Hedging: Case of American Airlines

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.