Airlines industry faces a substantial strategic, financial, hazard and operational risk.

Due to
various financial risk faced by this industry it creates an uncertainity in the future cash flows. This
uncertainity may arise due to changes in the economic conditions, revenues operating
expenditure and financing various costs. Thus an integral part of the airline industry is to manage
exposures to these risks.

The most important risk that is considered to be faced by the Qantas is the interest rate risk,
currency risk, and fuel price risk. Most of these risks are hedged. Qantas stated in the annual
report in 2003 stated that it is subjected to interest rate, foreign currency fuel price and credit risk.
It also states that Qantas manages these risks by the use of various financial instruments. The
financial instruments which they use are interest-rate swaps, forward rate agreement, cross
currency swaps forward foreign exchange contract and currency options. They also employ
options and swaps on fuel and crude oil in order to manage the fuel price risk.

(i) Interest rate risk: - Interest rate risk refers to the risk that the fair value or future cash
flows of a financial instrument will fluctuate because of changes in market interest rates.
This risk is more common to airline industry due to the high usage of debt financing.
There is a presence of high leverage ratios in the industry because it is capital intensive
and has a high cost of equity. Since there is a high earning volatility raising funds from
equity may be difficult. The borrowing costs are directly related to interest rate changes.
Qantas airlines is exposed to interest rate risk since it has a portfolio of assets and
liabilities (e.g. corporate debt, cash and leases) in different currencies such as AUD,
GBP and EUR which are highly sensitive to interest rate risk. Since the borrowing
portfolio of the Qantas group is highly sensitive to the interest rate changes, this group
manages the risk by reference to target duration. Since there is a mix of fixed and floating
interest rate the Qantas group manages this by using interest rate swaps, forward rate
agreement and options. Since Qantas has taken assets on lease, it should use insurance
as an option to hedge the leased asset. Since, leased asset cannot be hedged by any
derivative.

(ii) Foreign Exchange risk: - It is that risk where the fair value of future cash flows of a
financial instrument will fluctuate due to changes in the foreign exchange rates. These
risks may arise from capital expenditure, operations and translation risk. The profitability
of the airline industry is related to currency values. Hence the management of Foreign
exchange risk is very important. Since the airline company operates not only in one
country but several other countries, thus they get their revenues and make expenditure in
several currencies. Even the borrowings made by these companies are done in several
other currencies. These exposures may be related to several other reasons such as the
mix between foreign and domestic sales revenue, amount of competition in domestic and
foreign market. Factors such as markup and pass through influences exposure levels to
these risks. Markup means the price which is over cost margin and pass-through is when
a firm adjusts its foreign currency price level to offset the impact of exchange rate
changes. Since the markup of the company is higher the firm’s exposure to these risks
may be lower.
 The Qantas group uses Cross-Currency Swaps in order to manage these risks. They
convert the long term foreign currency borrowing to currencies in which they have a
forecast of sufficient surplus net revenue to meet the principal and interest obligation. The
foreign currency borrowing, which the Qantas group convert have a maturity between one
to twelve years. Till the time a foreign currency gain or loss is incurred and the cash flow
hedge is deemed effective, it is deferred till the time the net revenue is realized.

Foreign exchange contract and currency options are used to hedge only a portion of the
net foreign currency revenue and expenditure. If any asset of the company is disposed or
any asset is purchased then these risks are hedged by the combination of forward foreign
exchange contract and currency options

(iii) Fuel price Risk: - Since the jet fuel costs forms the major part of an airline industries
operating cost, fuel price risk management is of great importance. Due to the fuel price
risk a firm may face difficulties such as underinvestment. The companies may not be able
to invest if there is any profitable venture coming up at the time of high jet fuel prices. Due
to the fuel price risk, an increase or decrease in the cost of jet fuel, the short term cash
funds may vary. Revenue generation may be slow initially in the short run. There is a fall
in the profitability of the company due to various direct and indirect costs associated with
the prices of fuel.

Qantas airline uses options and swaps as a tool to hedge the risk arising from fuel price
fluctuations. The policy that Qantas uses is that about 100 percent of the forecast fuel
consumption in the next one year is hedged and 50 percent of the next 12 months can be
hedged. For any other hedging tool outside these parameters requires an approval from
the board.

(iv) Liquidity Risk: - An airline company may face liquidity risk in future due to shortage of
liquid funds available. It is that risk where the firm will have difficulty in meeting its
financial obligations in future. These risks can be managed. The Qantas group manages
these risks by setting up a minimum liquidity level. They keep a minimum amount of
liquidity so that they have a surplus cash in future to meet its obligations. The long term
commitments of the company are managed by the estimated forecasts of the future cash
inflows in the company. Moreover the company has kept its option open by having an
access to various other types of funding sources for example commercial paper and
standby facilities. Standby facility is a flexible source of funding for the working capital
and cash flow needs. It is also known as the overdraft facility which may be used by
Qantas airlines to meet its future cash needs.

(v) Credit Risk: - Credit risk is the risk arising from a transaction when the counterparty
defaults on its payments. This is the risk arising from the travel agents, customers and
industry settlement organizations. The Qantas group manages these risks by the
applications of stringent credit policies and accreditation of travel agents. Many other
groups also need to deposit some cash collateral in order to deal with the company. In
the first quarter of 2009 the Qantas group had around $32 million as cash collaterals.
These collaterals may be helpful as it may be useful if any party defaults on payment.
Moreover above this the Qantas group also has a policy not to deal with any party which
has a credit rating below standards. It is the credibility of the company that is seen before
dealing with them so that there is a low probability of default in the payment resulting in a
loss to the company.
2. QANTAS Financial Risk Management:

Liquidity Risk:
Overview:

Types of Liquidity Risk:

1. Asset Liquidity - An asset cannot be sold due to lack of liquidity in the market -
essentially a sub-set of market risk. This can be accounted for by:
• Widening bid/offer spread
• Making explicit liquidity reserves
• Lengthening holding period for VaR calculations
2. Funding liquidity - Risk that liabilities:
• Cannot be met when they fall due
• Can only be met at an uneconomic price
• Can be name-specific or systemic

Liquidity risk is the risk that an entity will encounter difficulty in meeting obligations associated with
financial liabilities. The Qantas Group manages liquidity risk by targeting a minimum liquidity level,
ensuring long-term commitments are managed with respect to forecast available cash inflow, maintaining
access to a variety of additional funding sources including commercial paper and standby facilities1 and
managing maturity profiles.

*Notes:
1
Standby Facility: It is a credit facility that arranges project financing through secondary obligations, rather than primary ones. A
standby facility guarantees payment if the original note issuer defaults. It is often used by weak credit borrowers, who pay a
commission to the guarantor, who is secondarily liable if the primary issuer defaults. It is an off-balance sheet item in financial
reporting.
Market Risk:

- Interest rate risk: Interest rate risk refers to the risk that the fair value or future cash flows of a
financial instrument will fluctuate because of changes in market interest rates. The Qantas Group
has exposure to movements in interest rates arising from its portfolio of interest rate sensitive
assets and liabilities in a number of currencies, predominantly in AUD, GBP and EUR. These
principally include corporate debt, leases and cash. The Qantas Group manages interest rate
risk by reference to a duration target, being a measure of the sensitivity of the borrowing
portfolio to changes in interest rates. The relative mix of fixed and floating interest rate funding is
managed by using interest rate swaps, forward rate agreements and options. For the year
ended 30 June 2009, interest-bearing liabilities amounted to $5,503 million (2008: $4,160
million). The fixed/floating split is 37 per cent and 63 per cent respectively (2008: 37 per
cent and 63 per cent). Other financial assets and liabilities included financial instruments related
to debt totaling $81 million (liability) (2008: $245 million (liability)). These financial
instruments are recognized at fair value or amortized cost in accordance with AASB 139.
Financial instruments are shown net of impairment losses3 for the year of $58 million (2008:
$59 million).
3
Impairment loss: Impairment losses relate to asset devaluations. Accounting standards require
that if an asset is carried in the balance sheet at a value greater than the asset's 'fair value' the
difference must be recognized as an expense in the profit and loss, i.e. it reduces profit in the
current period)

Interest bearing liabilities:

2009
- Fixed : (0.37 * 5503) = 2036.11
- Floating : (0.63 * 5503) = 3466.89

2008
- Fixed : (0.37 * 4160) = 1539.20
- Floating : (0.63 * 4160) = 2620.80

Here, we can see that in 2009, Qantas had a more of floating interest bearing liabilities, nearly
double the amount of fixed interest bearing liabilities. In the case of interest-bearing liabilities
where the interest paid is linked to a floating interest rate, the risk is that the floating interest rate
would move positively resulting in interest paid on a debt (Liability), such as treasury bills,
corporate debt on short-term borrowings paying the prime rate, paying more than the LIBOR or
the fixed interest rate.

Hedging a floating interest rate exposure with an interest rate swap agreement:
An exposure on a debt with a floating interest rate stream of payments can be hedged by
swapping the floating rate income stream for a fixed rate income stream. This will give
the borrower, a certainty about the payment that he will make on his borrowing, and
future cash flows. Depending on the movement of the floating rate involved, this could
be positive or negative to the borrower.
Hedging floating rate exposures with caps, floors and collars
The topic of interest rate hedging is becoming increasingly more discussed in current
market conditions. Many borrowers have found themselves with no option other than to
remain on a Lenders Standard Variable Rate (SVR), due to criteria, limited lending
options and loan to value (LTV) restrictions narrowing the refinancing market to an
unwelcome low.
With Businesses unable to adjust their borrowing exposure to a product or Lender to suit
their business plan and attitude to risk, stand alone Interest Rate Management products
such as Caps, Collars and Swaps become a suitable alternative.
A borrower paying a floating interest rate can hedge the risk of increasing interest rates
by selling a floor or buying a collar. In this case the borrower will receive money if the
floating rate increases above the collar rate.

Hedge using the exchange traded derivates:

- CBOT 5 year Interest Rate swap: These are traded in the Chicago Mercantile
Exchange. Qantas has majority of its loans as the medium term (1-5 years) ones. Thus it
can go for the above mentioned derivative to hedge its medium term loan.

About the Report

Contract Specification of a 5 year CBOT interest swaps
- 3 Month Overnight Index Swap Futures: These can be traded in the Chicago
Mercantile Exchange. Overnight Index Swaps (OIS) are interest rate swaps based on a
specific currency that exchanges fixed rate interest payments for floating rate payments
based on a notional swap principal at regular intervals over the life of the swap contract.
The floating rate is based on a specified published index of the daily overnight rate for
the OIS currency. For swaps based on the United States dollar (USD), the referenced
floating rate is the daily effective federal funds rate.
Thus, for the loans, which have maturity of less than 1 year can hedged using a 3 Month
OIS Future by Qantas.

March 2010 swap

 Contract specification for 3 month OIS swap
*Block Trade minimum: CBOT Rule 526 and CME Rule 526 (“Block Trades”) govern block
trading in CBOT and CME products, respectively. Block trades are permitted in specified
products and are subject to minimum transaction size requirements which vary according to
the product, the type of transaction and the time of execution. Block trades may be executed
at any time at a fair and reasonable price and are required to be reported by the seller to the
Globex Control Center (“GCC" ) at 312.456.2391 within five minutes of the execution time,
except for block trades in interest rate futures and options executed outside of Regular Trading
Hours (7:00 a.m. – 4:00 p.m. Central Time, Monday-Friday on regular business days) and
Housing and Weather futures and options which are subject to a 15-minute reporting
requirement. Block trades executed when the GCC is closed must be reported no later than
five minutes prior to the opening of the next electronic trading session for that product.

- Eurodollar Futures Contract: A Eurodollar future is a future on a three-month

Eurodollar deposit of one million US dollars. Final settlement at expiration is based on
the value of 3-month BBA Libor. Eurodollar futures are the exchange-traded equivalent
of over-the counter forward rate agreements (FRAs). Eurodollars offer greater liquidity
and lower transaction costs also. These can be traded on CME, Euronext and Singapore
Exchange (SGX).
-7 Year Interest Rate Swap: These are also traded in the CME. We can see Qantas has
got debt maturing after 5 years i.e. long term borrowings. So, they can hedge their
interest rate exposure using this derivative. The Dec 2009 swap can be seen below.

7 YEAR INT RATE SWAP Dec 2009 (CBOT:7I.Z09.E)

Contract Details as per the last trading day

The Figure, above, shows the last closing of the contract, as well as the high price till
now along with the low price. It also depicts the contract expiration date. It also shows
the open interest*.
*Open interest: Number of outstanding contracts in the market.
Hedging the FX Risk using Options and Futures:

Overview on FX Risk Hedging:

Foreign exchange risk is the variability in returns and cash flows (gains and
losses), which occurs when one must transfer values from one currency to
another.

There are two types of foreign exchange risk. Contractual risk is the
variability of outcomes occurring when a specified currency exchange must
be made on a given date. Non-contractual risk includes the general business
impact of changing exchange rates on: importers & exporters, investors, etc.

Foreign exchange risk can be left unhedged and any loss/gain consequences
of changing foreign exchange rates accepted. Alternatively, remove the
impact of varying exchange rates by hedging.

FX risk can be hedged by trading in forward foreign exchange contracts,

foreign exchange futures contracts, or financial futures option contracts.

The cost of the hedge is the difference between the forward rate and the
expected spot rate when payments are made.

Hedging foreign exchange risk makes sense for it focuses the business
manager on “business” and not exchange rate forecasting and does not cost
much.

Qantas trades predominantly in AUD, GBP and EUR. Thus, it can go for the
AUD/USD, AUD/EURO, USD/EURO options and futures according to the
situation. Since, in an airline industry, the payment is generally immediate, so
Qantas can long a put option before hand and then exercise it, if it finds it
suitable to exercise the option.

We can see different kind of options available in the exchange market, below.
Here, we have considered Chicago Mercantile Exchange and NYSE Euronext,
since it is suitable for Qantas’geographical business.

Since Qanats has its major operation in Australia and deals in GBP, Euro and
USD, besides AUD, Qantas can always take a long position in a futures
contract or a call option for USD/AUD contract or EURO/AUD contract, if AUD
seems to be appreciating against these currencies.
 AUD/USD FuturesMarch 2010

Contract Specifications for AUD/USD March 2010 Futures: CME

USD/Euro Options (DEX): Euronext
USD/EURO Put Options March 2010: European Style: Euronext
 Contract specifications

AUD/USD Option: American style

CREDIT RISK:

Potential defaults by borrowers, counterparties in derivatives transactions, and bond issuers give
rise to significantly credit risk for banks and other financial institutions. As a result, most financial
institutions devote considerable resources to the measurement and management of credit risk.
Regulators require banks to keep capital to reflect the credit risks they are bearing.

Reference:
http://www.eagletraders.com/books/afm/afm10.htm
http://benrandall.co.uk/hedging.aspx
http://quotes.ino.com/exchanges/?e=CBOT
http://www.cmegroup.com/trading/interest-rates/
http://en.wikipedia.org/wiki/Liquidity_risk#Managing_Liquidity_Risk