Risk Management by Airlines

Sunny Jain
01001010
Introduction

„ Risk
„ Defined as the combination of an event and its consequences
„ Can give rise to opportunities for benefit or threat to success
„ In statistical terms, defined in terms of the variance of actual
returns around expected returns

„ Risk Management
„ Provides framework for future activity to take place in consistent
and controlled manner
„ Improves decision making, planning and prioritization of business
activity
„ Contributes to more efficient allocation of capital and resources
„ Protecting and enhancing assets and company image
Risks Management Process
• Problem definition, along with
identification of associated issues.
• Defining the associated Risks
• Formation of team, and allocation
• Risk Scenarios are developed using
of resources and assignment to
information
• Probabilityfrom sources such as:
and consequences of
them.
• Personal
various risk scenarios
Experiences,discussed
Shared Expertise
• Establishment of process for the
• • Risk Indicators
Uncertainties
involvement and still exist
(from even of
Inspection
consultation on
• Manuals)
Estimatingofofaccurate
the benefit and costs
availability
stakeholders. information
• Flight
associated Training & Aviation Education
about the risk
Database
• Decision is taken if
• Various options for mitigating risks
•the risk is acceptable as it currently
discussed
stands,
• Contingency plans made for
•the risk is unacceptable at any level,
residual risks and
• Effectiveness of feasibility
decision of
• • the risk could
Implementation
financing these be
plansmitigated,
of the it would be
decision
discussed
monitored
acceptable over time
•
• Strategy for communicating
Provides opportunity is put
to identify
into
new play
risks and assess the impact of
changes on known risks
Risk Identification and Description

„ Risk Identification
„ Requires initimate knowledge of the airline, market of operation
„ Sound understanding of the strategic and operational objectives of
the airlines
„ Categorization and quantification of the identified risks
„ Can be carried out by outside consultants

„ Risks faced by airlines : Classification

„ Operational Risks „ Internal Risks
„ Financial Risks „ External Risks
„ Hazard Risks
„ Strategic Risks
Key Risk Drivers (Airlines)
 Risk Estimation
„ Most risk and return models agree on two steps of risk analysis :
„ Risk comes from distribution of actual returns around expected return
„ Should be measured from perspective of marginal investor who is well
diversified
„ In most simple terms, risk quantified by frequency of risk and the
severity of risk
„ Severity measured in terms of financial losses
„ Thus the product of frequency and severity gives an estimate of the
impact of the risk
„ More accurate measurement done in terms of beta
„ Beta of an asset defined as
 Risk Estimation
„ Thus expected return on an asset written as: E(Ri) = Rf + βi(E(Rm)-Rf)
„ where E(Ri) = Expected return on asset ‘i’, Rf = Risk-free rate,
„ E(Rm) = Expected return on market portfolio, βi = beta of investment ‘i’
„ For an airline, exposure to business risks measured by regressing
stock returns, given as: Rjt = αj + ∑βjkRkt + εjt
„ where Rjt is return on jth stock, Rkt is innovation on kth risk factor
„ Major financial risks faced by airlines include changes in interest rates,
currency and fuel price risk
„ Exposure to these risks for a period of time T estimated as:
„ Rjt,t+T = αj + βjIRIt,t+T + βjXRXt,t+T + βjFRFt,t+T + βjmRMt,t+T + εjt,t+T

„ where Rj,t+T is excess return on the airlines, RI,t+T is the innovation in the long term
interest rate, RF,t+T is the innovation in the fuel price factor, RM,t+T is the part of
market return orthogonal to other risk factors
Risk Map
Operational Risks: Aircraft accident
„ The most severe risk
„ Loss of income even on occurrence of accident or
terrorist act on other airlines
„ Consequences include
„ Aircraft damages and compensation for passengers
„ Loss of business and social credibility
„ Loss of income due to decrease in passengers
„ Risk Prevention Steps
„ Aviation Insurance to provide compensation for passengers, aircraft
damages and damages to third parties
„ Airline operation through a diffusion of aircraft models to avoid
grounding risks
Operational Risks: Fuel Procurement
„ Fuel Procurement Risk
„ Refers to the event when fuel cannot be loaded
„ Unavailability of fuel on the airport
„ Delivery or purchasing delays
„ Directly affects the operations of the airlines
„ Risk Prevention Steps:
„ In addition to “delivery at loading”, fuel kept in tanks
purchased to be used in case of emergencies
„ Tankering method employed; the fuel loaded at departure
sufficient for round trip flight or till next fuel supply
Operational Risks: Fuel Prices
„ Increase of single cent in fuel price => $25 million
increase in operating expenses for major airlines
„ Fuel costs account for 10% of operating expenses
„ Hence fuel price risk hedging employed
„ Commonly used hedging contracts by airlines:
„ Swap Contracts: Plain Vanilla and Differential swaps
„ Call Options
„ Collars: zero-cost and premiur
„ Futures and forwards contracts
Operational Risks: Fuel Prices
„ Plain Vanilla Swap

„ Basically an agreement where floating price exchanged for fixed price

„ Call Options
„ Cross market hedges commonly used
„ Airline may buy option in heating oil to offset rise of jet fuel price
„ Thus the airline may have to buy the jet fuel at a higher price, but the
difference can be offset partially by selling the heating oil
„ Such type of hedges only used when the prices are highly correlated
Operational Risks: Fuel Prices
„ Collars
„ A combination of a put option and call option
„ Collar created by selling a put option with strike price below and call option
with strike price above current price
„ Thus min and max of commodity price created until the expiration of the
options
„ Futures and Forwards Contracts
„ Futures contract an agreement to buy/sell specified quantity for certain
price and designated time
„ Traded on exchange, which specifies standard terms for the contracts and
guarantees performance
„ Forwards Contracts are customized and not traded on exchange
„ Settled at maturity only, unlike futures contracts which are marked to
market daily
Thank You
References
„ Geoffery Loudon F., “Financial Risk exposures in Airline Industry”, Australian
Journal of management, Vol 29, No.2 Dec 2004
„ Carter Dave, Rogers Dan, Betty Simkins, “Fuel Hedging in Airline Industry: The
Case of Southwest Airlines”, School of Business Administration, Portland State
University
„ “Risk Management Standard”, AIRMIC, ALARM, IRM:2002
„ Damodaran Aswath, “Estimating Risk Parameters”, Stern School of Business,
New York
„ Nomura Kichisaburo, “Managing Risk in airline industry”, Japan world and the
economy, Vol 15, Feb 2003
„ Vadhindran Rao K.,”Fuel price risk management using Futures”,Journal of Air
Transport Management, Vol 5, 1999
„ http://www.tc.gc.ca/civilaviation/SystemSafety/Pubs/tp13095/Q850/