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INTRODUCTIONRisks are divided into:

Core business risksFirm has at least some direct control

Environmental risksFirm has little, even no direct control

Strategic RisksIt includes a variety of risks, that are:

Inventory price riskTransactional price riskTranslational price riskCompetitive price risk, andAnticipatory price risk

Airline BusinessThe 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 TechniqueStrategic risks can be managed in several

ways, there are:To pass the risks along to customerBy way of asset/liability managementBy hedging: either with futures, forward, swap

Quantifying Strategic RisksThe 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 RiskA 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 Hedging1. Futures

• 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 Hedging2. Forward

• 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 Hedging3. Swap

• 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 Hedging4. Option

• 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 IndustryEarly 1990s:

Declining 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 fuelthe other problem is the age of fleets with an

average age of 15 years oldIn addition, older aircraft are as much as 30 to

35 percent less fuel efficient than newer aircraftMore intensive price competition because of the

deregulation of the airline industry during 1980s.

The Airline IndustryThe 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 AirlinesWas launched by a small group of pilots and

investors in 1980From 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: 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, upward-sloping 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 HedgingTax 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 1Sebagai 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 kontrakKemudian 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

Nomor 2Kontrak future 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 3Setiap 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 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 profitRisk 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 followIf 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