Airline managers operate in a fiercely competitive environment amid cost and revenue variables that are often highly volatile. This creates unique challenges to managing risk for finance and treasury executives.

On the cost side the primary inputs are aircraft and fuel. Together, these can account for up to 60 p.c. of expenses. Moreover, both are US dollar denominated which adds to the complexity for carriers operating outside the dollar zone. Aircraft expenses are broken down between the unit itself and associated cost items. Typically, airlines pay pre-delivery payments for up to three years before the arrival of a plane. Thereafter, maintenance and insurance expenses accrue and these too can usually be denominated in US dollars. Given the volatility of FX markets, airlines must decide on hedging strategies that ensure actual local currency costs do not stray materially from budget. Recently, Airbus has moved to introduce euro pricing which may help the hedging policies used by carriers in Europe but the installed global commercial aircraft fleet remains primarily dollar priced.

Internal hedging: a key tool in managing aviation fuel price risk

Fuel, which accounts for up to 40 p.c. of costs in a lean LCC, is probably the biggest challenge for management teams. Its price movements can be erratic and together with FX shifts can sharply alter the actual cost on running an airline in any year. With many airlines running EBIT margins of under 5 p.c. fuel can quickly convert in to heavy losses or large profits. Some carriers adopt rolling hedging programmes that cover a fixed percentage of fuel costs for a period extending out to one year irrespective of price. Others are more opportunistic and raise or lower their hedge positions dependent on price changes. Treasurers in non US airlines will often hedge the currency without fixing the underlying fuel, which provides some flexibility to adjust local currency expenses as market prices for oil change.

Parallel to these cost issues is revenue management. Airline executives aim to balance capacity, costs and yield per passenger to extract an optimal return. With air travel hugely sensitive to economic trends and consumer confidence it is difficult to provide certainty over total revenue in a given year. Carriers operating across global markets have to lock FX exposures around their revenue lines but this cannot guarantee actual sales alone.

It is the role of yield managers and their colleagues in finance departments to get the mix between sales and costs across a myriad of variables in line with targeted returns. Those plans rarely match expectations for more than a quarter of the calendar year given the rate at which unit revenues, unit costs and FX markets change. Ultimately, the primary mission is to ensure the financial stability of the carrier and avoid losses that threaten the underlying integrity of the business. This is why some carriers choose to maintain balance sheets that are technically inefficient (i.e. have high cash levels) and therefore provide buffers in the event of adverse revenue or cost movements.

Risk managing an airline's balance sheet is yet another responsibility for the treasury department. Strong seasonal customer bookings generate surges in cashflow that must be placed in instruments that maximise returns while minimising risk and ensuring flexibility to adjust up and down as seasonal factors (e. g. summer demand) are handled. Both cash and debt must be structured in short and long term facilities to support the operation of the carrier while providing resources behind fleet and fuel management. Aircraft can be financed through conventional loans, finance leases or operating leases and each if these require specific balance sheet entries.