Risk Management Analysis for Air NZ

Abstract
Recent financial theories argued firms can increase their values through hedging by reducing taxable income, agency cost and the cost of financial distress. This report provides a qualitative and quantitative analysis of corporate risk management for the company Air New Zealand. We uses a time series OLS regression model. The fair value of derivatives is used as dependent variable to measure the extent of financial instrument usage. The result shows that the use of derivatives by Air NZ fails to add value to the company.

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1. Introduction
Air New Zealand Limited is the national airline and flag carrier of New Zealand. Based in Auckland, New Zealand, the airline operates scheduled passenger flights to 56 destinations locally and internationally. Air New Zealand is a member of the Star Alliance global airline alliance, having joined in 1999. Air New Zealand originated in 1940 as Tasman Empire Airways Limited (TEAL), a flying boat company operating trans-Tasman flights between New Zealand and Australia. TEAL became wholly owned by the New Zealand government in 1965, whereupon it was renamed Air New Zealand. The airline was largely privatized in 1989, but returned to majority government ownership in 2001 after a failed tie up with Australian carrier Ansett Australia. As of 2008, Air New Zealand carries 11.7 million passengers annually.

Do hedging create firm value has been a popular topic argued through decades. In this report we are going to identify whether Air New Zealand create value through hedging. In this report we are going to discover the following questions what kinds of risks are faced by Air New Zealand. How does Air NZ manage such risks and does the company hedge effectively?

The following of this report is sorted as 2.risks faced by Air NZ; 3.Air NZ risk management; 4.Air NZ hedging strategies; 5.Literature; 6.Data; 7.Method; 8.Results; 9.Conclusion and 10.Limitation.

2. Risks faced by Air New Zealand

2.1. Jet fuel prices risk: A major component of the operating cost for Air NZ is from jet fuel price which is approximately 15% of the overall costs. According to Carter, Rogers and Simkins (2004) and Loudon (2004) fuel price changes are negatively correlated to cash flows and stock returns of Airlines including the case of Air NZ. Comparatively, an increase in fuel cost can cause dramatically loss on profit as most other expenses are long term fixed such as planes, personal, etc. Thus, airlines have a few options: Increase fuel efficiency of their fleet, pass on the increase of costs to their customers or use hedging instruments to control their losses.
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However, a complication is that when airlines need fuel price hedge the most – on the edge of bankruptcy – they do not have the liquidity to buy oil futures as they can’t provide the margin requirements; they could buy options though, but again this costs cash, increasing today’s cash flow risk to avoid potential future risk. This was argued by Weiss and Maher (2009) “financial leverage and derivatives used to protect from fuel price volatility are insignificantly associated with the hedging rank”.

2.2. Foreign Currency Risk: Exchange rate risk is equally important to manage because it is related to Air NZ profitability (Loudon, 2004). Exchange rates influence the tourist numbers both internationally and domestically, it also influences the revenue and expenses incurred by Air NZ denominated in different currencies (Loudon, 2004). Aviation fuel is mostly traded in US dollar; fuel costs make up about 15% of the overall costs, so managing exchange rate risk becomes very important. Moreover, borrowings and investments of Air NZ are also denominated in different currencies (Loudon, 2004).

2.3. Interest Rate Risk: Interest rate risk refers to the risk of loss to Air New Zealand due to fluctuations in interest rates. Interest rate changes directly affect the borrowing costs. Interest rates changes are of significance to Air NZ because debt financing is extensively used. Air New Zealand has the exposure to interest rate risk because of ongoing activities relied on the long-term debt. Moreover, direct and indirect costs of borrowing are directly related to interest rates (Loudon, 2004). Air New Zealand has exposure to interest rate risk as a result of the long-term borrowing activities which are used to fund on-going activities.

2.4. Credit risk: “Credit risk is the potential loss from a transaction in the event of default by a counter party during the term of the transaction or on settlement of the transaction”. Credit risk can be divided into three types: credit default risk, concentration risk and country risk. Credit default risk implies there is a possibility that the borrowers cannot fully pay back their loan obligation.
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Concentration risk means that the risk associated with one single group have the potential to make a loss that is enough to threaten the bank’s operation. And the country risk occurs when a sovereign state cut off their foreign currency payment which would incur a huge loss. In Air NZ’s context this risk arises from trade receivable and other financial instruments.

2.5. Liquidity risk: Liquidity is also considered as a significant role in the risks that they faced. It can be divided into two types: funding risk liquidity and market liquidity risk. Funding liquidity is a normal concern that whether there is enough cash to meet the paying requirement. And market liquidity is simply asset illiquidity, which means that non-current assets may not be sold or sold at their desired prices. Air NZ holds significant cash reserves to enable it to meet its liabilities in normal course of its business and as protection from unexpected external events.

3. Air NZ Risk Management
The outlook for Airlines looks bleak, facing declining demand, operating losses and expensive fuel hedging costs, liquidity remains a major concern for all operators including Air NZ (Moody’s, 2009). However, researcher argued if firms set out to discover every potential risk the risk management do more harm than good. Therefore, in order to survive through these tough times all airlines need to engage in effective risk management with focus on prioritizing their risks. From the public information of the company’s website it shows Air NZ’s strategic risk management works successfully and differentiation through innovation is starting to show results and work for fuel alternatives is underway. On an operational level Air NZ has used the downturn to acquire new airplanes to rejuvenate the fleet for long term efficiencies. The ownership model provides the leverage for good times as well as the positive cash-flow options for difficult times; the passenger load factor is improving and the cash holdings are high.

Moreover, Air NZ has, in addition to high levels of short term assets, hedged not only significant levels of currencies, interests, credit risk and fuel costs to reduce variability and, if needed, time to pull operational levers. Air NZ has put itself into a very good position to weather the storm
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that might come and to participate from the long term trend of increasing air travel and cargo levels.

4. Air NZ risk hedging strategies
Air New Zealand Ltd., manage their exposure to volatile fuel prices by locking in a proportion of their planned fuel consumption at certain prices through forward contracts, a process known as fuel hedging. Such arrangement is now preventing them from any immediate respite to their cost pressures from the recent decline in oil prices.

Air NZ hedges up to 85% of its oil consumption in any three-month period, though the proportion of hedged fuel is lower over a longer time horizon. Consequently, the flag carrier doesn't immediately benefit from favorable movements in the spot fuel market.

Air NZ CEO Rob Fyfe said "The airlines that do best in their hedging strategy are the airlines that hedge consistently through the cycle and don't try to modify their hedging to gamble depending where the oil prices happen to be today." He also commented that fuel hedging not only trying to remove volatility and also provide airlines ability to compete against its rivals. Fuel hedging makes sure airlines have some parity in fuel costs with competitors and prevent competitors from undercut on prices (in case rivals obtained a lower fuel cost).

To mitigate the financial risks mentioned above, Air NZ has used the following financial instruments:

4.1. Fuel price risk management: Compared to other Airlines, Air NZ has hedged significant portion of its fuel cost. Air NZ (2010) has entered into option agreements and fuel swaps. “Between 75% and 95% of estimated fuel costs for the first 6 months are hedged, with progressive reductions in percentages hedged in subsequent months out to 1 year”. 90% of the fuel is hedged for the second half of financial year 2010 and nearly 53% is hedged for the first half of financial year 2011. This aligns to the findings of Air guide Business (2010): “after huge oil price swings over the past two years, airlines are taking a variety of approaches to hedging”.
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4.2. Foreign Currency Risk Management: Foreign currency operating cash inflows are denominated in Australian Dollars, European Community Euro, Japanese Yen, United Kingdom Pounds and United States Dollars and outflows are primarily denominated in United States Dollar. Air NZ’s treasury risk management policy is to hedge between 75% to 95% of forecast net operating cash flows for the first 6 months, with progressive reductions in percentages hedged in subsequent months out to 2 years. Air NZ foreign operations assets are exposed to foreign currency translation risk; this risk is managed through borrowings denominated in the relevant currency of the country where the operations are based.

4.3. Interest Rate risk management: “Air NZ group policy is to fix between 70% and 100% of its exposure to interest rates, including fixed interest operating leases, in the next 12 months” (Air NZ, 2010). Air NZ uses Interest Rate Swaps to achieve a right mix of fixed and floating rate exposure (Air NZ, 2010). According to the 2010 annual report no interest rate derivatives are outstanding and there was no impact on earnings as of 30 June 2010.

4.4. Credit Risk Management: To manage Credit Risk, Air NZ (2010) has invested money in short-term deposits and derivatives. To limit exposure to one institute money is invested in many institutes. Only financial institutions with a Standards & Poor rating of A and above are chosen. Air NZ also conducts credit evaluations on customers requiring direct credit (Air NZ, 2010). To effectively control the credit risk, first you can manage the proposed life cycle of a loan from start, to servicing, to recovery. Second, it needs to accurately forecast or estimate, monitor and report potential credit risk exposure through the whole period of the loan by both counterparties. Then we should have an alternative plan for hedging or transferring risks.

4.5. Liquidity risk management: To manage its liquidity risk, Air New Zealand set a minimum liquidity level and forecast their future cash flows. Air NZ holds significant cash reserves enabling it to meet its liabilities in normal course of its business and also to protect it from unexpected external events. In 2010
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Total Current Assets were $1,688M that represents 42% of operational revenue or 105% of current liabilities; this was even higher in 2009 at $2,275M representing 50% of operational revenue and 129% of current liabilities (Air NZ, 2010).

5. Literature
As the business environment becomes more and more complex, most corporations use hedging to reduce the risks that companies may face. Hedging means that a firm can reduce or limit their risks by trading in a forward, future or option market. Many theories in corporate risk management say that with the use of hedging, firms can increase their value. Smith (1995) provides a comprehensive empirical test of these theories. Recent theories argue that risk management can add value to a firm if there are capital market imperfections such as costs of financial distress, progressive tax rates, and conflicts of interest between shareholders and senior claimholders. As noted in Stulz (1996), financial distress costs include those related to failure to invest in valuable projects because of costs of debt. Froot et al. (1993) extend the Smith and Stulz (1985) analysis by illustrating the value of hedging for firms facing financial constraints. Hedging generates additional cash in the case of financial distress, thus circumventing the underinvestment problem. An important feature of the Froot et al. model is that it allows for the firm’s investment opportunity set to be correlated with cash flows from the hedgeable risk. If a positive correlation exists, less hedging is necessary because the firm enjoys a natural hedge. Thus, hedging is more valuable to firms as investment opportunities are less positively correlated with the risk factor’s cash flows.

6. Data
The data is mainly obtained from the Air New Zealand annual reports and interim annual review covering the period from January 1, 2008 to December 29, 2012, where the firm is required to report the fair value of the derivatives and other balance sheet financial instruments. We use half year (6 months) data as input of regression model. Thus, there are 12 observations in our case.

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We use the fair value of derivatives (options, swaps, futures and forwards) which is defined as the gain/loss of all derivatives at balance date used by Air New Zealand as dependent output. Some years the dependent variable is made up by derivatives of hedging on exchange rates and jet fuel, while some years it may include interest rate derivatives as additional. The data input of fair value of derivative is at the level of 1000 million, by making data in such level the coefficient and be smaller other variables like p-value and R square will not be affected.

Independent variables include firm market value, interest cover, leverage, P/E ratio, asset growth/cash flow, liquidity, dividends payout. The firm market value is defined as the log of the sum of the book value of liability and market value of equity and preferred capital. Interest cover is refers to the log of the earnings before interest and tax over the interest expense. Leverage is refers to book value of liability over the market value of equity. P/E ratio is refers to price per share over earning per share, however, to avoid outlier problems with small earnings the input is E/P ratio rather than P/E ratio (Berkman & Bradbury, 1996). The expected asset growth is refers to the log of the ratio of the year’s difference in net tangible assets add depreciation to net profit add depreciation. Liquidity is refers to the log of current asset without inventory over current liability. Dividend payout is refers to dividend per share over earning per share.

The reasons for using the above data as dependent and independent variables are summarized as following: the ideal measure for dependent output should be the hedging ratio of the contracts of risk management (Berkman & Bradbury, 1996). However, the data is not available that only jet fuel hedging ratio can be collected. In this report our group is trying to identify the hedging activity which includes jet fuel hedging, interest rate hedging, foreign currency hedging etc. Due to the limitation on data we use the fair value of derivatives as dependent variables. For the independent variables we follow Berkman & Bradbury (1996) as we agree that such data can effectively reflect the information of capital market imperfections. Thus, by input the above data we should can discover the effectiveness of Air NZ’s hedging activities by identifying its capital market imperfections.

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Table 1. Descriptive statistic of dependent and independent variables
Mean Std.Dev Min Max Fair Value of Derivatives Firm Market Value Interest Cover Leverage P/E ratio Asset Growth/Cash flow Liquidity Dividends Payout 3.083 8.518 1.110 0.344 0.083 -0.174 0.069 0.593 51.388 0.066 0.950 0.028 0.057 0.668 0.303 0.440 -119 8.426 -0.116 0.310 0.028 -1.171 -0.328 0.139 126 8.641 3.237 0.383 0.256 0.743 0.920 1.522

7. Methodology
This report uses time series ordinary least squares (OLS) regression test which is a widely used method on identifying linear statistics. (1) where refers to case ’s dependent variable, , where is a constant variable, refers to the refers to a

weighting for predictor variable

is case ’s th predictor variables.

error in the case. Moreover, equation (1) can be expressed with matrix notation as: (2) equation (2) is an x ( + 1) matrix, y refers to an x 1 vector as dependent variable, x refers to refers to the partial and particular

an independent value, and is the error for the matrix,

relationship between each independent variable and the value y. The assumptions made up on regression model are regarded to Berry (1993) and White (1980). Based on equation (1) the relationship between hedging ratio and its predictor variables can be expressed as:

(3) where FVD refers to fair value of derivative; FMV refers to firm market value, IC is interest cover, Lev refers to leverage, PE refers to P/E ratio, AG/CF refers to asset growth/cash flow, Liq refers to liquidity, DPO refers to payout ratio, is error residual.

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8. Empirical results
Table 2. Time series regression results with depend variable of fair value of derivative instruments
R Square Observations Intercept Firm Market Value Interest Cover Leverage P/E ratio Asset Growth/Cash flow Liquidity Dividends Payout 0.704884172 12 Coefficients 2.294788617 -0.274422414 -0.008876902 0.232540618 -0.542686518 0.003904147 0.012344115 0.035054993

P-value 0.432306632 0.44755014 0.703313996 0.75966402 0.179913156 0.913147298 0.872669372 0.540281776

Table 2 shows that when the fair value of derivatives is used to describe hedging activity the result is that R square is at 70% level while none of the coefficients of independent variable is significant at any (10%, 5% and 1%) level. The earning-price ratio is the best figure we have to be significant while it is still far away from 10% level significant. Overall, our empirical results are insensitive to prove that Air NZ use derivative effectively on increasing its present value of tax losses and reducing its cost of financial distress.

9. Conclusion
Recent financial theories argued firms can increase their values through hedging by reducing taxable income, agency cost and the cost of financial distress. This paper presents an empirical study of the hedging strategies used by Air New Zealand. From the qualitative research shows Air New Zealand have a series of methods on derivative hedging and the situation is promising while the quantitative result is insensitive to show Air New Zealand’s hedging helps the company increasing its value. Overall, we conclude that Air NZ’s hedging is not effective enough.

10. Limitations
Our paper suffers from data limitations: first, a small number of observations; second, the ideal dependent variable of derivative hedging ratio is not available.
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11. References
Airlines Split On Hedging Strategy For 2010. (2010). AirGuide Business, 1. Retrieved from http://www.airfinancejournal.com/sectors/19890/airlines.html?Year=2009&Month=6 Berkman, H., Bradbury, M. E., & Magan, S. (1997). An international comparison of derivatives use. Financial Management, 69-73. Berry, W. D. (1993). Understanding regression assumptions (Vol. 92). Sage. Carter, D. A., Rogers, D. A., & Simkins, B. J. (2006). Does hedging affect firm value? Evidence from the US airline industry. Financial Management, 35(1), 53-86. Froot, K.A., Scharfstein, D.and Stein, J. (1993). Risk management: Coordinating investment and financing policies, Journal of Finance, 48: 1629-1658. Loudon, G. F. (2004). Financial risk exposures in the airline industry: Evidence from Australia and New Zealand. Australian Journal of Management, 29(2), 295-316. Moody's: outlook for airlines is negative. (2009). Airfinance Journal, 22. Retrieved from

http://www.airfinancejournal.com/sectors/19890/airlines.html?Year=2009&Month=6 Morrell, P., & Swan, W. (2006). Airline jet fuel hedging: Theory and practice. Transport Reviews, 26(6), 713-730. Smith Jr, C. W. (1995). Corporate risk management: theory and practice. The Journal of Derivatives, 2(4), 21-30. Stulz, R. M. (1996). Rethinking risk management. Journal of applied corporate finance, 9(3), 825. Weiss, D., & Maher, M. W. (2009). Operational hedging against adverse circumstances. Journal of Operations Management, 27(5), 362-373. White, H. (1980). A heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity. Econometrica: Journal of the Econometric Society, 817-838.

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