Event 1: Rising fuel prices: The constant sorrow of the airline industry
The consistent volatility in oil prices has been a serious concern for airline companies now. Although the mid-east crisis seems to be solved now and oil prices have now returned to a more sustainable level with the current market prices hovering around $105-106/ barrel, however, the upside-downside trend in the oil prices has endowed an unwanted pressure on profitability of airline companies. The issue is not about higher or lower price, but relating to the rate at which they increase or decrease as the airline company has to set out a budget for fuel purchase.
Thus, in order to tackle the issue in consistent change in oil prices, the role of finance manager in the airline companies has been vital now. In order to mitigate the risk in changing oil prices, finance managers are now adopting the commodity futures where using the derivative instrument, they ensure that the airline company do not face losses because of uncertainty in oil prices. The example provided below, will be a suitable illustration as how finance managers in airline companies manages the oil price risk:
Buying Oil Futures
Considering the change in oil prices, the finance manager of King Airlines on 22nd September enters into oil future contract and agreed to pay $110.83per barrel ($110,830) for 1000 barrels of crude oil. The delivery date fixed under the contract is 22nd October and the contract was traded on New York Mercantile Exchange. On delivery date, the spot price of crude oil increased to $112.55.
Important to note that, since the airline company entered into commodity future, they will be entitled to take the delivery at $110.81 and have also gained $1720 in their margin account. In this way, the finance manager not only mitigated the risk of volatile oil prices but also gained $1720 from the oil futures. Below is the margin adjustment account of the airline company:
Event 2: Indian Rupee fall affecting the importers
In another event, consistent volatility in price of USD/INR has largely affected the import houses of India and the prices they are paying for their imported goods. However, the companies are able to manage the risk to some extent with the help of their prudent finance manager who are using currency forwards to mitigate the risk. An example below will illustrate the process of using currency forwards as a hedging technique:
Entering into Currency Forward Contract
Corporation A based in India has starting to import Black Pepper from Vietnam and is liable to pay $1 Million by the end of 60 days. Considering the volatile exchange rates between USD/INR, the finance manager entered into currency swaps today at the rate of 59.22 INR/ USD. At the time of expiration, the price of USD/INR was 62.18. However, since the corporation entered into currency swap, it allowed them to purchase $1 Million at 59.22 INR/USD at the end of 60 days. In this way, it mitigated the currency exchange rate risk and also earned a profit of 2.96 INR/USD in their forward agreement.
Investopedia. Currency Forward Contracts. 9 June 2014 <http://www.investopedia.com/exam-guide/cfa-level-1/derivatives/currency-forward-contracts.asp>.
Jain, Sudeep. Rupee Fall Hits India’s Small Importers. 9 June 2014 <http://blogs.wsj.com/indiarealtime/2013/06/18/rupee-fall-hits-indias-small-importers/>.
Rising fuel prices: The constant sorrow of the airline industry. 9 June 2014 <http://www.airlineleader.com/this-months-highlights/rising-fuel-prices-the-constant-sorrow-of-the-airline-industry>.