This report is commission to analyse the activities of the Qantas Group and main risks that Qantas has to face. Through analysing the factors that may affect the profit of the corporation, different derivatives that Qantas Group can use to hedge the risks are discussed and the advantages and disadvantages of these derivatives are given. As a listed company, Qantas Group focuses on providing airline services both in domestic and international markets. During daily operations, input price risk, foreign exchange risk and stock price risk are the main risks that the company has to use different derivatives to control. Based on analysis, it is suggested that these risks could be hedged by using options and forward contracts respectively and specific reasons are provided to demonstrate the feasibility of these derivatives. Through hedging, it is believed that the risks of Qantas facing today could be better controlled in the future. 1.1 Activity Description Qantas Airways Limited is Australia’s number one airline, which connects Australia to 81 destinations in 40 other countries worldwide and operates extensive domestic services in both Australia and New Zealand (Qantas Airways Limited 2011). Its main business is the ‘transportation of passengers using two complementary airlines, Qantas and Jetstar, operating international, domestic and regional services’ (Qantas Airways Limited 2011).
In addition to airline brands, the Qantas Group operates a number of related activities to broaden its portfolio of businesses and investments, such as Qantas Frequent Flyer and Qantas Freight Enterprises. With the increasing competition in the airline industry, Qantas Group continues to manage its strategic, financial and operational risks, respect the rights of shareholders, introduce new technology that enhance the customer experience and provide more safety service (Qantas Airways Limited 2011). According to the 2011 annual report, Qantas had suffered several significant weather events and natural disasters during the year. Hence, Qantas now tries to control the potential risks and recover the airfreight market through improving its joint venture agreements with both domestic and international airfreight network. 1.2 Main risks As a listed national airline company which occupies approximate 65% Australian domestic market share and 18% international market share (Qantas review 2012), Qantas faces various risks during its daily operations, mainly including input price risks, foreign exchange risk and stock price risk. The input price risk refers to the volatile in the prices of inputs which may impact a company’s financial result (Harper 2010). As an airline company, Qantas heavily depends on the jet fuel to support its normal business operation.
For instance, it incurred 3,684 and 4,329 million dollars of fuel costs in 2011 and 2012, separately (Qantas Airways Limited 2012), which leads the company to be significantly sensitive to the price fluctuations in the jet fuels. As a rise in the fuel price might largely increase the costs of flight services while a decline in input price would save costs in contrast, it may further influence the ticket prices and sales volume in its business. In other words, it exposes Qantas to the input price risk to a relative high level. The foreign exchange risk is the financial risk of an exposure to unexpected exchange rates between currencies, which may have either a positive or negative impact to a company’s financial position and performance (Harper 2010). Besides the domestic destinations, Qantas also serves international flights and has developed codeshare relationships and joint service agreements with many foreign airline companies all over the world (Ports and Relationships 2012). It indicates that Qantas has to face the financial risk in the unanticipated currency exchange rates between Australian dollar and various foreign currencies in terms of sales, costs, expenses and investments.
As a listed company on the ASX, Qantas also confronts the stock price risk, as the changes and fluctuations in its stock price may significantly impact the entity’s financial position and shareholders’ wealth. Generally the stock price is influenced by both the macroeconomic trends and the corporation-specific factors. For instance, the global economy recession may impact the financial situation in all industries including airlines, which would result in the decline in all stock prices in the stock market; while some company-specific factors only influence the certain company’s stock price, such as the weather factors suffered by Qantas which affect its services and financial performance may specifically impact the stoke price of Qantas. As explained by Harper (2010), many companies develop strategies to hedge risks by adopting certain derivatives. Qantas can choose proper derivatives such as futures and options to assist in reducing the risks mentioned above to a reasonable level. Hedging input price risk by using options Hedging through options could reduce the risk from potential future market movements (Hull 2011).
Because of the great deal of jet fuel consuming, the price changes in inputs (fuel) are of significant importance to Qantas (Investopedia 2012). Qantas hedges against the price increase of jet fuel (crude oil and jet kerosene) to eliminate the potential risk. Qantas held the hedging using options, which is traded on the Australian securities exchange, of future aviation fuel purchases by crude oil and jet kerosene derivative contracts in 2012 (Qantas Airways Limited 2012). Qantas uses options on crude oil and jet kerosene to hedge exposure to fuel price movements. According to Qantas policy, up to 80% of the estimated fuel consumption out to 12 months and up to 40% in the subsequent 12 months could be hedged. Any other hedging outside the parameters must be approved by the Qantas Board. 58% (2012) and 53% (2011) of the estimated fuel exposure less than one year have been hedged. Also, 6% (2012) and 9% (2011) of the estimated fuel exposures more than one year but less than three years have been hedged. The net gain from future aviation fuel payments less than one year is minus $11 million (2012) and $130 million (2011) (See Appendix 2.1.1)
(Qantas Airways Limited 2012). Advantages and disadvantages: The advantage associated with the hedging strategy is that it reduces the potential fuel price movement risks. Qantas airway, which provides airline services to customers, has no particular skills in predicting changes, fuel price for example (Hull 2011). Hedging the risks associated with these potential increasing variables could be beneficial. Qantas could place more focus on the main business activities by avoiding unpleasant risks through hedging (Hull 2011). However, there are several limitations within the hedging strategy. First, competitive pressures within the airline industry could result in the fluctuation of costs of raw materials. As a result, companies without hedging strategy can have constant profit margins, and companies which have adopted hedging strategies to reduce potential risks may have fluctuating profit margins (Hull 2011).
Second, Bakshi and Kapadia (2003) argued that there could be a market price for the exposure to volatility uncertainties when the expected volatility is not constant. The fuel price could experience increasing or decreasing in the estimated period of time, so the hedging using options could bring a loss of the upfront payment.2.2 Hedging foreign exchange risk by using forward contracts The basic principle of hedging foreign exchange risk is to exchange the currency when exchange rate is favourable, and then invest currency which is native to the country of origin. The purpose of this approach is to prevent a monetary loss by safeguarding the investor against currency exchange rate fluctuation (Sayali Bedekar Patil 2012). Forward contracts are usually used to lock the receipts and payments in a fixed exchange rate. It offers stability to both the receipts and payments. In Australia many banks provide forward rate as a service to customers. By entering into a forward contract with a bank, the Qantas can simply transfer the risk to the bank, which will now have to bear.
In this case, Qantas forecasts the exchange rate could fluctuate and end with a possible depreciation of USD. Qantas then can enter into a short forwards contract with a bank to fix the exchange rate reduce the foreign currency risk. FXStreet website (2012) contains information on spot and forward quotes for the AUD/USD exchange rate, Dec 24, 2012. (See Appendix 2.2.1) By entering into the forwards contract using forwards, Qantas is guaranteed of an exchange rate of AUD 1.0375 per USD in the future irrespective of the spot exchange rate in three months. If USD were actually depreciated in three months, Qantas would hedge the risk. However, if it were to appreciate, then Qantas would have to forego favourable movement and hence bear implied losses. Advantages and disadvantages: Forward contract is a management technique to reduce, mitigate and eliminate risks. The transactions are over the counter without regulation, so the two parties (buyer and seller) can negotiate that they mutually agree in any terms, such as the underlying asset, timing, location, amount and type of trade.
The contracts are characterized in flexibility, they are not settled until the specified date so there is no initial upfront payment required, moreover, there is no commission paid on the trade (Khalid, Mohammed, Abdul and Hisham 2011). On the other hand, the contracts are often illiquid, because a forward contract is usually designed to meet specific needs. The buyer may find it difficult to sell the position to a third party because of its specificity. Moreover, the credit risk exists as the clearinghouse does not guarantee the amount. Finally, it is unregulated that a formal body has the responsibility for setting regulations and procedures to protect their transition (Khalid, Mohammed, Abdul and Hisham 2011). 2.3 Hedge stock price risk by using options Stock price risk refers to the company performing under its expectation, i.e. a decrease in its stock price (Moazeni and Foroghy 2012). Greater returns should be in relation with higher stock risks (Koslowsky 2009), and to pursue a higher return in stock market, Qantas has to face a higher level of stock risks, i.e. a larger possibility that the company may suffer loss when stock price decrease.
To hedge the stock risk, i.e. to hedge stock price from decreasing, we found that Qantas has a number of call and put options in market, with underlying assets of Qantas Airways, of different expiry date, either in American or in European style, which is in turn effectively in manage its exposure to risk in stock market. Call option refers to the right to buy while put option refers to the right to sell. As an option seller, Qantas uses call options for the Airways stock in expectation that the stock price will decrease in the future whereas use put options for the Airways in expectations that the stock price will increase in the future. First of all, as a call option seller, Qantas will get benefit when the market price is below the exercise price as their exercise price is locked. This is because their counterparty will not exercise the option when market price is below the exercise price, so Qantas will benefit from the premium their counterparties paid. Similarly, as a put option seller, Qantas will benefit when stock price increases. In addition, as we found that Qantas has a number of options with different expiry date up to 17/12/2015 (ASX 2012), we could say that Qantas will be effective in managing its stock risk by using options in a time horizon.
Advantages and disadvantages: The advantage of shorting options is the option seller will get benefit, i.e. premium paid by their counterparties, in shorting calls when stock price increases, and in shorting puts when stock price decreases, and it is quite flexible, as their counterparties can exercise the option before the expiry date, depending on the volatility of the share price. However, the disadvantage of selling option is the loss from stock price volatility, that is, the loss is unlimited in selling call options when stock price increases and in selling put options when stock price decreases.
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