Financial Risk Exposures in the Airline
Industry: Evidence from Australia and New
Zealand
by
Geoffrey F. Loudon †
Abstract:
Important financial risks facing the airline industry include interest-rate, currency
and fuel-price risk. This paper estimates the exposure to these risks within the airline
industry of Australia and New Zealand, using both linear and non-linear
specifications, for a variety of horizon lengths. Evidence for exposure, both
symmetric and asymmetric, tends to strengthen as the return horizon is lengthened.
Exposure to these financial risks is largely unchanged by the terrorist attacks and
the collapse of a major competitor in September 2001.
Keywords:
FINANCIAL RISK EXPOSURE; RISK MANAGEMENT; AIRLINE INDUSTRY.
† Department of Accounting and Finance, Macquarie University, NSW 2109. Email:
gloudon@efs.mq.edu.au
Australian Journal of Management, Vol. 29, No. 2 December 2004, © The Australian Graduate School of Management
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1. Introduction
irlines face substantial strategic, fi
Financial risks create uncertainty about
A
nancial, operational and hazard risks.
future cash flows due to changes in
general economic conditions and specific changes in revenues, operating
expenditure and financing costs. Managing exposure to key financial risks is an
integral part of the corporate finance function. This paper studies exposure to three
major financial risks confronting the airline industry in Australia and New Zealand.
It analyses the interest-rate, currency and fuel-price risk exposures for Qantas and
Air New Zealand, which are the dominant airlines in Australia and New Zealand,
respectively. Considerable volatility and a variety of trends occurred in interest
rates, currency values and the fuel price throughout the period studied. This
suggests that there were potentially large gains to be derived from managing these
risks effectively.
In addition to volatility in key market variables, these airlines also confronted
severe turbulence in their operating environment during the sample period. The
global airline industry faced intense external pressure as a result of the terrorist
attacks on September 11, 2001. Furthermore, the airline industry in both Australia
and New Zealand underwent a major shakeout with the demise of Ansett and the
related financial difficulties of its parent company, Air New Zealand. Ansett was
the principal domestic competitor of Qantas until it was placed into voluntary
administration on September 12, 2001. In the latter part of the period of this study,
the airline industry also faced declining demand due to the Bali bombings, the war
in Iraq and the outbreak of the SARS virus. Throughout the time frame of this
study, airlines also faced actual and potential competition from new entrants to the
industry.
Interest-rate, currency and fuel-price exposure are acknowledged to be
important risks affecting the airline industry and are commonly hedged. For
example, in its 2003 annual report to shareholders, Qantas states in note 32 that it
‘is subject to interest rate, foreign currency, fuel price and credit risks’.1 This same
note indicates that Qantas ‘manages these risk exposures using various financial
instruments’ and provides examples of hedging instruments which they employ.2
These include interest-rate swaps, forward rate agreements and options to manage
interest rate risk; cross-currency swaps, forward foreign exchange contracts and
currency options to manage currency risk; options and swaps on aviation fuel and
crude oil to manage fuel price risk. As this set of risk management tools provides
both linear and non-linear payoffs, it is apparent that management can identify
important symmetric and asymmetric components of exposure.
Three related literatures are relevant for our paper. Several papers develop
theoretical models that examine the determinants of currency exposure, including
Shapiro (1975), Marston (2001), Allayannis and Ihrig (2001), Bodnar, Dumas and
Marston (2002). This literature establishes the prime importance of the competitive
structure within the industry. Another stream of literature analyses stock returns to
provide empirical measures of corporate exposure to risks such as exchange rates,
interest rates and commodity prices. Risks analysed in this manner include foreign
exchange (Jorion 1990), interest rate (Sweeney & Warga 1986), gold price (Tufano

1. Credit risk exposure is not analysed in this paper, as it is considered to be the least important of the four.
2. Similar evidence is contained in the annual report for Air New Zealand.
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Vol. 29, No. 2
Loudon: FINANCIAL RISK EXPOSURES IN THE AIRLINE INDUSTRY
1998) etc. Finally, an extensive literature canvasses theoretical arguments for and
against hedging of financial risks by non-financial corporations. For example, Stulz
(1984), Smith and Stulz (1985), Froot, Scharfstein and Stein (1993) and Nance,
Smith and Smithson (1993) identify tax minimisation, managerial risk aversion,
financial distress, resolution of the underinvestment problem as motives for
corporate hedging. Carter, Rogers and Simkins (2002) make the case that the
airline industry is one in which corporate hedging is likely to add value by
minimising the underinvestment problem.
Our study seeks to contribute in the following ways. Many previous studies
have tested for the existence of a single extra-market risk. Most of these have been
for exchange-rate exposure and while some have tested for interest-rate exposure,
this has been largely for financial corporations. In contrast, we simultaneously
examine interest-rate, currency and fuel-price exposures.3 Most previous papers
have examined either broadly aggregated industries or a wide spectrum of
individual companies, without controlling for industry effects.4 We argue that the
analysis of companies within a single industry in a specific context provides useful
incremental knowledge. Ongoing external threats to the global airline industry and
public debate about competition in the Australian-New Zealand region makes these
two airlines an interesting place to analyse the existence and relevance of financial
risk exposures.5
Our main findings are as follows. Short-term returns for Qantas and Air New
Zealand are negatively exposed to fuel-price risk, but not significantly exposed to
interest-rate or currency risk. Using multi-week returns, the incidence of significant
linear and non-linear exposures to these three risks tends to increase with the
horizon length. A possible explanation for this evidence is that airlines are better
able to manage their short-term exposures. Although the extraordinary events of
September 2001 had a substantial impact upon airline returns, they had virtually no
influence on the degree of exposure exhibited by our sample airlines to either
interest-rate or currency risk. In contrast, fuel-price exposure measures show some
sensitivity to these events.
The rest of our paper proceeds as follows. Section 2 provides a theoretical
analysis of financial risk exposures in the airline industry. Section 3 describes the
data and methods employed. Results are reported and analysed in section 4.
Finally, Section 5 concludes the study.
2. Financial Risk Exposures in the Airline Industry
This section analyses the potential consequences of interest rate, currency and fuel
price risk on airline stock returns. Exposure to these key financial risks is expected
to impact heavily on the returns of airlines due to several distinctive features of the
airline industry. This industry is characterised by: (i) cyclical demand; (ii) strong

3. For example, Carter, Rogers and Simkins (2002) provide a detailed examination of fuel hedging in the
U.S. airline industry, but ignore currency and interest-rate risk.
4. An exception is Williamson (2001) who examines a sample of automotive firms.
5. On September 9, 2003, the Australian Competition and Consumer Commission rejected a proposed
Strategic Alliance Agreement between Qantas and Air New Zealand, on the grounds that it was anti-
competitive and not in the public interest. Since exposure and competition are related, exposure provides
further, indirect evidence of the effectiveness of competition.
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AUSTRALIAN JOURNAL OF MANAGEMENT December
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price competition, both domestic and international; (iii) high capital investment;
(iv) high gearing levels; (v) high fixed costs of labor and equipment; and (vi)
regulatory impediments such as ownership restrictions and control of landing
rights. Such factors limit the ability of airlines to effectively reduce the impact of
these exposures by restructuring their operations to internally hedge or to initiate
other offsetting action.
As well as being in direct competition with each other on some routes, both
sample airlines are in competition with other international operators. Qantas and
Air New Zealand are Full Service Airlines or Network Carriers. As such, they are
also subject to competition from low cost, restricted service airlines, known as
Value Based Airlines. These represent a relatively recent, yet credible competitive
threat. The demise of Ansett illustrates that established Full Service Airlines are
susceptible to the entry of Value Based Airlines, such as Virgin Blue.
2.1 Interest Rate Exposure
Interest rate risk is especially important to airlines given their substantial use of
debt finance. High leverage ratios are prevalent in the airline industry due to its
capital intensive nature and the relatively high cost of equity. Equity can be more
difficult to attract because of high earnings volatility, as reflected in the lower than
average price-earnings ratios typically found in the airline sector.
Borrowing costs are directly related to interest rate changes. Moreover there
are significant indirect costs associated with higher yields. Bartram (2002)
emphasises the impact of interest rates on general economic conditions and the
progression of the business cycle, with its consequential effect on consumer
demand. This is especially pertinent for industries such as airlines, where demand
is cyclical and contains a large discretionary component. Carter, Rogers and
Simkins (2002) consider the underinvestment problem due to expected distress
costs. Higher interest rates increase expected costs of distress and this is
particularly so for the airline industry where leverage is high and distress costs are
substantial.6
Since both direct and indirect costs of borrowing move in the same direction
as interest rates, returns should be negatively related to interest rates. It is therefore
expected that interest rate exposure coefficients will be negative.
2.2 Currency
Exposure
Management of exchange rate risk is important since airline profitability is related
to currency values for a number of reasons. First, revenues and expenses are
denominated in several currencies. Second, borrowings often are denominated in
several different currencies. Third, tourism demand, both inbound and outbound, is
influenced by exchange rate levels.
Shapiro (1975), Marston (2001), Williamson (2001), Allayannis and Ihrig
(2001), Bodnar, Dumas and Marston (2002), inter alios, contribute to a large
literature that analyses the theoretical determinants of exchange rate exposure,
under a variety of industry structures. These papers show that exposure is related

6. Forced sales of aircraft fleet represent an important source of financial distress in the airline industry.
Pulvino (1998) shows that distressed airlines sell aircraft at heavily discounted prices, with the discount
being larger during recessions and for airlines with above industry average debt levels.
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Loudon: FINANCIAL RISK EXPOSURES IN THE AIRLINE INDUSTRY
to: (i) the mix between domestic and foreign sales revenue; (ii) the intensity of
domestic and international competition; and (iii) the extent to which domestic and
foreign inputs to production are substitutable.
The exposure determinant literature emphasises that the nature of the
competitive structure of the firm’s industry plays a crucial role. Industry related
factors such as markup and pass-through strongly influence exposure levels.
Markup is the price over cost margin, while pass-through refers to a firm adjusting
its foreign currency price levels to offset the impact of exchange rates changes.
Exposure is lower for more highly concentrated industries, since markups are
higher.7 Exposure and pass-through are related to product substitutability and
market share.8
Appreciation [depreciation] of the domestic currency reduces [increases] the
borrowing cost of foreign-denominated debt and other foreign sourced costs. This
suggests a positive relation. However, the effect of currency movements on
revenue is ambiguous. Foreign demand for international and domestic flights
moves inversely with the value of the home currency. For example, if the $A
depreciates, demand for flights to and within Australia from non-residents will rise.
While domestic travel demand from residents also moves inversely with home
currency, demand for international travel changes directly. For example, if the $NZ
depreciates, New Zealand residents are likely to substitute domestic travel for
international destinations. Competition in the airline industry is expected to prevent
airlines from fully protecting their revenue from the impact of these currency
movements. Given these counteracting effects, it is not possible to predict the sign
of the currency exposure.
2.3 Fuel Price Exposure
Fuel price risk management matters since jet fuel costs comprise a significant
component of airline operating costs. Carter, Rogers and Simkins (2002) argue that
airlines also face an underinvestment problem whenever profitable investment
opportunities arise during times of high jet fuel costs.
Short term cash flows are likely to be directly related to changes in the fuel
price due to price change inertia. Revenue responsiveness may initially be slow due
to advance sales, pre-committed advertised package fares, etc. In the longer term,
much of the price effects are likely to be passed on as all airlines face similar fuel
costs. The adjustment will not be complete, however, to the extent that total
industry demand is affected. In the medium term, the impact of fuel price exposure
is likely to be more firm specific and reflect varying degrees of competitive power
and/or fuel efficiency across different airlines. Carter, Rogers and Simkins (2002)
provide evidence that airline cash flows and stock returns are negatively correlated
with fuel price changes.

7. Allayannis and Ihrig (2001) provide some empirical support for the prediction of their model that
exchange rate changes have larger valuation effects during periods of higher competition and lower
markups.
8. In the analysis by Bodnar, Dumas and Marston (2002), for any given market share, higher
substitutability decreases pass-through and increases exposure. Empirical support for the predictions of
their model is limited, although this may partly reflect the difficulty of operationalising the theoretical
variables.
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AUSTRALIAN JOURNAL OF MANAGEMENT December
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Airline profitability is reduced by the direct and indirect costs associated with
the fuel price. Since competition prevents an airline from perfectly undoing the
impact of changes in fuel prices by adjusting its fare schedule or seat capacity, the
fuel price exposure coefficient is predicted to be negative.
3. Data
and
Method
3.1 Data
Weekly data is collected for the period August 1995 to June 2003.9 All equity
price, interest rate, currency and fuel price data is sourced from Datastream [DS].
Individual stock returns are obtained for Qantas and Air New Zealand, and the
returns on the relevant DS Market Index are used to proxy for the national markets
of these airlines. Returns are computed in the relevant domestic currency. Short-
term interest rates are used as proxies for the risk free rate to compute excess
returns—Australian 90–day Bank Accepted Bills are used for Qantas; the New
Zealand 3–month Treasury Bill rate is used for Air New Zealand.
Interest rate risk is proxied by changes in the long-term interest rate.
Domestic 10–year Treasury bond rates are used for Qantas and Air New Zealand.
Measures of long-term interest rate exposure are preferred to their short-term
counterparts, as the major proportion of airline debt financing is long-term.
Changes in the trade-weighted index of the relevant domestic currency are used for
assessing foreign exchange risk. As these airlines derive their revenues in many
different currencies and use multi-currency debt structures, it is inappropriate to use
a single exchange-rate and infeasible to estimate exposures to all relevant
currencies.10 Hence trade-weighted indexes appear the most useful, though
imperfect, proxies available. Variation in fuel prices is measured from changes in
the $U.S. price per barrel of jet kerosene, FoB, Singapore. This price is converted
to a local equivalent by using the relevant exchange rate to isolate currency effects
from fuel price effects.
Figures 1 and 2 plot the key variables throughout the study period to assist our
readers visualise the potential impact on airline returns of the risks we analyse, and
hence the likely gains from managing these risks effectively. Figure 1, panels (a)–
(c) show the U.S. dollar return on $US1 invested in Qantas, Air New Zealand and
the global airline industry, respectively.11 In a period where the market value of the
global industry declined, the results for the two airlines are very different. Although
Qantas doubled in value, substantially outperforming the global market, Air New
Zealand performed well below the industry average. Part of this differential
performance can be attributed to the demise of Ansett. Each plot shows the large
and negative initial impact of September 11, 2001. While the effect was reversed in
the short term for Qantas and the global industry, the negative impact lasted longer
for Air New Zealand. This reflects the divergent nature of the ongoing impacts of
the closure of Ansett upon Qantas and Air New Zealand.

9. The start of the sample period coincides with the public listing of Qantas.
10. For example, Qantas states in its 2003 annual report that it derives revenue in approximately eighty
countries.
11. Datastream’s World Airlines and Airports Index is used to proxy global industry returns.
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Vol. 29, No. 2
Loudon: FINANCIAL RISK EXPOSURES IN THE AIRLINE INDUSTRY
Figure 1
Airline Returns
3.0
3.0
2.5
2.5
2.0
2.0
1.5
1.5
1.0
1.0
0.5
0.5
0.0
0.0
1995
1996
1997
1998
1999
2000
2001
2002
2003
1995
1996
1997
1998
1999
2000
2001
2002
2003


(a) U.S. dollar return on $US1
(b) U.S. dollar return on $US1 invested
invested in Qantas
in Air New Zealand

3.0

2.5
2.0
1.5
1.0
0.5
0.0
1995
1996
1997
1998
1999
2000
2001
2002
2003

(c) U.S. dollar return on $US1 invested
in global airline industry

Figure 2 presents sample paths for the raw variables used to capture interest rate,
currency and fuel price risk. Panels (a) and (b) graph long term interest rates in
Australia and New Zealand, revealing three basic regimes that largely coincide
across both countries. Falling interest rates characterise the first and last parts of the
study period, with a period of rising rates occurring in the middle. Panels (c) and
(d) graph the trade-weighted index value for the $A and $NZ, respectively. Plots of
the Australian and New Zealand currencies display similar secular trends. After an
initial period of appreciation, they tend to depreciate for much of the sample
period, until they recover much of the lost ground in the final couple of years of the
study. Panel (e) plots the fuel oil price which exhibits relatively high volatility. In
particular, there is a substantial upward trend in the price from levels below $US15
in late 1998 to levels above $US45 in October 2000. Another temporary spike
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AUSTRALIAN JOURNAL OF MANAGEMENT December
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occurred during February-March 2003 with the price levels briefly breaking
through the $US40 level.
Figure 2
Risk Variables
10
10
9
9
8
8
7
7
6
6
5
5
4
4
3
3
1995
1996
1997
1998
1999
2000
2001
2002
2003

1995
1996
1997
1998
1999
2000
2001
2002
2003

(a) Australian long-term interest
(b) New Zealand long-term interest
rate, % per annum
rate, % per annum

128
128
120
120
112
112
104
104
96
96
88
88
80
80
72
72
64
64
1995
1996
1997
1998
1999
2000
2001
2002
2003

1995
1996
1997
1998
1999
2000
2001
2002
2003

(c) $A trade-weighted index
(d) $NZ trade-weighted index


50

45
40
35
30
25
20
15
10
1995
1996
1997
1998
1999
2000
2001
2002
2003

(e) Jet kerosene in $US/BBL
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Selected characteristics of the airlines, collected from their annual reports, are
listed in table 1, together with a description of how these characteristics are
measured. These measures are relevant for assessing the potential importance of
exposure to interest rate, currency and fuel price risk. They also are suggestive as to
the relative ability of the airlines to respond to large and unexpected changes in
these market rates.
Table 1
Selected Airline Characteristics
This table reports statistical data sourced from the airline annual reports. Both airlines end their
fiscal year on June 30. Foreign Sales is percentage of total revenue derived from geographic
regions outside the domestic country. Fuel Cost is cost as a percentage of total operating
expenditure, excluding depreciation, amortisation and interest. Gearing is percentage of net debt to
net debt plus equity. Gearing incl. Off is same as Gearing, except that it also includes off balance
sheet debt. Interest Cover is earnings before interest and taxes divided by net interest expense.
Long Term Debt is percentage of non-current debt to total debt, as recorded in the balance sheet.
Revenue Seat Factor is percentage of revenue passenger kilometres to available seat kilometres.
n.a. denotes data not available.
Fiscal
Year
2003 2002 2001 2000 1999 1998 1997 1996
Panel A: Qantas
Foreign
Sales
34.5 37.7 45.4 41.1 42.1 41.7 41.7 44.3
Fuel Cost
15.5
15.8
15.1
11.4 10.7 12.7 13.0 11.8
Gearing
37 31 28 24 20 20 28 40
Gearing
Incl.
Off 50 50 55 48 42 44 51 62
Interest
Cover
8.8 14.1 7.0 7.9 7.6 5.6 5.2 4.9
Long
Term
Debt
84.7 81.0 70.7 81.3 83.8 93.0 82.7 95.3
Revenue
Seat
Factor 78.3 78.6 76.1 75.6 73.4 72.1 78.0 78.8
Panel B: Air New Zealand
Foreign
Sales
76.8 77.7 88.8 80.5 79.1 78.0 78.6 78.8
Fuel
Cost
17.9 18.0 17.4 15.7 11.8 13.6 n.a. n.a.
Gearing
23 47 87 66 35 36 29 16
Gearing
Incl.
Off 65 74 93 76 56 53 52 n.a.
Interest
Cover
17.8 –0.4 –0.2 3.0 3.5 4.2 11.1 69.2
Long
Term
Debt
89.3 91.0 76.0 68.5 87.7 86.1 82.9 72.8
Revenue
Seat
Factor 74.4 72.3 71.6 69.7 67.9 67.6 68.5 67.7
In reference to interest rate exposure, both airlines have high gearing ratios, with
debt being predominantly of a long-term nature. Gearing ratios, including off
balance sheet debt, range from 42% to 62% for Qantas and between 52% and 93%
for Air New Zealand. Average end of year ratios of long-term debt to total debt, as
recorded in the balance sheet over the sample was 84% for Qantas and 82% for Air
New Zealand. Given their higher gearing levels, coupled with a much lower
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AUSTRALIAN JOURNAL OF MANAGEMENT December
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interest cover in 1999–2002, Air New Zealand appeared to have a higher exposure
to interest rate risk than Qantas for much of the period studied.
Having regard to currency exposure, on the revenue side, both airlines have
substantial foreign exchange earnings.12 The lowest proportion of foreign to
domestic revenue is 34.5% [Qantas, 2003] while the highest is 88.8% [Air New
Zealand, 2001]. For Air New Zealand, the average annual foreign sales revenue
proportion over the entire sample is approximately 80% compared to around 40%
for Qantas. This imbalance suggests that the impact of currency exposure may be
quite different for the two airlines.
With respect to fuel exposure, costs are a major component of airline
operating costs, representing between 11–18% of total operating expenditure,
across both companies. The relative importance of these costs has increased in the
latter part of the sample for both airlines. In all years for which this information is
available for both companies, the proportionate cost of fuel is slightly higher for
Air New Zealand.
To help evaluate the comparative ability of these airlines to manage these
risks from changing pricing and capacity decisions, the revenue seat factor is also
provided in table 1. The revenue seat factor is the percentage of revenue passenger
kilometres to available seat kilometres and provides a measure of capacity
utilisation. Average annual revenue seat factor is 76.4 [Qantas] and 70 [Air New
Zealand], with Qantas having the higher rate in every year of the sample. The
higher revenue seat factor attained by Qantas may suggest a competitive advantage,
but the difference is relatively small.
3.2 Method
3.2.1 Linear Risk Exposures While corporate managers have access to internal
data for evaluating the sensitivity of their firm’s cash flows to key business risks,
external analysts are often restricted to share price and macroeconomic data.
Operational measures of exposure to financial risks can be developed by extending
the analysis of foreign exchange risk in Adler and Dumas (1984). They define
exposure as the change in the market value of the firm in response to the change in
the value of each currency to which the firm is exposed. They also propose that the
partial regression coefficients from a multiple linear regression of firm value on the
vector of exchange rates provide operational measures of exposure to the individual
currencies. In the same manner, exposure to K business risks can be estimated by
regressing stock returns on the returns associated with the underlying risks, that is
K

R = α +
β R
ε
jt
j
∑
+

jk
kt
jt
k =1
where R is the return on the jth stock and R is the innovation in the kth risk factor.
jt
kt
To attenuate omitted variable bias, it is usual practice to include the market
return when estimating exposure coefficients. This takes into account the impact of

12. No specific information is available to analyse expenditure by currency. While segmental information
provided in the financial statements of both airlines allocates revenue to different geographic areas, it
apportions earnings before interest and taxes among business functional units, rather than across
currencies.
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Document Outline

• Abstract:
• Keywords:
• FINANCIAL RISK EXPOSURE; RISK MANAGEMENT; AIRLINE INDUSTRY.
• 1.Introduction
• 2.Financial Risk Exposures in the Airline Industry
• 2.1Interest Rate Exposure
• 2.2Currency Exposure
• 2.3Fuel Price Exposure
• 3.Data and Method
• 3.1Data
• 3.2 Method
• 4.Results
• 4.1Linear Risk Exposures
• 4.2Non-linear Risk Exposures
• 4.3Consistency of Exposure, Pre- and Post- September 2001
• 5.Conclusion
• References

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