Foreign Exchange Risk in the Airline Industry

INTRODUCTION

Airline carriers sell tickets in many part of the world, and each country has different policies that govern their currencies. Countries such as the Great Britain uses Pounds sterling (GBP), Japan with Yen, and United of America with Dollar and some part in EU is on Euros. Basically airlines around the globe fly to different part of the world, and majority of these airlines have offices around the globe and which incur operating expenses in the currencies of the countries they operate. Exchange rate has become a big threat to the airline industry. The turbulence of an exchange rate makes it impossible for airlines to match in transaction and timing of foreign currency expenses.

The airlines around the globe have a huge task of managing revenues,assets, capital investments and liablities in the local and foreign currencies, Often times airlines minimise the risk of exposure to large currency. Allthough fluctuation of foreign exchange happens because of supply and demand for currency in the airline industry, however airlines must ensure that foreign exchange exposure is limited, or they face financial contrain at the end of the final year.

There are different possibilities in dealing with foreign currency exposure, is either the airlines does nothing but depends on the spot market, or hedge the risk by having a negative by buying a forward. Spot market market can be difine as a market in which currencies are sold for cash and immediately transfered to the airlines. Spot can help the airlines operates whenever an infrastructure exists for conducting transaction.

Aim and Objectives

The aim of the project is to explore the relevance of airline foreign exchange risk and identify other factors that are present currency and hedging which could affect the airline industry.

The objective below would attain the aim of the project. They are:

• To evaluate the foreign exchange risk in the airline industry
• To define how the currency issue is changing the airline past, present and future
• Review the result against the finding of other research
• Evaluate other factors how hedging on fuel has greater profit than airline purchasing fuel at current market prices.

Literature Review

The following literature review will examine this section of the research project; literature will be examined and reviewed critically.

Literature review is an analysis of previous works relating to the subject being examined. Hart considers a review to be important as it would provide an understanding of your topic, of what has already been dine on it, how it has been researched, and what the key issues are. (Bell 2005). According to a case study by Daniels, Radebaugh, and Sullivan, “3M uses operational methods for managing the foreign-exchange risk to which its overseas operations are exposed”.  In its annual report, 3M states its policy towards foreign-currency translation:  “local currencies generally are considered the functional currencies outside [domestic operations],” and therefore 3M implements a current-rate method of translation in its accounting practices (Daniels, et al, 728). [1] 

The subsequent literature review will examine the literatures which are for and against the significance of foreign exchange risk policy in decisive currency value in different countries. This review would identify the methods used and characteristics of various airline industries which have been examined with the aim to identify any variation to the theory surrounding foreign exchange risk in the airline industry. The theories will be discussed in the theoretical literature.

THEORETICAL LITERATURE

There have been researchers on the effects foreign exchange risk has on the airlines; however these researchers were generated from three theoretical literatures. The three theories provided explanation. Hedging reduces the expected cost of financial distress (Mayers and Smith (1982), Smith and Stulz (1985)).Hedging may also be motivated by tax incentives. When firms face a convex tax function, hedging should help reduce the expected taxes (Mayers and Smith (1982), Smith and Stulz (1985)). Hedging can also increase the debt capacity, therefore realising greater tax advantages from greater leverage (Leland (1998)) [2] 

According to the Financial Management (Financial Management Association), spring, 2006 by David A. Cater, Daniel A. Rogers, and Betty J. Simkins in their research that “currency had a significant effect on the foreign exchange market. Many researchers are keen to know whether the value of hedging increases in the airline industry. Allayannis and Weston (2001) examine the relationship between foreign currency hedging and Tobin’s Q. They conclude that hedging is associated with higher firm value. On the other hand, Jin and Jorion (2004) find no relation between hedging and firm value for oil and gas procedures”. Pulvino (1998, 1999) finds that distressed airlines are forced to sell aircraft at below-market prices. Froot et al. (1993) suggest that firms facing significant expected distress costs will choose to under invest”.

Based on the theories it is evident that as currencies in different countries changes, it increases the expenses of the airline and it would also increase as long as there is no equivalent decrease in the growth rate. Example, Laker Airways, one of the British airline in the 1980’s, the airline borrowed huge amount in dollars to purchase a new aircrafts, the airline eventually purchased in fixed payment dollars, unfortunate for the airline they received more than halve of the airline revenue in Pound sterling. This led the airline go bankruptcy. This illustrates how serious currency risk can easily affects the airline industry unaware.

However a rise in the payout ratio of an airline would decrease the amount of money available to be reinvested in the company to yield more profits. Therefore the growth rate would fall. It can be concluded that that an increase in dividend could have two opposing effects if the earnings of the airline has not increased inline.

They expected future and present foreign exchange risk in the aviation industry also provides a signalling effect and could affect the value of the airline capital.

For example, the way an airline collects its revenue is different to most other business transactions. According to ICAO “An airline is constantly exposed to transactions in different currencies that are different from the airlines home currency. Airlines usually capture currency of collection while processing tickets in its revenue accounting system and the will be used to determine foreign currency component and multi currency mix of sales for every route group operated by the airline” [3] 

According to the case study of Froot, Scharfstein, and Stein (1993) explained “we are the first to find empirical evidence pointing to the source of value from hedging operations. We find that the airline industry exhibits two characteristics consistent with the general assumptions the airline industry’s history of investment spending is not negatively correlated with jet fuel costs, as one might expect. In fact, the relation between these two variables is largely positive. Second, airlines face significant distress costs. For example, Pulvino (1998, 1999) finds that distressed airlines are forced to sell aircraft at below-market prices. Froot et al. (1993) suggest that firms facing significant expected distress costs will choose to under invest”.