends is also significant in ensuring that hedging costs are worthwhile and fuel acquired is at reasonable prices all the time (Sebehela & Madimabe, 2009). Due to the extensive financial activities hedging against exchange rate fluctuations and interest rates is also advocated for, especially for global multinational airlines.
Heskett, J. L., & Sasser, W. E, 2010, ‘Southwest airlines: in a different world’,Harvard Business School Entrepreneurial Management Case, (910-419).
Lucey, B. & Berghöfer, B. 2013, Fuel Hedging, Operational Hedging and Risk Exposure- Evidence from the Global Airline Industry, Federal Reserve Bank of St Louis, St. Louis.
Morrell, P, 2013, ‘Airline finance’, Ashgate Publishing, Ltd.
Martin, H, 2015, ‘American Airlines’ fuel-buying bet pays off in record profit’, Los Angeles Times
Pierson, K., & Sterman, J. D, 2013, ‘Cyclical dynamics of airline industry earnings’, System Dynamics Review, vol 29, no. 3, pp. 129-156.
Shapiro, S. 2008, “Airlines hitting financial turbulence amid soaring prices for aviation fuel”, Business insurance, vol. 42, no. 37, pp. 16-16,18.
Sebehela, T., & Madimabe, K, 2009, ‘Airline Hedging Using Derivatives’, ICFAI Journal of Derivatives Markets, 1(2).
Weiss, D., & Maher, M. W, 2009, ‘Operational hedging against adverse circumstances’, Journal of Operations Management, 27(5), 362-373.
Zeidan, R. M, 2012, ‘Hedging and the Failures of Corporate Governance: Lessons from the Financial Crisis’, Available at SSRN 2011297.