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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 (BGP), 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”.

METHODOLOGY

Methodology refers to the philosophical basis on which the research is founded and the technique used to collect the data is the method. (White 2005)

The methodology adopted in this thesis is the analysis of secondary data with the aim of establishing whether the any of the theories relating to the effect of currency will be present in airline foreign exchange risk.

Secondary data as described by Saunders. M (2007) is used to illustrate “descriptive and explanatory research and may contain raw data which has little or no processing or complied data that have received some form of selection or summarising” The secondary data for this thesis will be drawn from different airlines around the world and how they manage risk will be carried out.

A hypothesis question will be drawn on the information. The information will be analysed using different airline strategies to help identify a correlation between the two variables. An example of the hypothesis question is illustrated below:

H1: Foreign exchange risk has a significant effect on the airline industry

VS

H2: Foreign exchange risk does not have a significant effect on the airline industry.

As there are limitations to the data available a cross section of hypothesis will be carried out. Example, airline foreign exchange against or actual currency market share prices.

The analysis of the information will aid in achieving the objectives of the thesis.

RESEARCH QUESTION

The project is important as it aims to identify the relevance of airline hedging strategies in an up-and-coming market where mainstream of the airlines choose to hedge fuel for a set amount of time with no instants outflow of cash.

The proposed study would be concerning with the following questions:

How does a multi currency affect the airline industry?

Does aircraft cost affect airlines foreign exchange?

How can airlines win through the turbulence of foreign exchange?

DESCRIPTION OF DATA ANALYSIS

Interviews will be transcribed by listening to the audiotape while reviewing the transcript word by word. During this process, all personal identifiers will be removed and a subject/interview code will be assigned to protect confidentiality. The researcher will code the content to look for common responses, ideas and feelings expressed in the interviews. A second and third person will also analyse the tapes and their transcripts in order to check any coding carried out and subjective biases in analyses. In the data analysis below, pseudonyms will be used to protect respondents’ identities (Bowling, 1997).

Every method used in data collection could be susceptible to problems, distortions and errors (Sarantakos, 1998). Despite the popularity of the interview in qualitative research, problems remain. Such errors are serious and can have effect on the quality of the data. Therefore researchers should particularly be aware of the ways in which such problems can occur and must prevent them happening as much as possible (Creswell, 1994).

Errors may occur during the recording of data and are associated with incomplete responses, misunderstanding of the respondent and the early or late responses to questions asked. Errors may also occur when extremely negative or positive responses are avoided and when loss of objectivity caused by knowing the respondent leads to a mild evaluation of responses. Furthermore, showing consent or rejection of responses while collecting data, forgery of parts of the data and withholding information collected may offer opportunities for problems and errors to distort the data analysis and interpretation. Threats to validity are minimized through careful attention to interview techniques, transcription and analytic process.

In order to analysed and present qualitative data, the researcher will have to be familiar with field notes, the tape recordings and their transcriptions and any other data collected. Making sense of the raw data collected in order to analyse and present can be challenging and expensive. After collecting, collating, analysing and interpreting the data, the findings of the study will be presented. The findings of this study will be presented in a narrative manner by analysing the data under each question.

ETHICAL ISSUES

Even though as a member of staff of an aviation company where I proposed to conduct the study, I have to be mindful of ethical considerations. One of my concerns is that of informant consent. As Grieg and Taylor 1999) suggested that in words they would understand, ensure that the subjects/ sample know what they are doing and enlighten the sample on the research and my role as a researcher and there in the matter. I will be sure to highlight that they are free to withdraw at anytime without any detriment. However, further make known to the sample what will be done with the data and who hear it.

Another ethical concern is that of access to setting. According to Cohen and Manion (1994), permission must be seek from first the anonymous responsible for the sample, then the sample. However, permission from the head of the department for permission to use the company lounge and the members, provision to provide an informed letter from the university and also personally acquaint the year tutor with the proposed topic and procedure.

In most research, samples are preferred to be anonymous. Therefore consent for confidentially and privacy would be maintained. Real names will not appear in report /write up and other identifying information will not appear.

Cooperation shall be a priority and do not take advantage of the power relations between employers and the staffs.

IDENTIFICATION OF POTENTIAL PROBLEMS AND LIMITATIONS OF THE STUDY

Time constraints of the semester and job call for less time than maybe sufficient for an aviation study. By being in an aviation company for only seven months, there are hurdles. The company culture and leadership practice pose limitation for vital information that could help the study. The terms and condition of the company led to screening of some information gathered during the interview. the reason for this action was to protect the company’s brand and position in the aviation industry.

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