by Roland Kern, Head of Treasury, Lufthansa Group
Lufthansa Group is a complex, global business operating in an industry that has experienced considerable volatility in recent years. In this article, Roland Kern, Head of Treasury, describes how Lufthansa’s treasury approaches risk management, and the success of the approach that the company has taken.
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Treasury organisation and priorities
We first undertook a review of our financial activities in 2004, and implemented a new risk management framework (our ‘finance cockpit’) including both market and credit risk the following year. As a global business, we have significant exposure to a wide range of market and credit risks, including:
- FX, fuel and interest risk. We manage exposures to 80 currencies, 9 million tonnes of fuel, and significant interest rate risk.
- Liquidity risk. We have around €5bn in liquidity, and have two-year credit lines in place amounting to €755m.
- Asset & liability management. We invest €2 out of 5 in asset management and manage pension liabilities of €14.6bn.
- Counterparty risk. We work with more than 30 banks, in addition to relationships with other financial institutions and oil traders.
Bearing in mind the scale and complexity of these risks, and the potential impact on the Group’s financial results, it was essential to devise a precise and effective risk management strategy.
Market (and other forms of) risk is an inherent element of our business model and it would not be feasible nor indeed desirable to try to fully neutralise these risks. Our objective instead is to hedge our risk to reduce variations and uncertainty, to give time for the Group to adjust to changing market conditions.
We have taken a rule-based approach to hedging market and credit risk, as opposed to basing our hedging strategy on market forecasts. This has proved a successful strategy, even during the period of extreme volatility that accompanied the global financial crisis.
FX and fuel risk
Looking at FX risk, for example, we have a five-layer approach (11 for our major currencies) to hedging our operating business over a two-year time horizon. Our hedging levels reduce over time, averaging 50% over the course of the two-year period. We also have specific strategies for particular types of risk. For example, for aircraft investments, we hedge 50% of our risk on the contract date, and hedge the remaining 50% in five layers of 10%, four using FX forwards and one using FX spot transactions, starting 24 months before cash flows are generated.
We take a similar approach to fuel hedging, but it is more complex in that we trade at 18 different prices. Our aim is to hedge layers of 4.7% each month, so that 85% of our risk is hedged over a six month period (see figure 1). We use option strategies to increase our flexibility and hedge our emissions through the Emissions Trading Scheme.
In addition to establishing a clear, rule-based approach to hedging, an important factor in the success of our hedging strategy has been to improve the quality of our financial forecasting. Consequently, by hedging an average of 50% of our cash flows (with a high hedge ratio for the next six months and then stepping down) FX volatility has less impact on our financial results for the coming 12 months. In some situations, we perform strategic hedging e.g., for USD-EUR, in which cases we can increase the hedge horizon and/or ratio further.
Interest rate risk
For interest rate hedging, as a cyclical business, we have significant natural hedges; furthermore, changing financial conditions affect both revenues and interest rates. We have set a benchmark that 85% of our long-term interest rate exposure should be floating rate. As with our FX and fuel hedging, this approach has proven very successful; for example, in 2008-9, when – as a result of lower interest rates – our costs remained roughly stable, despite higher debt (see figure 2).
Click image to enlarge
Since we first implemented this risk hedging strategy eight or nine years ago, we have reviewed and refined our hedge ratios annually, but these changes have been quite small. For example, we increased from five to 11 hedging layers for our major currencies, and we refined the choice of instruments a little for each hedge layer.
Liquidity risk
Liquidity risk is a major priority for Lufthansa Group, not least as it is also a major focus for the rating agencies, so we need to ensure a high liquidity ratio. We have a strategic liquidity portfolio of €2.3bn that we hold over the long term; however, in a low interest rate environment, generating a yield on this portfolio is important. We had a yield benchmark based on highly liquid instruments (i.e., tradable instruments or those maturing within two weeks) but we also use government, corporate, equity and commodity investment to boost the yield on our portfolio. However, given the importance of security and proactive risk management as well as generating yield, we put in place an overlay manager to review our risk daily and minimise the impact of mark-to-market movements. Compared with our operational liquidity portfolio, which is comprised of short-term investments such as money market funds, short-term bonds, commercial paper, deposits etc. the difference in yield has been considerable: 150bps on our strategic liquidity compared with a yield of 50bps on our operational liquidity.
We have a dynamic approach to liquidity in order to adapt to changes in the interest rate environment. In addition, we need to ensure the availability of cash over different time periods and to manage event risk and changes in the company’s risk appetite. Appointing an overlay risk has been a very valuable means of preserving sufficient access to liquidity, security of cash in accordance with Lufthansa’s risk appetite and achieving a competitive yield.
Supporting the business
With a robust risk management strategy in place, we have been able to focus on other treasury priorities, such as liquidity optimisation and payments centralisation, whilst ensuring that we support the needs of the Lufthansa Group effectively. In our experience, a rule-based approach to hedging, such as for FX and fuel, is very valuable in providing simplicity and transparency in risk management, and reducing the impact of market volatility. What is more difficult to achieve is a reliable cash flow forecast, particularly where the underlying business is volatile, such as in the airline industry. In these situations, it is important to be able to rely on detailed financial planning, or to understand and react quickly to changes in the cash flow forecast. Adopting a layering strategy to hedging makes it easier to respond to changes to the business and maintain an effective and appropriate approach to managing risk.