LoCo AIRLINES CASE 1: FINANCIAL RISK
Aims & Objectives
This case illustrates a structured approach to analysing financial risk that is applicable in a
range of business situations. The issues dealt with here particularly relate to the market risk
surrounding exchange rates and fuel prices for a small airline but the general principles are
applicable across all types of business. The case uses a simulation model approach.
Supporting lecture notes, reading materials and data are referenced below.
Case Study
You are the finance director of a small low cost airline based in London, called LoCo
Airlines. LoCo has been in operation for one year. You are concerned about the amount of
financial risk being taken in the firm’s business. The two routes that the firm has are
Stanstead – Barcelona and Stanstead – Geneva. The volatility of foreign exchange and fuel
price is the real problem. The competitive nature of the market means that the firm cannot
raise prices when exchange rates change. For example on the Barcelona route the low cost
Spanish operators will undercut you if you try to raise Peseta prices to your Spanish
customers in order to keep prices constant in Pounds Sterling. The same happens on the
Geneva route. Effectively there is a cap on prices which keeps margins low at about £25 per
one-way ticket. With revenue in Pesetas, Swiss Francs, and Pounds Sterling The recent
addition of the Geneva route has allowed you to sell half of your seats on a long-term
contract to a tour operator to try and reduce risk in the revenue stream. However, the
revenues are payable in Swiss Francs and is in addition to the existing Peseta and Pounds
Sterling Revenue. With costs in US Dollars, Deutchmark and some in Pounds Sterling the
risk are considerable. The recent low fuel prices cannot be guaranteed either.
You have already built a simple spreadsheet model of the system, a few months ago, but it
does not take account of the volatility of foreign exchange and fuel prices. With a very small
capital base the risk is that accumulating loses will drive your capital base below £1 million
and the airline regulator will close LoCo down. The owner of the company does not want to
invest more capital and so your job is to carry out the necessary further analysis, and solve
the problem. The owner of the company wants to meet at 9.00 tomorrow morning to discuss.
Assessment
Please work in pairs to carry out the following analysis and report writing. This work counts
for up to 10% of your final course grade. You may pair with anyone but please ensure that if
you are intending to have the course assessed you are paired with someone who is also
having the course assessed, not with someone who is auditing. Write up your results and
analysis as a short management report of no more than 3 pages including charts (12point
Times New Roman, A4 paper, 2.5 cm margins). Send as Microsoft Word document and copy
of Excel spreadsheet model attached to e-mail jbower@london.edu. Please ensure report,
spreadsheet, and e-mail is clearly marked with your names and arrives by deadline 9.00 a.m.
Friday 14 April 2000.
1. Familiarise yourself with the operation of the @Risk simulation tool by using the
Financial Risk (Financial Market Simulation).xls file to simulate portfolio returns for a
portfolio containing 2 shares [Portfolio Sheet]. Use Starting Price, Starting Portfolio
2.
3.
4.
5.
Value, Annualised Yield, Annualised Volatility, Holding Period (Years) to calculate CaR
for a $100m portfolio divided between 2 shares with different annual return and volatility.
Familiarise yourself with the simulation of a financial market time series from Financial
Risk (Financial Market Simulation).xls. Explain what each element of the equation used
to calculate the market price is doing.
Convert the spreadsheet model in Financial Risk (LoCo Airlines Model).xls into a
simulation model, to take account of risk and uncertainty in exchange rates and fuel
prices using @Risk Add-In to Excel. First calculate the returns and daily volatility on the
FX and fuel markets [Daily FX and Fuel data]. Use this data to simulate the year 2000
market price data in the table [also on Daily FX and Fuel Data sheet]
Using the simulation model from 3 above, to estimate the probability of LoCo suffering
loses of such size as to deplete its capital base below £1,000000. Hint: Use NORMDIST
function.
What would you do to solve the problem. Try and model your solution to check its
viability.
Reading
All the following can be found in the course pack and must be read to be able to do the case
“Financial Risk: Introduction” lecture presentation by John Bower
“Financial Risk Management: Statistics and Simulation of financial risk”
“Tutorial on Risk Analysis with @RISK”
Software
This case study can be completed on an Excel spreadsheet using the standard built in
statistical and mathematical functions along with the @Risk Add-In.
Data file
The case data is on the LBS forum at http://www.london.edu/faculty/kvlahos/prm/ just click
on Course datafiles. It is also on Q: drive in a subdirectory called CBFM\PRM.
Disclaimer
This case study, and supporting materials has been prepared for teaching purposes only. It
uses only publicly available data. No corporate, governmental, or private entity has been
involved in the preparation of the case materials other than the author. The case has been
considerably simplified and is not intended to illustrate actual decisions or events made by
any company. No inference should therefore be drawn about the level of risk or risk
management capabilities of any company from the case.
Author
John Bower, Decision Sciences Department London Business School, Sussex Place, Regent’s
Park, London. NW1 4SA. Contact jbower@london.edu. Case date: April 2000.