Risks and Recommendations for Chinese Domestic Airlines

Ten most important risks facing Chinese airlines

Task:

You work for a Chinese domestic airline called Jet Safe. 

In April 2019 Jet Safe generated revenues of CNY 100 million i.e., 500 flights producing (on average) CNY 200,000 each. Revenues are partly determined by demand from international visitors to China who are sensitive to currency movements. 

Assume that the percentage change in flights in the current month has a delta of 0.8 with respect to returns in the USD/CNY exchange rate in the previous month. For example, the USD appreciated by 0.75 % in April so flights in May will be 0.60% (i.e., 0.75%*0.8) higher at 503 after rounding. We assume that there is currently plenty of capacity to meet any increase in demand for flights. 

Every month Jet Safe has fixed costs of CNY 50 million (this includes depreciation and debt servicing with interest costs fixed). 

The most significant variable cost is jet kerosene. Each flight requires (on average) 13 metric tons of jet kerosene. 

We assume that the USD price of jet kerosene at the end of the month will apply to all usage of jet kerosene during the following month (i.e., USD 640 per metric ton as at 30 April 2019 will apply for the entire month of May). To convert to CNY, we convert at the spot exchange rate applying at the end of the previous month (6.7712 CNY per 1 USD 30 April 2019 will apply for May). 

Other variable costs are CNY 35,000 per flight. 

So, in May (i.e., month 0) the Earnings Before Tax (EBT) for Jet Safe will be CNY 4,657,799 

Cash at hand is currently CNY 2,500,000.  

Jet safe has a liquidity covenant built into its debt facility such that liquid assets (i.e., cash) must not fall below CNY 1,000,000 at any time. 

1?Consider a domestic airline operating in China i.e. without the simplifying assumptions we have made above. What are the ten most important risks facing Chinese airlines? Describe each of them briefly and rank them in order of importance. To answer this you will need to do some research into the airline industry.
2?Based on your research a) critique the analysis performed in Questions 4-5 ?provided the answers below?and b) provide specific recommendations for how the analysis could be improved.
3?Based on your research, your analysis and what you have learned in the FRM classes/notes, what specific recommendations would you make for evaluation and possible treatment of risk in a real-world Chinese airline? Your answer should consider market risk and one other risk of your choosing

Answers for Q4 and Q5
Q 4) Simulate 1000 paths of monthly prices for the next 12 months for jet kerosene in USD and the USD/CNY assuming that: 
the mean of log returns for both series is zero, 
the volatility of the jet kerosene returns is 10% per month, 
the volatility of the USD/CNY returns is 0.7% per month, and 
the two series have a correlation of -0.12. 
Produce two histograms (one for jet kerosene and the other for USD/CNY) showing the distribution of prices at the end of 12 months. Hint: there is a Histogram tool in the free Data Analysis Add-in 
For the first path you should show all your workings (no other calculations to be presented). Your starting point (month zero) should be the prices as at 30 April 2019. Show sufficient calculations so that the marker can identify the source/nature of any errors. 
Comment on the shape of the histograms and why they take this shape. 

The two figures show different bell shapes. The probability distribution of jet fuel price volatility is more like a lognormal distribution because it is relatively to the left. Compared with the distribution of currency price fluctuations, currency price fluctuations are normally distributed, with relatively smaller fluctuations, and more data samples are concentrated near the center.
Q 5) For each path, calculate the total EBT over the next 12 months (no need to adjust for time value). 
Now analyses the distribution of 12-month earnings across all the simulated paths using appropriate risk measures. 

Each time you hit the F9 button or the Enter key, Excel will recalculate everything with a new set of random numbers. If at any time you want to stop this from happening you can change the calculation options under the Formulas tab. Try recalculating everything ten times and discuss/explain what you observe.