MIAMI – Airlines have tried for many years to reduce earnings volatility by employing financial hedging strategies for various costs, such as interest rates, exchange rates, and fuel. The reason for this, of course, is to keep their costs as stable and predictable as possible by not being exposed to seasonal fluctuations or unexpected volatility.
Maintaining stable financial performance, though, is not limited to good cost management. The revenue side of the equation is equally important, and for the airlines, that means ticket prices. But how can hedging be applied to ticket prices?
A company called Skytra, a subsidiary of Airbus, has been working for the past two years to figure this out.
Founded in London in 2018 by Elise Weber and Matthew Tringham, Chief Sales and Marketing Officer and Chief Strategy and Product Officer respectively, Skytra has been approved by the United Kingdom’s Financial Conduct Authority (FCA) to establish the world’s first air travel price Indices known as ‘Skytra Price Indices’.
This is the first step toward establishing a basis for hedging instruments for ticket prices which airline companies can use to help stabilize their revenue, much as they have used hedging to stabilized many of their costs. Before we talk more about the work Skytra is doing for the airline industry, let us discuss hedging in general along with a simple example.
A Basic Overview of Price Hedging Based on Well-established Benchmarks
Long-term investors in airline or other stocks are primarily interested in steady growth, predictability of earnings, and overall stability of performance. While sharp and sudden increases in stock price and earnings, or even moderate volatility, can be welcome for short-term gains, investors do not view earnings or stock price volatility favorably over the long run.
While stock price and performance volatility have many potential underlying causes, both internal and external to a company, this discussion is focused on the most direct and obvious component of the equation – revenue and/or expense volatility.
Of course, volatile financial performance over several quarters can be generated on the revenue or the expense side of the ledger, or potentially both. For example, revenue may be steady and strong, but if expense control is poor or a company faces an uncontrollable rise in expenses, the resulting volatility in earnings will generally be viewed unfavorably.
Similarly, if expense control is tight and costs do not vary significantly from period to period, yet revenue proves difficult to forecast and subject to unexpected spikes and/or dips, as we’ve seen with airlines during the pandemic, overall earnings performance will be seen as unpredictable and penalized accordingly by the investment community.
One of the ways airlines attempt to control stabilize costs is through a process known as hedging. Generally speaking, hedging is the process of entering into separate transactions that tend to offset, or counterbalance, the volatility in those transactions in which the airline typically encounters the most risk, such as fuel cost on the expense side, or ticket prices on the revenue side.
By engaging in “hedging” transactions, airlines are able to keep a given cost, for example, within a certain range so that the hedged transactions can be predicted with greater accuracy over a financial period, whether it’s a month, quarter or year.
The most common form of hedging transaction used by airlines, and most other companies for that matter, is a type of financial instrument that is often referred to as a derivative, an accounting term used to describe contracts that, among other common attributes, “derive” their value from a source outside the contract itself, usually a financial index such as a regularly published interest rate, foreign exchange rate, or commodity price.
Usually purchased from a bank or other financial institution, derivatives offer the holder a form of protection from the volatility of a designated risk to earnings stability. Further, it is the availability of widely recognized and reliable indices for interest rates, commodity prices, etc., that provide a suitable reference point for the hedging instrument, or derivative, to be built around.
As an example of how a SWAP hedging instrument works, if the actual rate of a hedged expense item falls below an agreed upon range or specific rate, the airline will pay the bank the difference. If the actual rate goes above the agreed upon range or rate, the bank will remit the difference to the airline.
While there will likely be differences every month, the goal for the airline is to have variances from the settlements of the hedging instrument that can be netted with the hedged expense, thus stabilizing the dollar amount of the hedged expense to a level at or near the forecasted expense.
Even if the airline comes out slightly behind (or ahead) in payments relative to the fixed-rate at the end of the derivative period, the fundamental goal of volatility minimization has been accomplished. Instead of the airline having wondered each month what a particular expense would be, the hedging derivative generated variances that enabled it to eliminate the variability that would have, if left unhedged, created undesirable earnings volatility.
Say, for example, an airline wants to borrow US$1m to be paid back at the end of one year. If it borrows the money with a variable interest rate, the interest expense for the loan can vary considerably throughout the year. And, while US$1m is a useful example for our discussion, the amount of the loan in a real transaction would likely be a lot more than that, causing interest expense to turn into “real money.”
Interest Rate Swap
To continue with our example, let’s say the airline borrows the money from Bank A with a variable interest rate. To mitigate fluctuations in that variable rate, however, the airline purchases a derivative from Bank B, and works with Bank B to agree upon a fixed or “benchmark” rate, fluctuations from which will create settlement variances which each party will pay to the other, depending on their direction relative to the benchmark rate.
This type of financial instrument is called an “interest rate swap.”
As you can see from Figure 1, the first column to the left shows the amount of the loan. In this example, a principal payment is only required at the end of the loan, so the airline is only paying interest each month. Column 2 shows the variable rate, which is the actual interest rate the airline will be charged by Bank A each month, and column 3 shows the interest amount the airline will pay to Bank A each month.
Figure 2 below represents the interest rate swap, a completely separate transaction with Bank B, a separate financial institution. Column 4 of Figure 2 shows the fixed, or benchmark rate that the airline and Bank B agreed upon for the interest rate swap. Since the rate is fixed, the airline’s “pay side” of the transaction will be the same each month. However, this US$2,500.00 does not actually change hands.
It is used only for reference by Bank B to determine the difference between the fixed benchmark rate and the floating rate, which determines whether Bank B must pay the airline the amount in the “net settle” column or whether the airline must pay Bank B.
|HEDGED DEBT TRANSACTION||HEDGE – INTEREST RATE SWAP (PAY FIXED / RECEIVE VARIABLE)|
Figure A Figure B
As Figure A and B above illustrate, the settlement variances generated by the interest rate swap (at far right) serve to offset the volatility in the airline’s variable rate debt, effectively eliminating the volatility relative to the fixed benchmark rate.
It’s important to understand, however, that most hedging transactions are a bit more complex than this one, and the accounting rules and requirements necessary to be able to record both the hedged transaction and the offsetting variances in the same periods can be very challenging, and require considerable skill on the part of a company’s accounting team.
Nevertheless, a sound hedging strategy like this one can be a game-changer for a company with significant revenue or cost volatility.
Hedging With Skytra
Now that the reader has a basic understanding of hedging, the focus now is on the work of Skytra. Simply put, Skytra has a set of six regulated air ticket price indices to enable airlines to hedge ticket prices to reduce revenue volatility, and potentially qualify for more favorable credit terms.
In addition to the founders of the company mentioned in the first section of this discussion, Régis Huc, an independent corporate finance consultant and a former member of the resident finance faculty and program manager at Toulouse Business School, analyzed the relationship between reduced earnings volatility and the potential credit upside.
In the executive summary of his analysis, he says, “Today, Airlines are using a series of financial risk management strategies and tools to reduce volatility on risks such as fuel prices, exchange rates, and interest rates. However, there has never been a financial instrument to reduce volatility on the largest position affecting their profit and loss statement – revenue.”
Therefore, the goal of Mr. Huc’s analysis, as well as of Skytra’s business model, has been to minimize the volatility of reported revenues to facilitate more predictable revenues and profits, which would lead to airlines raising their credit ratings, which means they can lower financing costs – i.e., qualify for lower interest rates on loans to the airline.
Quoting the executive summary of Mr. Huc’s research, “The findings of this study suggest a single notch improvement on the airline industry’s cost of financing could result in up to US$7.7bn in savings per year. The impact of a notch on credit spreads is between 10 and 100 basis points when using the observed spreads, and between 10 and 40 basis points when adjusting for default risk.
Through building the world’s largest air ticketing database, Skytra developed its regulated benchmarks based on US$ per Revenue Passenger Kilometre ($/RPK). This represents the wholesale price of air travel per KM flown by an individual passenger in each of the six regions it represents.
Marking the one-year anniversary of Skytra’s launch, its BA (Benchmark Administrator) status allows customers to use the benchmarks to price derivative contracts, providing an effective hedging solution to protect against revenue volatility. These contracts will initially be traded in Over-The-Counter (OTC) markets, facilitated by banks and inter-dealer brokers.
Huc goes on to say that “The assessment was based on a combination of two methods: 1) investigating the cost of a “notch” for each credit rating and applying this average value to the typical credit rating of the airline industry, and 2) using a theoretical model (Emery’s Lambda) to link earnings volatility and default probability, and its implied effect on credit spreads.”
While the details of Mr. Huc’s analysis are beyond the scope of this article, we have provided a brief overview of Skytra’s methodology. What we haven’t yet discussed, though, is the importance of price indices.
Skytra Price Indices
Earlier in this article, the following sentence appeared: “. . . it is the availability of widely recognized and reliable indices for interest rates, commodity prices, etc., that provide a suitable reference point for the hedging instrument, or derivative, to be built around.”
All of the work that Skytra has put into this project focused on the building of a set of strong indices to serve as benchmarks for ticket pricing. In a January 2021 news release, Skytra announced the following: Skytra, a wholly-owned subsidiary of Airbus, has obtained approval from the UK’s Financial Conduct Authority (FCA) to be the regulated Benchmark Administrator (BA) for its Air Travel Price Indices.
Regulatory approval marks a key milestone in Skytra’s strategy of bringing to market the next generation of risk management tools allowing the air travel industry to manage air travel pricing risk for the first time.
Dynamic Pricing vs Hedging
In an additional discussion during an Airways conversation with Skytra, we asked about how ticket price hedging would work with current pricing methods that culminate in wide variances paid for tickets by a group of passengers on a particular flight.
Skytra said, “Dynamic pricing and hedging are two separate activities with two different levels and with diverse objectives. While the objective of hedging is to reduce volatility on yields at a macro level (regional level), dynamic pricing increases yield volatility on an individual route level (Origin and Destination) to optimize the revenue per flight.
Revenue managers have to maximize ticket prices in a very competitive environment that is driven by supply and demand. Neither can they disregard market trends when they price nor can they use a “cost plus operating margin” model when selling tickets. The price at which an airline can sell the ticket is more or less the result of the market pressure.
The high intra-day, intra-week, and intra-month price fluctuation of tickets is rather a necessary evil to stay profitable than the desired feature. At a macro level, it impacts airlines’ overall revenues – making them unpredictable. Hence the benefits of hedging. In a nutshell, hedging will not change the dynamic pricing, – once trades will be done – the forward curve might inform revenue managers about where ticket prices are in the future . . .
So, it’s a new source of information!”
Skytra and the Industry
Finally, Airways asked how Skytra begins building relationships with airlines and financial institutions to win them over to using Skytra’s services.
Skytra told us that “Being a subsidiary of Airbus, we are fortunate to have access to airlines all over the world and we are able to build on this to help airlines improve their risk management position and support them out of this current climate.
The company added, “We also take a direct approach with financial institutions, many of which have approached us first to learn more about our proposition. Further, Skytra also employs a number of people with financial services backgrounds who have networks we can leverage.”
Note: We greatly appreciate Skytra’s time spent talking with Airways, about ticket price hedging, with particular thanks to Elise Weber, Matthew Tringham.
Featured image: Skytra