Chapter Opening Case: Exchange Rates and the Profitability of Korean Airlines

1. Chapter Opening Case: Exchange Rates and the Profitability of Korean Airlines

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Chapter Opening Case: Exchange Rates and the Profitability of Korean Airlines

You are about to read a short case detailing the implications of currency movements on South Korea’s two major airlines. In 2019, both airlines reported losses due to currency movements. You will be asked to answer questions linking your knowledge from the chapter to the situation detailed in the case.

This activity is important because as a manager, you must be able to understand exchange rates. In particular, it is important to recognize why exchange rates move, the implications of those movements on your business, and where exchange rates might go in the future. A variety of exchange rate forecasting services are available to help companies determine exchange rates in the future; however, some argue that the best predictor of future exchange rates are forward rates. The goal of this activity is to demonstrate your understanding of exchange rates and their movements, and the impact of those movements on business.

Read the case and answer the questions that follow.

In May 2019, South Korea’s two major airlines—Korean Airlines and Asiana Airlines Inc.—were hit by foreign exchange losses arising from the weakness of the Korean won against the U.S. dollar. Korean Air announced that it posted 148.20 billion won (US$124.49 million) in operating profit from January to March, down 16.2 percent from the same period a year ago. Asiana Airlines announced on the same day that its operating profit in the first quarter had declined 89 percent to 7.20 billion won (US$6.05 million) from a year earlier. In February 2020, it happened again. Asiana Airlines announced that for the three months that ended on December 31, 2019, net losses widened to 234.8 billion won (US$199 million) from 163.9 billion won a year earlier due to foreign exchange losses.

These foreign exchange losses arose from two sources. First, like the oil from which it is derived, in the global marketplace jet fuel is priced in U.S. dollars. Hence, any fall in the price of the won against the U.S. dollar drives up fuel purchasing costs when translated back into won. Second, Korean Airlines and Asiana Airlines have both taken on dollar-denominated debt to finance their purchase of jet aircraft from Boeing and Airbus, both of which are also priced in U.S. dollars. They have done this because interest rates on dollar-denominated debt have been significantly lower than interest rates on won-denominated debt. However, borrowing in a foreign currency brings with it an exposure to foreign exchange risk. A fall in the price of the won against the U.S. dollar will drive up the costs of servicing that dollar-denominated debt when translated back into Korean—and that is exactly what has happened.

So how much has the won fallen against the U.S. dollar recently? In mid-February 2018, one U.S. dollar was trading at around 1065 won. By mid-February 2020, one US dollar bought about 1,200 won. Put differently, the won had depreciated in value against the U.S. dollar by around 12.5 percent. When the dollar cost of jet fuel and debt service, both paid for in dollars, was translated back into won, this implied a 12.5 percent increase in costs of these Korean airlines over this time period and, consequently, a fall in their profitability.

The decline in the value of the won against the dollar has primarily been driven by economic uncertainty created by America’s tariff-raising binge since Donald Trump became president and a desire on the part of investors to put their money in safer assets that are less vulnerable to disruption from American-imposed tariffs and trade conflict. Those safe assets have included U.S. Treasury bills. So investors have taken their money out of other currencies, including Korean won, and put them in U.S. dollar assets. This increases demand for dollars and reduces demand for won—hence, the depreciation in the value of the won against the dollar over the last two years.

Looking forward, economic uncertainties seem to be increasing due to the spread of coronavirus in early 2020, and the global pandemic of COVID-19 infections. Economic forecasts suggest that the spread of COVID-19 could seriously disrupt global supply chains, dealing a blow to business earnings and hurting countries like South Korea that depend significantly upon international trade to drive their economies. Thus it seems possible that the won will decline further against the U.S. dollar, which will cause all sorts of financial pain for both Asiana and Korean Airlines.

QUESTIONS:

1.) What has happened to the value of the South Korean won relative to the U.S. dollar from January to July given the following information? January USD1 = WON1,000; July USD1=WON1,200

A.) THE WON HAS APPRECIATED AGAINST THE DOLLAR

B.) THE WON HAS DEPRECIATED AGAINST THE DOLLAR

C.) THE DOLLAR HAS DEPRECIATED AGAINST THE WON

D.) THE WON HAS APPRECIATED BY ABOUT 15 PERCENT

E.) THE DOLLAR HAS DEPRECIATED BY ABOUT 15 PERCENT

2.) At least some of the losses reported by the two South Korean airlines can be attributed to __________ fuel costs associated with a __________ won.

A.) FAILING,WEAKENING

B.) LOWER,APPRECIATING

C.) RISING,WEAKENING

D.) LOWER,DEPRECIATING

E.) RISING,RISING

3.) Which type of exposure are South Korea’s airlines facing when they make a single purchase of jet fuel and pay for it in USD?

A.) TRANSLATION EXPOSURE

B.) TRANSACTION EXPOSURE

C.) ECONOMIC EXPOSURE

D.) ORDINARY EXPOSURE

E.) SINGLE SOURCE EXPOSURE

4.) Which type of exposure are South Korea’s airlines facing when they report their year-end results?

A.) ORDINARY EXPOSURE

B.) REPORTING EXPOSURE

C.) TRANSACTION EXPOSURE

D.) ECONOMIC EXPOSURE

E.) TRANSLATION EXPOSURE
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1. The correct option is B.) THE WON HAS DEPRECIATED AGAINST THE DOLLAR.

As per the passage,the won had depreciated in value against the U.S. dollar by around 12.5 percent during the specified time period.

2. At least some of the losses reported by the two South Korean airlines can be attributed to rising fuel costs associated with a weakening won.

Jet fuel is priced in U.S. dollars. Any fall in the price of the Won against the US $ drives up fuel purchasing costs in Won.

3. The correct option is B.) TRANSACTION EXPOSURE.
   Transaction exposure is derived from changes in foreign exchange rates between the dates when a transaction is booked and when it is settled.

4. The correct option is E.) TRANSLATION EXPOSURE.
   Transactions based in US$ when reported in home currency at the end of accounting period could create loss or gain in financial statments. This accounting exposure is translation exposure or risk.