Various sources of financial risk inevitably play some part on the Group’s operations by nature. The Board of Directors is responsible for defining treasury policy measures to reduce the exposure of risk. The approved treasury policy, outlines the parameters and framework to which the Group is subject to, when dealing with financial risk arising from price volatility, liquidity fluctuations, asset management and corporate financing. An internal Risk Management Team, chaired by the CEO, actively controls the risk exposure within the Board’s policy limits.
The main policy objectives outline the methods to be used to reduce costs and inconvenience arising from price volatility and uncertainty. To that end, the financial budget is used as a benchmark when evaluating market conditions and hedging strategies.
Foreign currency risk
The Group seeks to reduce its foreign exchange exposure arising from transactions in various currencies through a policy of matching, as far as possible, i.e. receipts and payments in each individual currency. Any mismatch is dealt with by currency trades within the Group before turning to outside parties. The biggest currency mismatch is found in Icelandair where US dollar cash inflow falls short of dollar outflow by roughly USD 100 millions due to fuel costs and capital related payments that are to a large extent denominated in US dollars. This shortage is financed by a surplus of European currencies, most importantly the Euro and Scandinavian currencies. The Group follows a hedging policy of 40-80% hedging ratio, 12 months in advance, and uses a portfolio of instruments, mainly collar options and forwards. Due to two years of continous weakening of the US dollar against the Euro the hedge ratio of EUR/USD has been kept at modest levels, thus allowing for enhanced participation of the beneficial upward trend.
Fuel price risk
The jet fuel price has proved to be increasingly volatile in recent years. Not only has the price development been characterised by a steep upward trend, generated by excessive world demand, but also surprises and unanticipated sharp movements due to volatile sentiment and speculative forces. Moreover, swap prices had for two years followed a positive curvature until returning to the more familiar “backwardation” during 2007. In 2007, the monthly average of jet fuel prices reached a record level of USD 920 pr tonne in November after starting off in January with the settlement price of USD550.
The Group follows a policy of 40-80% hedging ratio, 12 months in advance and has recently maintained its ratio between 40 and 50% i.e. close to the lower policy boundaries due to the historically high prices. Hedge instruments used in 2007 weere to a big extent swaps and 3 way collars. Despite the unfavourable price developments, Icelandair and Air Iceland managed to keep fuel costs within budget limits.
Interest rate risk
The largest share of outstanding loans are directly related to aircraft financing and denominated in US dollars. This is a consequence of the fact that the most liquid market for commercial aircraft denominates prices in US dollars. The Group follows a policy of hedging 40-80% of interest rate exposure of long term financing, 2-5 years in advance.
Currently, only the aircraft loans are hedged against interest rate fluctuations with swap contracts, where the 6 month floating rate is exchanged for fixed interest rates. Forward rate agreements and options have occasionally also been used to that end. The contracts amount to USD 100 million and have been considerably favourable in recent years, as the floating rate has been increasing for some time. The average fixed interest rate is 4% compared to the 6 month floating rate, mid year 2007 of 5.5%. Most of the swap contracts expire in 2009 and 2010 so the recent US interest rate reductions will bring opportunities for improved hedge positions beyond 2009.
The Group’s policy extends to two tiers of liquidity preferences. Tier one relates to the necessary minimum benchmark to maintain adequate operational liquidity and tier two relates to a preferred minima for strategic liquidity. In both cases, certain asset classes are identified to qualify for each tier based on duration and value sensitivity. The amounts are re-valued annually with regards to the estimated turnover, annual fixed costs, cost of capital and uncertainty.
Balance sheet risk
Some part of the Group´s loan portfolio is composed of rather unfavourable ISK short term loans. To reduce the effects of those loans on total financial costs, currency and interest rate swaps were used to exchange ISK rates for lower EUR and USD rates. To the extent that such contracts cause imbalance between currency composition of assets and liabilities, exchange rate exposure will result and the net effects feed into the financial items of the income statement. The relatively strong ISK in 2007 supported such actions and thus donated some improvements to the financial items in the income statement.