There are few industries that are exposed to such a diverse assortment of risks as the airline industry. Ever since the first powered human flight in 1903, the progress of aviation and air travel has been inextricably linked to economic and political developments. The airlines of today face all of the four major categories of risk; operational, strategic, operational, financial and hazard risks.
During the past 50 years, the airline industry has gone through several major changes. In the 70’s and 80’s, the North American and European airline industries were deregulated. This allowed new airlines to compete more freely with the established major carriers. This put a pressure on the profitability of airlines, and subsequently led to the emergence of the low-cost carriers that are now dominating the regional markets in Europe and North America. The price hikes in oil in the late 70’s also had a substantial effect, leading to higher fuel costs and spelling the doom for several airlines.
More recently, the terrorist attacks of 9/11 in 2001 led to a significant drop in the demand for air travel. The ensuing wars in the oil-producing countries around the Persian Gulf spurred a substantial increase in oil prices. The airline industry has also suffered from flu outbreaks and volcano eruptions, which has decreased demand and driven up costs, respectively.
WHY MANAGE RISK?
Firm believers in Modigliani & Miller’s theories would argue that companies theoretically should not hedge any risks, since shareholders can diversify away any risks taken by the individual firm. In practice however, we can see many examples where risk management has been successfully implemented and helped increase shareholder value. Specific reasons to manage risks are detailed below:
* A major reason to manage risk is to reduce the cost of financial distress. These costs can be decomposed into two parts, the cost of default and the likelihood of default. Risk management can, by reducing the likelihood of default, reduce the cost of financial distress.
* Another incentive to manage risks is that it can reduce the cost of capital, by reducing the risk premium required by investors. Firms who use risk management are also more likely to be able to finance new projects with internal funds, instead of issuing debt or equity.
* The underinvestment problem might also be mitigated by the proper use of risk management. The problem arises when shareholders who are seeking higher returns reject low-risk projects, even if they have a positive NPV. Debt holders obviously don’t like this since they can’t take advantage of the upside of more risky projects.
* Risk management, especially in the form of hedging also reduces the volatility of earnings, which helps reduce taxes.
As previously stated, the airline industry is exposed to a wide variety of risks. These can be classified within four broad categories: Operational risk, financial risk, strategic risk and hazard risk.
Operational risks are the risks pertaining to day-to-day operations within the airline. More specifically, it is in the Basel II regulations defined as risks resulting from insufficient or failed internal processes, people and systems, or from external events. Using this definition, I will, for the purpose of this essay, regard strategic and hazard risks as parts of the overall operational risk. A survey made by the consulting firm Mercer showed specifically which risks were prone to cause a decrease in shareholder value. The graph below details the results of this survey. (Zea, 2002)
Risk events precipitating stock drops, 1991-2001
Figure 1. Source: Mercer
Note that the above graph only shows the number of drops in stock price associated with each risk factor, and not their severity.
As we can see, almost half of the value-destroying events are associated with strategic choices and competition. In an...