Question 1:

COVID-19 and its impact on the travelling industry have number of implications for the airlines around the world. According to IATA (2020), the novel COVID-19 has had a devastating impact on the financial outlook for the airlines industry in USA along with the other countries. According to the report, the USA airlines have had to experience a revenue loss of $21.1 bn with shrinkage of 10% in the passenger numbers. The following of the financial risks are likely to be faced by American Airlines given the COVID-19 prevalence in the world.

• Fuel Costs:

In normal times, the American Airlines would worry about the rise in fuel cost that could affect its bottom line. However, with COVID-19 pandemic, number of airline fleets is already grounded around the world while the oil prices fell below $23/barrel depressing the demand for oil worldwide (BBC, 2020). Due to the surge in the internal costs and rising interest expenses, the liquidity pressure on American Airlines would put it at risk in future. Moreover, with declining passenger traffic and airport revenues in America, the ramifications of such financial shocks could go far beyond the loss of the operating income (The Guardian, 2020).

• Plummeting Passenger Demand:

IATA (2020) reported that the passenger demand for travelling has plummeted at unprecedented levels while making it difficult for major airlines to cut through the bankruptcy likelihood. The financial liquidity crises is real in case of American Airlines as it scored 1 in FRISK rating indicating a higher bankruptcy risk compared to an average public company (Credit Risk Monitor, 2020). Due to rising severance, regional expenses and higher labor cost, the company already reported $2.2 bn net loss and decline in shareholders’ equity to a negative of $2.6bn in 2020 (Josephs, 2020).

• Debt-Exposure:

Worst of all, the American Airlines also hold highest debt-to-assets ratio of 43% as compared to other operators (Credit Risk Monitor, 2020). A higher debt ratio means that the American Airlines would face difficulties in paying off its debts in such pandemic crises. Before the pandemic, the portfolio betas of the Airlines industry remained to be under one indicating the industry to be less risky as compared to other market. However, with new beta of American Airlines touching 1.15 means that the company’s stock has become riskier than a given stock market index in America. The floating rate of interest will also be affecting the company’s long term debt as its lease payments of the small number of aircrafts could fluctuate and can potentially negatively affect firm’s liquidity position.

• Volatile Ticket Prices:

Due to COVID-19 pandemic, the airline industry is experiencing huge volatility in its base fares that plummeted significantly while pushing the revenues further down (Airlines for America, 2020). This could have a long-term impact on American Airlines as the aircrafts might stay grounded and revenues could fall sharply. With rising proportion of costs of fuel, leasing, maintenance and staffing coupled with falling ticket prices around the world, the American Airlines could be forced into bankruptcy and worst of all be repossessed by lessors.

In order to pass through these turbulent times, the American Airlines might either have to consider various hedging options or must have enough cash in hand to survive before needing to file for bankruptcy or worst. With current research statistics, it is known that American Airlines has only 4.8 months of cash on hand as compared to Allegiant and Southwest that have around nine months of cash to cope up with such crises again.

Question 2:

In response to above identified financial risks including ticket prices, fuel cost, debt exposure and plummeting revenues, the following hedging strategies are recommended for American Airlines.

• Hedging Fuel Cost:

Till now, American Airlines have been shunning hedging fuel costs along with Delta Airlines and United Continental Airlines (Carter, et al., 2006). This has worked in court of American Airlines as the jet fuel costs amidst COVID-19 fell down globally while leaving many airlines around the world to be locked into high hedge rates that are costing them millions of losses (Leff, 2020). Around ten airlines lost a total of $4.65 bn on fuel hedging due to COVID-19 (Leff, 2020). Hence, it is still recommended to leave the hedging of fuel as it is and carry o reflecting the fuel prices in the ticket prices. However, had it the case where American Airlines had hedged against the fuel prices, it would end up in over-hedged position and would be required to unwind its hedging position by doing reversals.

• Hedging Ticket Prices:

In the given case scenario where the ticket prices are falling and the costs maintenance and running air fleets is eating up the Airline’s operational existence probability, there is a strong need to get involved in hedging of passenger ticket prices (Davies, 2020). This can be done by measuring the pricing trends and then hedge the exposure of American Airlines to the ticket price volatility. Although it is very difficult for predicting the ticket prices in the near-term, yet developing price indices could help American Airlines in predicting the prices that have huge influence on the long-term investment decisions for the company (Li, 2020). This would give more financial predictability to American Airlines in such pandemics as the company will be able to hedge its revenue risk by keeping itself protected from lower fare prices and lower yields.

• Hedging Debt Exposure:

American Airlines can use the cash flow hedging and fair value hedging techniques. It is considered where the operating cash inflows in foreign currency  is hedged using the foreign currency risks associated with the financial liabilities incorporating lease liabilities or aircraft financing.  However, under IFRS 9, it is only possible when American Airlines is able to calculate its highly probable cash flow in near future (IATA, 2020). Before considering on hedging the financial liabilities risk, the Airlines must assess the factors like extent of loss or disruption of operations, financial & operational ability of the firm, and frequency of past transactions and commitment of its resources  (KPMG, 2020). In order to hedge against the financial liability for borrowing of the aircrafts, the company must be able to enter declining amount of future cash flows for establishing a qualifying hedging relationship.

As discussed above, it is recommended to indulge into hedging ticket prices and hedging debt exposure by carrying on forecast of future value of the cash flows of American Airlines. However, using the jet fuel hedging isn’t still recommended given the falling prices of crude oil due to COVID-19 pandemic (The Global Treasurer, 2020).

Question 3:

As recommended above, the American Airlines must indulge into hedging practices against volatile ticket price and high debt exposure. The following tools are to be used for hedging practices;

• Future and options are the two major types of the financial derivatives that are traded in the share market. This allows the signing of contracts by two parties for trading a stock asset at a pre-determined price at a later date(Turner & Lim, 2015). Such instruments allow the companies to hedge market risks involved in stock market trading. The financial futures and option contracts can be used by American Airlines to hedge against its revenue risks. The ticket price hedging would be done by selling the futures contract that will allow the airline in locking its $/Revenue Passenger Kilomenter at a given price in future (Euro Finance, 2020). This would mean that even if the demand for the ticket falters in future, the American Airline would still be able to lock in the profits. With the future contracts like this, the American Airline would be able to immunize its profitability against any demand side shocks that drives the markets. Both options and futures will allow the American Airline to protect itself from lower fare prices and lower yields by entering into the financial contracts. However, such revenue side derivative contracts are still to be rolled out in the market based on airline ticket indices in the near future as till now only cost side hedging derivatives are available in the market (Merkert & Swidan., 2019).
• Interest rate swaps are the financial derivatives available to be signed between two parties to make periodic interest payments based on specified principal amount. The fixed interest rate is set that is known as the swap rate(Treanor, 2015). These swaps are used for minimizing the interest rate risk that is the risk of fluctuating future cash flows as a result of changes in the market interest rates. American Airlines is subject to this risk due to its financial leases and aircraft financing. American Airlines can use the interest rate swaps for limiting its exposure to negative movement in the interest rates on its debts, lease liabilities, aircraft financing and capital obligation  (Treanor, 2015). This would be done by entering into interest rate swap agreement to fix the interest rates over all of its long-term debts in future. Similarly, it can enter into a pay fixed-receive floating interest rate swap in order to hedge against the variability in the fair value of aircraft with regard to the interest rate component of the bond. It can also consider floating-to-fixed interest rate swap agreements for following its cash flow hedging technique (Merkert & Swidan., 2019). Also, for limiting its foreign currency exchange risk, American Airlines can enter into foreign exchange forward contracts as cash flow hedges for the accounting purposes.

Hence, by using the above identified financial instruments, the American Airlines can reduce the likely financial risks posed by COVID-19 in terms of ticket price volatility and debt crunches.

References

Airlines for America, 2020. Impact of COVID-19: Data Updates. [Online] Available at: https://www.airlines.org/dataset/impact-of-covid19-data-updates/
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BBC, 2020. Coronavirus: Oil price collapses to lowest level for 18 years. [Online] Available at: https://www.bbc.com/news/business-52089127
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Carter, D. A., Rogers, D. A. & Simkins., B. J., 2006. Does hedging affect firm value? Evidence from the US airline industry. Financial management , 35(1), pp. 53-86.

Credit Risk Monitor, 2020. High-Altitude Bankruptcies Due to COVID-19 Causing Major Turbulence. [Online] Available at: https://www.creditriskmonitor.com/resources/blog-posts/high-altitude-bankruptcies-due-covid-19-causing-major-turbulence
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Davies, P., 2020. Airbus reveals plan to manage airline ticket price volatility. [Online] Available at: https://www.travelweekly.co.uk/articles/355563/airbus-reveals-plan-to-manage-airline-ticket-price-volatility
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Euro Finance, 2020. Covid-19 puts airline hedge strategies under new focus. [Online] Available at: https://www.eurofinance.com/news/covid-19-puts-airline-hedge-strategies-under-new-focus/
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IATA, 2020. IATA Industry Accounting Working Group Guidance IFRS 9, Financial Instruments. [Online] Available at: https://www.iata.org/contentassets/e65a4360f04e41b1a6c45063060d1939/iawg-guidance-ifrs-9.pdf
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IATA, 2020. IATA Updates COVID-19 Financial Impacts -Relief Measures Needed-. [Online] Available at: https://www.iata.org/en/pressroom/pr/2020-03-05-01/
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Josephs, L., 2020. US airlines are losing money for the first time in years as coronavirus ends travel boom. [Online] Available at: https://www.cnbc.com/2020/04/23/coronavirus-us-airlines-set-to-report-their-first-losses-in-years-as-travel-demand-falls.html
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KPMG, 2020. Airlines: Financial Reporting Implications of COVID-19. [Online] Available at: https://assets.kpmg/content/dam/kpmg/xx/pdf/2020/04/airlines-financial-reporting-implications-of-covid-19.pdf
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Leff, G., 2020. On Top Of COVID-19 Airlines Lost Almost $5 Billion On Fuel Hedges This Year. [Online] Available at: https://viewfromthewing.com/as-if-covid-19-wasnt-bad-enough-airlines-lost-almost-5-billion-on-fuel-hedges-this-year/
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Li, Y., 2020. Wall Street’s next trading innovation: Air-fare derivatives. [Online] Available at: https://www.cnbc.com/2020/01/22/airbus-nasdaq-to-create-derivative-trading-for-airline-tickets.html
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Merkert, R. & Swidan., H., 2019. Flying with(out) a safety net: Financial hedging in the airline industry. Transportation Research Part E: Logistics and Transportation Review , Volume 127, pp. 206-219.

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Treanor, S. D., 2015. Operational and financial hedging: friend or foe? Evidence from the US airline industry. Journal of Accounting and Finance , 13(6), pp. 64-91.

Turner, P. A. & Lim, S. H., 2015. Hedging jet fuel price risk: The case of US passenger airlines. Journal of Air Transport Management , Volume 44, pp. 54-64.