By examining Easyjet's reports up to 2009 it is apparent that company used forward contracts as a mean of hedging against the risk of oil increasing oil prices.
Figure 1.2
As we can see from figure 1.2, the overall fuel cost for Easyjet has risen by 9.7% from 2006 to 2007 and 66.6% from 2007 to 2008. This big increase is a result of crude oil prices rocketing to $147/barrel. By studying the accounts from 2007 to 2008 Easyjet hedged 40% of the fuel at $735 per metric tonne compared to 66% being hedged at $1147 per metric tonne over the 2008-2009 period. In previous years Easyjet used forward contracts effectively to minimize fuel cost, however, in 2008 it is obvious Easyjet did not fully appreciate the economic climate. With a worldwide downturn being predicted and a reduction in demand for oil from emerging economies such as China and India we believe Easyjet did not expect oil prices to drop drastically from exceptional highs of $147/barrel to lows of $32/barrel. As fluctuations in fuel price will affect Easyjet's performance, an increase in fuel cost (which is a very big proportion of total cost) will cause a decrease in profits; therefore, higher cost per seat, as a result hedging must be seen as a viable option to control such fluctuations.
The aviation industry as a whole was affected adversely during 2008 due to the oil prices, however not all airlines were as badly affected as Easyjet who hedged 66% of its fuel requirements. We have looked into other airlines, to provide an indicator to the general hedging consensus. Lufthansa hedged 24 months out, building up their hedges by 5% per month, so by the time their hedging reached 85-90% it was already 18 months out. So by August 2008 Lufthansa had hedged 54% of its fuel requirements. Air France-KLM also have a similar approach to hedging but hedged 48 months out, 80% in year one, 60% year two, 40% year three and 20% year four. This policy limits the affect of volatile prices but they are taking the risk of paying more than the current market price. It should be noted that both Lufthansa and Air France-KLM have a different business model to Easyjet therefore will be able to invest more into their hedging strategies.
In such volatile markets it was incorrect for Easyjet to lock in fuel prices over a period of 12 months, where in fact they should have initiated contracts over a smaller time period 3-6 months, as a 12 months period is not efficient, as the company cannot adapt to favourable conditions. Nonetheless the use of forward contracts is correct as it provides flexibility for Easyjet.
Another option at Easyjet’s disposal is the use of futures contracts. Future contracts are very similar to forward contracts, except they are exchange-traded and defined on standardized assets. The future option is not viable due to the above reasons as Easyjet have specific requirements such as different volumes required during a particular year that may well not be available on an exchange, therefore, their needs must be tailor made.
A third financial instrument that could be used to mitigate fuel cost risks is an option. The option can be divided into two subsections of a collar and a cap.The collar works by allowing the airline to purchase put and call options based on a set range of oil prices. The airline trades off some of the upside cap by agreeing to a floor rate, below which the airline will not benefit. This is a good option as there are no upfront premiums that an airline needs to pay. Secondly, with the cap method the airline will pay a premium to buy an option to cap the maximum amount it will pay for its fuel in the future. If the market price for a barrel of oil goes up, the carrier pays no more than the capped level. The cap is effective for airlines with a favourable credit risk. Both of the mentioned methods can be expensive due to volatility of underlying asset and counterparty risk involved but provide an excellent level of flexibility for Easyjet.
Foreign exchange risk
Foreign exchange risk is another major risk affecting Easyjet due to major input costs being in different currencies, for example fuel costs are priced in USD, and as mentioned previously, have a major impact on profitability of Easyjet. Furthermore a selection of the planes used by Easyjet are leased from US suppliers the leases are also priced in USD. On the other hand, the widely held routes for Easyjet are European so the main proportions of their fares are in EUR and GBP.
The foreign exchange market is very volatile with prices fluctuating every second, therefore Easyjet need to have a sufficient risk mitigation strategy in place to hedge against currency movements. As small as 1 cent change in currency either direction can cause significant changes in the profitability of the company due to the large volume of transactions.
Figure 1.4
As the figure 1.4 indicates the highest percentage of Easyjet’s total revenue is received in GBP whereas the largest part of the expenditures is paid in US dollars. This observes that changes in GBP currency against the US dollars will have a high impact on the company’s costs. If GBP devalues and US dollar appreciates this will increase the costs of the company since now they will buy fewer dollars with the same amount of GBP.
Airlines are not hedging to improve profits. They are hedging to reduce the swings in profits.
The use of zero cost collars is a common practice for aviation companies as it locks the cost of a currency between two unknown values. This is similar to Easyjet’s strategy, as it secures a return through a purchase of a cap and a sale of a floor. The cap protects the holder from adverse price increases above the strike price at the cost of the premium, which is paid in any event. The holder of the cap will also hold a floor, which limits the advantage it can take of price reductions below the strike price. Therefore the net position is zero cost as any advantages are cancelled out.
Another derivative used to mitigate currency risk is forward contracts, which are over the counter agreements, traded between two parties. This is beneficial as Easyjet can lock in into different exchange rates more specifically GBP/USD as USD is the highest proportion of their costs.
Furthermore Easyjet seek to reduce foreign exchange exposure arising from transactions in various currencies through a policy of matching as far as possible, receipts and payments in each individual currency and selling the surplus or buying the shortfall of its currency obligations.
We believe Easyjet put into operation the correct strategy to reduce such considerable risk, however, the use of forward contracts increases the magnitude of counterparty risk as failure of counterparties to meet their obligations will result in financial loss for Easyjet. Because they are exposed to counterparty risk the company has to acknowledge the significance of credit risk.
Credit Risk arises whenever payments or performance to a contractual agreement by another organization is expected, and consists of the likelihood of a loss arising from failure or default of another organization. Easyjet’s surplus funds are invested in high quality short-term instruments, mainly money market funds or bank deposits. The company faces the potential impact of the financial loss that might arise in the event of default of counterparty, which might be a financial institution given recent turmoil in financial markets. Even though the institutions rated as AAA by several agencies such as S&P, Moody’s and Fitch, the risk of counterparty default still exists. Therefore Easyjet could deposit smaller amounts with a larger number of institutions, to reduce the potential risk of an institution defaulting.
It is vital that the company holds sufficient cash or liquid funds as a form of insurance. Aviation companies can face any unpredictable events such as natural disasters, accidents or changes in regulation affecting aviation. However in recent years the high volume of regulation has meant airlines are facing higher cost that in turn will be passed onto the final customer. After 9/11 regulation was passed, forcing aircraft manufactures to have cameras positioned outside the cockpit. This was introduced to act as a deterrent but costs were passed down the supply chain, from manufactures to airlines to the paying customer. Furthermore other unforeseen circumstances such as the recent volcano eruption have added costs to airlines which in fact cannot be passed onto the final customer so there needs to be sufficient reserves to meet such exceptional circumstances.
It is very important that Easyjet’s financial position is reviewed continuously by experts such as accountants to make sure that the company maintains acceptable levels of cash which should be set as a target during any financial year.
Safety risk
One of the most important key risks that any aviation company faces is safety risk. It is a risk that needs to be carefully measured and forecasted since it involves the safety of people which is Easyjet’s priority.
In order to maintain economic viability, direct costs must be minimized and resource utilization must be maximized. To make the most of crew resources, low cost carriers adopt scheduling practices that emphasize high productivity measured in hours, multiple sector duty days and minimum crew rest. These scheduling practices, where they are not managed, can have detrimental consequences for crew alertness and performance and potentially lead to an unacceptable level of fatigue risk exposure. As part of Easyjet’s business model they aim to minimize costs. By implementing this Easyjet increases its exposure to engineering faults, insufficient baggage handling staff, slow crew transport and difficulties of staff getting through security. This will have an adverse affect as crew alertness can be compromised as they are taking on more duties than required. Furthermore to obtain maximum utilization staff is unable to achieve sufficient rest as they are flying at least two flights a day with a minimum change over period. In addition to this by looking at the staff roster, most staff have a 5 on 2 off week; this is causes fatigue to accumulate as there is inadequate time to attend to domestic duties. Ineffective dealing with staff fatigue can lead to a reduction in staff alertness as a result; the security processes put in place by Easyjet may not be followed effectively.
Failure to prevent or deal successfully with any security incident, will strongly affect the company’s reputation, financial and operational performance. Safety risk is unavoidable in this industry, has a very low probability of occurring but if it does it will have a huge impact on the company. The key lies in how this risk is identified and managed in a transparent manner.
Operational risk
The internet has revolutionized the way businesses are run, they have allowed companies to minimize labour and administration costs by implementing systems to deliver essential services. Seeing that over 90% of Easyjet's business is generated by the internet, there is a substantial risk exposure which needs to be mitigated. As an internet based company we have identified three key areas which need to be secured such as payment systems, backup systems and virus/hacking prevention.
For Easyjet the majority of payments are received online, the high dependency on such systems as eRES is a concern as it is susceptible to attacks. This risk is not only external but internal; such data must not be accessible to employees as this can also cause fraud. Such leaks of data can affect the reputation of Easyjet, as this could deter potential customers. The handling of customers’ personal details is very important as any lapses will have a damaging effect on business reputation.
The formation of the Revenue Protection Team has provided another level of security preventing any internal or external leaks.
Continuing on from high levels of dependency on technology it is essential backup systems are in place. Backup systems are required when the current systems fail and allow business continuity, therefore reduce potential drop in productivity. Easyjet are implementing the use of backup systems effectively. However Easyjet's business interruption shows that there is place to improve.
Conclusions
To conclude, the aim of this report is to identify various risks that Easyjet faces, focusing on those risks that have the greatest impact on the company. By focusing on these fundamental risks we analyzed them using COSO ERM model. The model provided us a guideline to go though each risk by using the steps of the model which are event identification, risk assessment, risk response , control activities , communication and finally monitoring.
Recommendations:
On behalf of Risk Management Consultants Ltd we put forward the following mitigation strategies that Easyjet should implement.
- Continue the use of forwards and collars for fuel hedging as they provide flexibility
- Restrict the size of contracts from 12 months to 3-6 months due to current economic instability
- Hedge future fuel requirements on a decreasing basis (year one 80%, year two 60% and year three 40%)
- Focus not only on oil price, but the broader economic world in order to avoid previous mistakes when hedging at the peak
- Continue the matching currency policy
- Commence agreements only with institutions with a AAA rating and thus minimizing counterparty risk
- Use netting to balance the shortfalls in cash for different entities, however, needs to be examined further as some countries have restrictions preventing a company pulling funds from other entities
- Look to transfer financial risk to the final customer by changing pricing methodology to offset the risk
- Change surpluses of convertible currencies back to home currencies as most income is in GBP and most cost is in USD
- Reduce possible fatigue of staff by reaching an agreement with airport operators to allow brisk passage through security
- Implement a different roster for staff to meet individuals’ needs, as some staff will prefer later shift and some earlier. Look into personal situations of staff.
- Implement the use of ‘mystery shoppers’ on flights to evaluate the level of service and alertness of staff
- Continue to upgrade fraud prevention software
- Ensure backup systems are in a safe and easily accessible area in an event of a emergency
- Continue maximizing utilization of input resources to the extent that will not affect safety.
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Reals K. (2008) Air Transport Fuel hedging strategies. [Online]. Available at:
Financial Times (2009) Easyjet hit by fuel hedging costs. Yahoo [online]. Available at:
Horcher, Karen A. (2005) Essential of financial risk management. [Online]. Available at:
Rendleman, Richard J. (2002) Applied derivatives: futures, options and swaps. Oxford: Blackwell
Easyjet (2009) Currency impact. [Online]. Available at:
Options for options (2010) The Zero Cost Collar and Using Collars as a Hedge. [Online]. Available at:
Investopedia (2010) Zero Cost Collar. [Online]. Available at:
Harrington, Scott E. (2003) Risk management and insurance. 2nd ed. London: McGraw-Hill
Robinson S. (2010) To hedge or not to hedge Qfinance [online]. Available at:
Easyjet (2009) Currency impact. [online]. Available at:
The Financial (2010) Easyjet puts volcano costs at £65m. [Online]. Available at:
ISAA (2006) An integrated system for managing fatigue risk within low cost carrier. [Online]. Available at:
Flight International (2006) Easyjet seeks better roster. [Online]. Available at:
Transport Canada (2010) Fatigue Risk Management System for Canadian Aviation. [online]. Available at:
Thomas D. (2005) EasyJet cuts virus attacks with email security service. Computing.co.uk [Online]. Available at:
Mari A. (2010) Easyjet system crash over weekend. Computing.co.uk [Online]. Available at: