Transcript ABC AIRLINES

Andy Seputro
0849057
Eni Ambarsari
0849021
Mera Puspita Sari 0747047
Subo Sumbogo Jati 0849052
INTRODUCTION
 Risks are divided into:
 Core business risks
Firm has at least some direct control
 Environmental risks
Firm has little, even no direct control
Strategic Risks
 It includes a variety of risks, that are:
 Inventory price risk
 Transactional price risk
 Translational price risk
 Competitive price risk, and
 Anticipatory price risk
Airline Business
 The price risk obviously come out from the exchange rate
between its functional currency and the currency of its
ticket sales.
 Fluctuations in exchange rate also influencing the
competitive price risk, because fluctuations in exchange
rates make travel to other countries either more or less
expensive, exclusive of air fares.
 By using fixed rate debt, it would influence the revenue of
the company itself. Because both of revenues and interest
rates are positively correlated. This correlation constitutes a
strategic risk.
Risk Management Technique
 Strategic risks can be managed in several ways, there
are:
 To pass the risks along to customer
 By way of asset/liability management
 By hedging: either with futures, forward, swap
Quantifying Strategic Risks
 The first step is identify the risk
Because if we are unaware of their existence then we
cannot begin to measure and manage the strategic
risks.
 The second step is quantify the risk
Converting Price Risk to Performance Risk
 A price risk, measured as the volatility (standard
deviation) of a price or, sometimes, as the volatility of
the rate of change in the price, is a risk that exist
independently of a given firm’s exposure to that risk
The Tools of Hedging
Futures
1.
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Has standardized contract for the deferred delivery of
a given quantity of some underlying asset
Delivery is scheduled during some specific period of
time for a price agreed to at the time of initial
contracting
Trade on future exchanges
The Tools of Hedging
Forward
2.
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Same as futures
But the contracts are less standardized and trade in
dealer-type markets
Both Futures and forwards are very good at
eliminating price risks that are of single-period
nature.
The Tools of Hedging
Swap
3.
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A series of exchange between two parties, called
counterparties.
The first counterparty pays the second counterparty a
fixed price, or rate, on a given quantity of some
underlying asset. In exchange for these payment, the
second counterparty pays the first counterparty a
floating price, or rate, on the same underlying asset.
The underlying assets are called notionals.
Swaps are very good at eliminating price risks
that are multi-period nature
The Tools of Hedging
Option
4.
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Is a right but not an obligation to do something or to
receive something
Two types of single period options that are call and
put options
The multi-period counterpart of a call option is called
a cap, and the multi-period counterpart of put option
called a floor
Options are used to eliminate only negative
deviation from an expected outcome.
The Airline Industry
 Early 1990s:
 Declining
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consumer confidence and an economic
recession, both of which cut into ticket sales and hurt
revenues.
Further aggravated by the Iraqi invasion of Kuwait and
the strong U.S. military response
Dramatic rise in the price of fuel
the other problem is the age of fleets with an average age
of 15 years old
In addition, older aircraft are as much as 30 to 35 percent
less fuel efficient than newer aircraft
More intensive price competition because of the
deregulation of the airline industry during 1980s.
The Airline Industry
 The decline in revenue and the increase in cost
occurred at precisely-the wrong time for the airline
industry.
 Because of the deregulation of the airline industry
in 1978, the industry had passed through an
extended period of restructuring
 By the middle of 1991, some of the oldest and most
staid carrier, including East-era, Pan Am, and
Continental had gone bankrupt, as had some of
the niche carriers like Midway.
ABC Airlines
 Was launched by a small group of pilots and investors in
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1980
From the beginning, management concentrated on
keeping fares low, operating costs down, and debt down.
Average salaries at ABC have long been 25% below those of
other airlines, but total compensation, after profit sharing,
is about the same
The 1981-82 recession made ABC’s start up difficult
By the middle of 1983, ABC was in good stead and
positioned nicely for the boom of the 1980s
Strategic Planning Committee Preliminary Risk
Management Report (August 1, 1991)
 The Economy
 At summer 1991, the economy appears to be nearing the
bottom of the recession that began in July 1990.
 Stagnation was caused by the reluctance of the The Fed
to stimulate the economy through lower interest rates
out of a fear of igniting inflation.
 Despite the weaker US economy, relative to Europe and
Japan, the dollar has recently been gaining strength.
 Economic forecasts:
 A double-dip recession with the worst yet to come. (current
banking crisis, the federal and states budget crises, high
unemployment and low consumer confidence.
 Interest rate have already hit bottom and that the Fed will not
lower rates again due to concerns over inflation.
 The downturn they foresee for the US economy is a prelude to
international economic problems.
 Optimistic economists: the strength of the US economy.
 International ecnomy is not at all bleak and the current
uncertainties merely represent a natural apprehension associated
with significant structural change.
 The opening of Eastern European markets is an ambiguously
positive economic development.
 Risk Management Strategies
 ABC airliness is exposed to a number of strategic risks that have
been shown to significantly impact EPS.
 Need to develop a more complete model of the firm’s exposure
that considers the interrelationship among the risks.
 In the interim, we should begin managing the risks
individually, such as:
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oil price risk
Interest rate risk
Exchange rate risk
 Oil price risk
 ABC spends approximately 36-40% of its operating budget on
fuel, more than the average airlines.
 The discrepancy is explained in part by age of ABC’s fleet and
in part of ABC’s ability to keep our other costs, notebly
employee compensation, down.
 Any increase of fuel prices impact ABC’s earnings directly
and quickly.
 Several hedging alternatives, there are:

Future Contract: the advantage is that the size of our hedging can easily
be adjusted to address changes in anticipated fuel usage. We must
prepared to deal with daily variation margin. It will also eliminate our
opportunity to benefit from any unexpected decline in the price of oil.
Commodity Hedge: enter a multi-period swap agreement with a
commodity swap dealer. The advantages: the swap dealer is
prepared to enter a swap tied specifically to jet fuel rather than to
oil and there will be no variation margin (no need to maintain
extra liquidity).
 Multi-period option on jet fuel. While the option strategy
(commodity cap) involves a substantial up-front premium, it has
a unique advantage of allowing us to benefit from any
unexpected declines in the price of jet fuel.
the up-front option premium that we would have to pay to
acquire the jet fuel cap would represent a sizable outlay for the
firm. Judy suggest that ABC consider employing a combination of
all three.
 It’s time to modernize the fleet.

 Interest Rate Risk
 At present ABC are carrying $320 million of intermediate to
long-term debt with fixed rate of interest. This debt has an
average maturity of 8 years and carries an average coupon of
10.25%. ABC also have $21 million of floating rate debt with an
average maturity about 3 years. Most of ABC’s debt is pegged to
LIBOR with an average rate of LIBOR plus 150bp. The remainder
is pegged to prime rate with an average rate of prime rate plus
75bp.
 While floating rate debt has the advantage in a stable, upwardsloping yield curve environment, of keeping borrowing costs
down, it can also add significantly to ABC financial costs should
interest rate move higher as some economist are predicting.
 Ticket revenue are positively correlated with interest rate. A
statistical decomposition suggest that the correlation is highest
when we allow for 3 month interest rate lag.
 ABC could reduce firm’s overall interest rate sensitivity if revamp
their financing strategy.
 Despite the treasurer’s occasional protestations, the interest rate
never been a major issue for this airline.
 Suggestion:
 raise $0,4 billion by selling additional equity and raise the remaining $1
billion by the sale of debt.
 Sell the debt as fixed rate debt and then employ an interest rate swap to
convert it to floating rate debt.
 The choice of selling debt directly as floating rate debt or as fixed
rate swapped into floating rate debt depend on the all in cost of
these financing alternatives.
Exchange Rate Risk
 The Problem resulted from exchange rate risk are:
It is even more difficulties to adjust international airfares
than it is to adjust domestic airfares in responses the
changing market prices.
We have marketed our international services almost
exclusively to Americans.when the dollar weakens our
ticket sales to American travelling to Europe decline
precipitiously.
Cont’d…….
 The several suggestion to solve that problem are:
The company need to asses the impact of exchange rate on
the firm’s revenue in dollars after adjusting the expenses
The company need to develop hedges that could be used to
offset the exchange rate risk including
the
transactional,translation,and the competitive risk.
 They should consider a focused marketing effort to
capture a larger share of the European travel market.
Benefit of Hedging
 Tax Related that is on average a firm with less variable before tax
profits will pay less total taxes over time than will a firm with the
same average, but more volatile, before tax profits. Thus less
volatile profits imply a higher after tax corporate value.
 Hedging lowers the probability that the firm will go bankrupt
and thus incur bankruptcy cost. Hedging will therefore add
value by reduction the expected future cost of bankruptcy.
Hedging reduce the likelihood of financial distress and therefore
preserves management flexibility.
 When management compensation is tied to market value of the
firm, management has a natural tendency to be more risk averse
and therefore derive great personal value from hedging.
Nomor
1 :
Sebagai ilustrasi
Perusahaan ingin meng-hedge 2 juta galon bahan bakar.
Kemudian untuk korelasi antara perubahan harga futures
tersebut dengan harga bahan bakar pesawat (r) adalah
0,928. sedangkan standar deviasi perubahan harga aset (Ss)
0,0263 dan harga futures (SF) 0,0313.
Dimana : h* = r (Ss / SF)
h* = (0,928) x (0,0263 / 0,0313) = 0,78
Cont’d....
 Misalkan besarnya satu kontrak futures minyak adalah
42.000 galon minyak, maka jumlah kontrak futures yang
harus dibeli adalah :
N* = 0,78 (2.000.000 / 42.000) = 37 kontrak
Kemudian jika standar deviasi futures dengan spot sama,
maka jumlah kontrak yang dibutuhkan adalah :
N* = 1 (2.000.000 / 42.000) = 48 kontrak
Payoff profile for one-period of a
jet fuel cap
ABC’s Residual Risk Profile with Jet
Fuel Cap
Kontrak future
Nomor
2
 Dengan meng-hedging
minyak masa depan dalam
bentuk kontrak future minyak, ABC dapat
mengeliminasi hampir semua ketidakpastian dan
hampir tidak mengeluarkan biaya.
 Ukuran dari hedge ABC dapat dengan mudah
di
adjust/disesuaikan
sesuai
dengan
perubahan
penggunaan minyak/bahan bakar.
 Futures membutuhkan likuiditas yang lebih banyak,
akan menghilangkan kemungkinan dari mendapatkan
keuntungan apabila terjadi penurunan pada harga
minyak
Cont’d....
Comodity Swaps

ABC akan melakukan perjanjian multi-period swap dengan swap
dealer.

Resiko dasar yang lebih rendah dibandingkan dengan future, dan
tidak akan terjadi margin yang bervariasi jadi tidak dibutuhkan
maintain likuiditas extra.

Kelemahan dari swap, antara lain: tidak mudah meng-adjust untuk
perubahan pada kebutuhan fuel dan terbukti sedikit lebih mahal.
Perpanjangan swap dari 16 bulan dapat menjadi masalah.
Multi-period options

Meliputi up-front premium, memiliki keunggulan yaitu ABC dapat
mengambil keuntungan dari unexpected decline harga jet fuel.

Up-front option premium berarti ABC harus membayar untuk
memperoleh jet fuel cap akan menunjukan outlay (pembiayaan)
yang cukup besar untuk perusahaan.
Nomor 3
Setiap metode hedging memiliki kelebihan dan
kekurangan masing-masing bagi ABC, seperti dapat
dilihat pada kasus oil prices yang dijelaskan pada
penjelasan di nomer 2 dan pada penjelasan kasus
interest rate pada nomor 4.
4. Explain clearly why Judy Waters concluded that ABC airlines has
an interest rate risk exposure. What are the sources of this
exposure and how does Judy Propose to deal with it? Does her
strategy seem reasonable? What opportunities does the firm
surrender if it adopts Judy’s plan?
Answer:
based on airline’s financial history, ABC’s ticket revenues are
positively correlated with interest rate. 3 month interest rate lag,
revenues begin to rise, on average, about 3 month before interest
rates begin to rise, means our revenues lead interest rates about 3
months. The interest rate effect on our revenue is quite
pronounced. Source of this exposure is sensitivity of interest
rate to firm’s revenue.
Judy’s suggest that the firm sell floating rate debt or sell fixed
rate debt and then employ an interest rate swap to convert it
to floating rate. Her strategy seem reasonable. The
opportunity may ABC get is a stable EPS when they sell
floating rate debt than if they sell fixed rate debt, it clearly
describe in exhibit 10-13 and 10-14.
5. The net exposure can be hedge in some methods are:
a. Currency futures,so that the change of interest rate can’t
influence of financial perform,they can make to enter futures
contract that is short futures,if the interest rate increase,value
of bond will be decrease,but future will get the profit .the loss
of spot will be compensation of profitable of futures position.
b. Forward contract ,they can use with combination short and
long position.if the currency weakness the company take short
$ position will be loss and converse.if the company take the
long $ position if the currency weakness they can get profit and
converse.
c. Currencu option, they can buy call option from $.it have
caracteristics if the market price of assets increase so they get
profit because take call option.if the mark of $ increase they get
the profit,that use to close loss from spot position.
Cont’d……
d. Currency swap,cash flow exchange from two company it
influence about unexpected condition of interest rate.each
company can do swap it will be part of asset or credit side
depend on needed of company.swap use term to decided
the ability to swap detail it based same position of present
value of swap cash.
advantage of hedging
• Hedging using futures and options are very good short-term
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risk-minimizing strategy for long-term traders and investors.
Hedging tools can also be used for locking the profit.
Hedging enables traders to survive hard market periods.
Successful hedging gives the trader protection against
commodity price changes, inflation, currency exchange rate
changes, interest rate changes, etc.
Hedging can also save time as the long-term trader is not
required to monitor/adjust his portfolio with daily market
volatility.
Hedging using options provide the trader an opportunity to
practice complex options trading strategies to maximize his
return.
Disadvantages:
 Hedging involves cost that can eat up the profit
 Risk and reward are often proportional to one others, thus
reducing risk means reducing profit.
 For most shorter trader, example A day trader hedging is a
difficult strategy to follow
 If the market is performing well, then hedging offer little
benefit.
 Trading of options or future often demand higher account
requirement like more capital.
 Hedging is a precise trading strategy and succesful hedging
requires good trading skills and experience