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.
Image: Skytra Derivatives
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