Financial Risk Managment (Term Paper Sample)

FINANCIAL RISK MANAGEMENTAuthor nameFaculty of Business Environment and SocietyProfessor nameName of University
Introduction
The report below analyzes the merits and demerits of hedging. This is in reference to FlyAir Airline that has over the years hedged the risk exposure of the ever changing fuel prices. Recent reports have portrayed that airlines that hedge their exposures of rising fuel prices could end up in losses in instances where there is a significant plunge in the oil prices. The CEO of FlyAir Airline is concerned over the likelihood that the company may suffer financial losses as a result of this.
The report will rely on various studies that have been conducted in the past regarding this matter. The report will also address the concerns raised in one of the newspaper articles. The article had raised concerns that several airlines could suffer financial losses as a result of hedging.
The report will also provide conclusions as to whether hedging provides any corporate value on the business. The report will analyze hedging theories and assumptions to examine the extent to which hedging adds value to a firm.
The use of derivatives such as futures, options and swaps has been on the rise since the mid-1980s (Mallin, Ow-Yong & Reynolds 2001; Bartram, Brown & Fehle 2009). The trend has increased, particularly, in countries with significant economies. The use of derivatives is crucial in managing the volatility of the financial market. Many firms, especially large firms, have increasingly used derivatives to manage price, interest, credit and other risks.
The practice of hedging has also been on an increase in the airline industry. The airline industry faces many risks. Among the risks is the volatility of the oil prices. Since oil forms a major component of airline costs, its management is prudent in the aviation industry.
In reference to the recent newspaper article ‘Fuel Hedges Seen Hurting Airlines’, the report below will analyze the advantages and disadvantages of hedging in the airline industry. A recommendation will be made to the management of FlyAir airline from that point forward.Advantages of hedging
In drawing conclusions as to whether hedging is good for a firm, various questions should be addressed. Among them include:-what is the motive of managers? Why are managers interested in hedging? What motivates managers to hedge? Does hedging increase the value of the firm and shareholders?
There are various dilemmas that face a company that wants to engage in hedging. Among them includes whether the firm should hedge. Secondly, companies need to understand how much they should hedge. Thirdly, the risk management team should understand how they should edge (Judge 2006).
According to Klimczak (2005), there is no clear justification as to why firms should engage in corporate hedging. This is despite the rapid increase in adoption of different risk management techniques. In airlines particularly, where risk management could bring losses or gains, critical evaluation is prudent.
Firms use derivatives as a way of hedging for various reasons. The study conducted by Chris, Kean & Martin (2000) compound the primary objectives for hedging. Many firms interviewed stated that the hedged mostly to manage economic exposures in the market.
Firms do operate in an extremely volatile market (Stephens 2003). There are various risks in the market. These include inflation, interest risks among others. For an airline that is exposed to various risks, risk management is not an option. However, careful evaluation of the risk management strategy is paramount.
Hedging is a valuable tool in profit maximization. Historically, this was the principal objective of risk management. However, profit maximization concept is a subjective criterion. It is not a feasible goal in a high volatile market.
Value maximization is the other corporate goal for risk management through hedging (Judge 2006). The management should consider hedging in its strategy to improve the corporate value of FlyAir Airline. Hedging wisely will lead to the firm increasing the value of the shares as well as the value of the debts. This becomes critical in choosing viable investment options.
Hedging will also benefit FlyAir Airline because it will boost the confidence level of the management while making decisions. The management can prepare budgets and projections with a certain degree of confidence as a major part of the risk will have been solved by hedging. The company can invest in markets that it would otherwise not have invested.
The company will also gain from tax shield benefit if it engages in hedging. According to the Modigliani-Miller (MM) paradigm (1958), hedging will add value to a company in cases where taxes exist. The assumption is that the company operates in an imperfect market. This is a realistic assumption as taxes are common in all industries. Hedging will enhance the company’s debt capacity due to reduced borrowing costs (Judge 2006). It also increases the tax shield benefit for an enterprise.
Companies gain two tax incentives from hedging. The company increases its debt6 capacity. The company also enjoys a reduced tax liability from corporate hedging. For a company to gain these incentives, the financial theory suggests that the market should have costly imperfections. Many empirical studies have been conducted to validate this.
Hedging will help the management of the cash flows of FlyAir Airline. By the use of hedging, the company can manage the volatility in its accounting earnings. In the airline industry, companies are faced with numerous fluctuations in accounting earnings. Proper management is paramount in order to maintain consistency in the revenue flows (Bailly, Browne & Hicks 2003).
The management of FlyAir Airline can use hedging to avert risks of adverse cash flows (Fatemi & Luft 2002). It is necessary for a capital intensive company to maintain a minimum cash flow at a given time. This ensures the company meets its financial obligations as and when required. Through hedging, the management of FlyAir Airline can mitigate the risk of low cash flows. This will save the company from borrowing emergency funds that have high-interest rates.
Disadvantages of hedging
The reasons hedging is not widely spread is because of inadequate knowledge and the high transaction costs involved. The use of hedging includes various tax and legal costs (Bailly, Browne & Hicks 2003). If the management is not keen enough, the costs of hedging might outweigh the benefits. The management should hire highly qualified risk experts that should help FlyAir Airlines make credible decisions in regard to hedging.
A study conducted by Chris, Kean & Martin (2000) pointed out that as good as mitigating financial risks is essential; it has severe effects on cash flows of a company. A hedge involves high contractual costs. In airline industry, for example, the aspect of hedging oil prices may hinder the company from enjoying reduced prices in oil. As seen from the article, a drop in oil prices may not be experienced by airlines that have hedged.
Another disadvantage of hedging is that it does not adequately cover the risk in question (Eun & Resnick 2010). Hedging provides a surety of what the company will obtain in future but does not state the purchasing power of the same currency in the future. This affects the financial projections of a company.
Hedging is a complex process. It requires hiring of highly qualified staff. This increases the administration costs of the company. To hedge successfully the risk managers must fully understand the future markets. Companies have to hire trained personnel that include brokers and hedging experts.
Does hedging increase corporate value?
Hedging as a means of risk management should be concerned with three components. These include value maximization, risk return trade off and the non-arbitrage principle. The value of risk management can be judged by using the three paradigms. The management should prepare a cost-benefit analysis to evaluate the value of hedging in the firm.
The advice to the management of FlyAir Airline is that hedging as a way of managing risk increases the corporate value of the firm. As a means of risk management, hedging increases the corporate and the shareholders’ value.
The management of FlyAir Airline should adopt hedging if and only if it increases the value of the firm and that of the shareholders. At no point, should the value of the firm and shareholders be compromised because of the choice of risk management.Recommendations
FlyAir line has used hedging in mitigating the risk of volatility in oil prices. As much as this is a good measure to protect itself from exposures, there are adverse effects that may arise from hedging. The airline may incur losses as a result of buying oil at the hedged price instead of the spot price which is lower. To avoid the Airline from suffering the consequences such as those of Cathay Pacific, selective hedging would be preferable. By selective hedging, the company would offset a portion of uncertainties in prices. Consequently, the company would also enjoy partially in instances of low prices.
In addition to hedging, it is advisable for the company to take an insurance cover to protect itself from a drop in oil prices. This means that since the company has hedged selectively, the insurance cover will indemnify the airline in cases where the company suffers financial losses due to high oil prices. Additionally, the airline should take insurance cover for other risks outside the increase in oil prices.
It is advisable for the management of FlyAir Airline to hire a skilled team that is knowledgeable enough to assess the costs and benefits of hedging and other risk management techniques. Poor planning cou...