International Financial Analysis-British Airways (Term Paper Sample)

Financial Risk Management of British Airways
(Name) (Institution) (City/State) (Date) Table of Contents  TOC \o "1-3" \h \z \u HYPERLINK \l "_Toc326959500"1.0 Introduction  PAGEREF _Toc326959500 \h
3 HYPERLINK \l "_Toc326959501"2.0 Financial risk exposures  PAGEREF _Toc326959501 \h
3 HYPERLINK \l "_Toc326959502"2.1 Market risk  PAGEREF _Toc326959502 \h
3 HYPERLINK \l "_Toc326959503"2.11 Fuel price risk  PAGEREF _Toc326959503 \h
3 HYPERLINK \l "_Toc326959504"2.12 Foreign currency risk  PAGEREF _Toc326959504 \h
4 HYPERLINK \l "_Toc326959505"2.13 Interest rate risk 5 HYPERLINK \l "_Toc326959506"2.2 Credit risk  PAGEREF _Toc326959506 \h
5 HYPERLINK \l "_Toc326959507"2.3 Liquidity risk  PAGEREF _Toc326959507 \h
5 HYPERLINK \l "_Toc326959508"2.4 Capital risk 6 HYPERLINK \l "_Toc326959509"3.0 Hedging techniques 6 HYPERLINK \l "_Toc326959510"3.1 Managing market risks  PAGEREF _Toc326959510 \h
6 HYPERLINK \l "_Toc326959511"3.2 Managing credit risks 7 HYPERLINK \l "_Toc326959512"3.3 Managing liquidity risks  PAGEREF _Toc326959512 \h
7 HYPERLINK \l "_Toc326959513"3.4 Managing capital risks 8 HYPERLINK \l "_Toc326959514"4.0 Evaluation and recommendation  PAGEREF _Toc326959514 \h
8 HYPERLINK \l "_Toc326959515"Reference list………………………….………………………………………………….………10 Appenidx……………………………………………………………………………………...….11  1.0 Introduction Risk management is a central aspect of each and every organization. This is because the general business environment is unpredictable. Management, investors and financial institutions would argue that financial risk management to improve the economic value of a firm through the use of financial instruments. Risk management is an integral part of company strategy in international organization due to an exposure to a variety of risks as compared to those operating in a single country. Thus, in this context, multinational organization often employs effective risk management systematic and/or unsystematic processes to identify, track and report potential and actual risks facing them, and adopt appropriate strategies to mitigate them. This paper provides a critical analysis of the financial risks facing British Airways (BA) and the techniques that the company has employed to hedge the risks. The data base used for this purpose are from the annual reports prior January 2011 when BA officially merged with Iberia thereby creating a new holding company structure the International Airlines Group (IAG). 2.0 Financial risk exposures BA faces four key risks; market risk, credit risk, capital risk and liquidity risk. The market risk consists of interest rate risk, fuel price risk, and foreign currency risk. 2.1 Market risk Market risk (systematic risk) is the risk that affects the entire market and which BA actively tries to mitigate (British Airways 2010, p. 91). 2.2 Fuel price risk The fluctuations in fuel prices pose a risk on the group’s operations such as profit and equity. For example, jet fuel supply deficit at Heathrow airport may paralyze the entire airline industry operating from this airport. BA has a fuel price risk management strategy (use of fuel derivatives) that protects the airline against unexpected and considerable increases in oil prices (British Airways 2010, p. 91). The following statistics shows the company’s financial instruments sensitivity; considering a 10% change in fuel prices. In 2007 as well as 2008, that fluctuation had resulted to changes in Profit Before Tax (PBT) of £ 14 million and in equity of £166 million respectively. In 2010, the fuel price changed by 30% resulting to a £ 4 million change in PBT and £ 432 million in equity (British Airways 2010, p. 92). 2.3 Foreign currency risk This is the risk that fluctuations in exchange rate may adversely affect the company’s financial reports. This risk arises because BA’s assets and liabilities are denominated in different currencies; US Dollar, Euro, and Yen (British Airways 2010, p. 92). Essentially, foreign currency risk affects the company’s purchases, revenue and borrowing. At the end of each financial year, all the assets and denominated in foreign currencies must be consolidated and reported in British sterling pounds. Like any other risk, the company’s report shows that the currency risk (holding other factors constant) has a significant effect on BA’s profit and equity (British Airways 2010, p. 92). Taking 31 December 2010 as the reference, it is clear that a 20% increase/decrease in exchange rate (US) resulted to a £ 8 million decrease/increase in PBT, and a £160 million decrease/increase in equity. The same report shows that an increase/decrease in euro ex-rate resulted to a decrease/increase in PBT and equity of £3 million and £ 70 million respectively. The same percentage change in yen rate resulted to a decrease/increase in PBT and equity by £ 7million and £ 98 million respectively (British Airways 2010, p. 92). 2.4 Interest rate risk This is the risk that the fluctuations in interest rates may adversely affect the profitability of a company. Debt financing is healthy for any organization. However, statistics indicates that adverse movements in interest rates may adversely affect the value of a company’s long-term liabilities and long-term assets (CPA Australia 2008, p.3). From the risk analysis point of view, the interest rate risk will negatively affect the company’s assets (especially cash deposits) when interest rates on cash deposits fall. Similarly, the risk will prevail if the interest rate on floating rate debt increases, since it increases the group’s cost of borrowing. The 2010 financial report shows that if interest rates increase by 100 basis points, BA’ income statement will improve by £ 1 million. However, if it falls by 50 basis points, it will have no impact on the group’s income statement (British Airways 2010, p. 92). 2.5 Credit risk Credit risk is the risk that the counterparty to the financial agreement, the borrower, may not meet his or her financial obligations. The risk is pronounced in organizations (for example, BA) that have in appropriate lending strategies (British Airways 2010, p. 93). A critical analysis of BA shows that the group is vulnerable to credit risk due to its high number of non performing loans, and to the point of non-performance by its counterparties in respect of financial assets receivable (British Airways 2010, p. 93). 2.6 Liquidity risk This is the risk that a particular asset and/or security cannot, quickly enough, be traded in the market to prevent the occurrence of a loss (market liquidity), or that the liabilities cannot be met when they became due (funding liquidity) (British Airways 2010, p. 94). The two liquidity risks are central to BA, since lack of solvency may paralyze its operations. 2.7 Capital risk Capital risk arises due to the volatility of returns from investments (Mattil 2005, p. 31). When an investor commits its funds in a particular project, he or she takes a capital risk, since the investment returns may turn out to yield either positive or negative returns. In this regard, BA is exposed to capital risks that affect the shareholders’ returns (British Airways 2010, p. 95). Capital risks are attributed to the possibility of negative (low) returns (dividends). 3.0 Hedging techniques There are various reasons why individuals or firms hedge. However, the key motive, here, is to reduce the probability of occurrence of a financial loss or the severity of the loss it may occur (British Airways 2010, p. 41). The risk management function BA has employed various techniques to hedge both potential and actual risks facing the organization. As indicated in its end year reports, the company employs the following hedge techniques to mitigate risks. This section provides a detailed review on these hedging strategies. 3.1 Managing market risks The company manages fuel risks through the use of fuel derivatives as a fuel risk management program. The most common fuel derivatives that BA employs are the over-the-counter (OTC) derivatives (British Airways 2008, p. 111). These are options and swaps. These instruments are preferred because their ability to be customized (Cobbs 2004, p.2). The company trades these derivatives directly with three or four distinct banks to diversify the risk. Moreover, the company uses cash flow hedges and in 2010 the financial report indicates that it made a future jet fuel hedge by purchasing forward fuel derivative contracts (British Airways 2010, p. 98). In managing currency risks, BA has employed both currency options and forward foreign exchange contracts to cover future operating payments and revenues in a variety of currencies (British Airways 2008, p.111). On the same risk, the group utilizes foreign currency (Euro, US Dollar, Yen) debt payments to hedge future revenues. Here, the company is matching receipts and payments. In managing interest rate risk, BA has entered into various interest rates swap arrangements with both domestic and foreign companies (British Airways 2010, p. 64). An interest rate swap is an agreement between two parties to borrow on behalf of each other for mutual benefit (Madura 2012, p.381). 3.2 Managing credit risks BA had adopted various credit risk management strategies in order to minimize any credit risks. The following are measures that have been directed to impose credit limits on counterparties (British Airways 2010, p. 93). First, BA continuously monitoring the counterparties’ defaults and credit limits and incorporates that information in credit risk control. Second, the overall risk exposure limit for every counter party is reviewed at least once a month. The reason behind this is to develop ris...