January 23th 2015

Team FO

Hedging strategy and pension fund management of IceAir

Introduction

1- Description of the company

2- Fuel hedging strategies

3- Pension fund management

4- Conclusion

Current situation

Company Description

• Specialized in passenger air transportation, distribution and marketing of vacation packages in Canada

• Serves 42 seasonal destinations in Europe and 72 seasonal destinations in the Caribbean

Fuel prices exposure

• Industry competitive pressures prevent the company to channel cost increases to customers

• Head of risk management has just left the company

• New fuel price hedging strategy is needed going forward

Underfunded pension fund

• Defined benefit• Deficit significantly increased in recent years• Active management for a portion of the portfolio

Developing a hedging strategy and pension liability management strategy is required for company success

Historical Oil Prices

2008 2009 2010 2011 2012 2013 20140

20

40

60

80

100

120

91

64

76

95 96

105

95

Since the financial crisis of 2008, the WTI oil price has increased sharply due to the economic recovery

US Production Growth

In our view the increasing global supply as well as weakened global economic factors will lead to a decrease in oil prices

Main Catalysts:

1. Increasing U.S oil production2. Slowing down of emerging markets3. European recession

DemandSupply WTI Oil Price

European GDP Growth

Europe has been experiencing negative GDP growth in the past 3 years

2005 2006 2007 2008 2009 2010 2011 2012 2013

-3.5%

-3.0%

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

0.5%0.7%

1.0%

0.7%

-3.0%

0.4%

0.9%

-0.3%

-0.5%

Asian GDP Growth

2005 2006 2007 2008 2009 2010 2011 2012 20130.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

10.0%

12.0%

15.0%

8.0%7.0%

10.0%

8.0%7.5% 7.5%

Asia and emerging markets have experienced slower growth

Hedging StrategyBased on historical data, the company’s five year yearly fuel consumption for the month of March is 12% and the needed fuel is 663 thousand barrels.

3 Main Criteria's:

1. Strategy that allows the company to benefit from the future expected oil price decrease2. Protects the company in the event of a an oil price increase3. Has the lowest volatility in terms of payout

Hedging Strategies:

4. Futures5. Swap6. Options

I. Put II. CallIII. Covered callIV. Bear Spread

FuturesDescription:Gives the buyer of the contract, the right and obligation, to buy the underlying commodity at the price at which he buys the futures contract

Futures could provide potential upside in the event of a WTI oil price increase but is also very volatile

1 2 3 4 5 6 7 885.0

90.0

95.0

100.0

105.0

110.0

115.0

Swap

$6.63M Loss

$6.63M Gain

SwapsDescription:An agreement whereby a floating (or market) price is exchanged for a fixed price, over a specified period of time.

Swaps could provide potential upside in the event of a WTI oil price increase but is also very volatile

1 2 3 4 5 6 7 885.0

90.0

95.0

100.0

105.0

110.0

115.0

Swap

$6.63M Loss

$6.63M Gain

CallProvides the buyer of the contract the right, but not the obligation, to purchase a particular amount of a specific commodity on or before a specific date or period of time.

Call options could provide potential upside in the event of a WTI oil price increase but doesn’t provide upside in the event of price depreciation

65 70 75 80 85 90 95 100 105 110 115 120 125 130 135 140-10

-5

0

5

10

15

20

25

30

35

40

OIl Price Price at Maturity

Profi

t / Lo

ss

Unlimited Upside$4.46M Loss

PutProvides the buyer of the contract the right, but not the obligation, to sell a particular amount of a specific commodity on or before a specific date or period of time.

The Put Bear Spread Hedging provides potential profit in the event of price depcreciation and offers some protection as well

65 70 75 80 85 90 95 100 105 110 115 120 125 130 135 140-10

-5

0

5

10

15

20

25

30

OIl Price Price at Maturity

Profi

t / Lo

ss

Significant Upside

$4.46M Loss

An option strategy seeking maximum profit when the price of the underlying security declines. The strategy involves the simultaneous purchase and sale of options; puts or calls can be used

60 65 70 75 80 85 90 95 100 105 110 115 120 125 130 135 140-6

-4

-2

0

2

4

6

Bear Spread

WTI Oil Price at Maturity

Profi

t / L

oss

$3.32M Gain

$3.32M Loss

Put Bear Spread

The Put Bear Spread Hedging provides potential profit in the event of price depcreciation and offers some protection as well

Hedging SummaryMethod Profit against WTI

price depreciationProfit against price appreciation

Protection against Payout Volatility

Swap

Futures

Put

Call

Put Bear Spread

The Put Bear Spread and the Put option are the two best alternatives

Met Investment Criteria

Didn’t meet investment criteria

Legend:

Long Put vs. Put Bear Spread

The Put Bear Spread Hedging strategy would be the best alternative

Since reduces the distance of the breakeven price and decreases the capital required to be bearish on a stock

60 65 70 75 80 85 90 95 100 105 110 115 120 125 130 135 140-6

-4

-2

0

2

4

6

Put Bear Spread

WTI Oil Price at Maturity

Profi

t / L

oss

65 70 75 80 85 90 95 100 105 110 115 120 125 130 135 140-10

-5

0

5

10

15

20

25

30Long Put

WTI Oil Price at Maturity

Profi

t / Lo

ss

$4.46M Loss

$3.32M Gain

$3.32M Loss

SignificantUpside

Hedging Implementation

Implementation Strategy:

1. Hedge 100% of March fuel needs ($66.3M)2. Purchase 66 1000 Put Options at a price of 2$, with a strike price of $1053. Write 66 1000 put option at a price of 7$, with a strike price of $954. If the price dips below the $105 exercise price, buy the option for the lower price to realize a gain of $3.32MPayout ScheduleStock Price 60 65 70 75 80 85 90 95 100 105 110 115 120 125 130 135 140Net Premium -5 -5 -5 -5 -5 -5 -5 -5 -5 -5 -5 -5 -5 -5 -5 -5 -5Long Put (105) 45 40 35 30 25 20 15 10 5 0 0 0 0 0 0 0 0Write Put (95) -35 -30 -25 -20 -15 -10 -5 0 0 0 0 0 0 0 0 0 0Profit 5 5 5 5 5 5 5 5 0 -5 -5 -5 -5 -5 -5 -5 -5

Current Portfolio Snapshot

• No more than 10% of the portfolio in cash• Bullish on US and emerging country equity• Neutral concerning Canadian equity• Expects higher interest rates in Canada and US

Bonds CashEquity

63% 24% 13%

-12.60% 54.18% 0.00%

Allocation

LY Return

Efficient Frontier of Risky Assets

2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% 20.0%4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

7.5%

8.0%

Risk

Retu

rn

Stock Equity Stock Bond

Return 7.60% 4.88%

S.Dev 17.66% 9.47%

Correlation Coefficient Covariance

-0.8142 -0.01362

Proposed Asset Allocation

• 2005-2014 10-year T. Bond and S&P500 historical returns• Difference in cash invested in equity to match efficient asset allocation

Bonds CashEquity

62% 33% 5%

4.88% 7.60% 0.00%

Allocation

Historical return

Passive Management

• iShares Barclays 20+ Yr T.Bonds

• Vanguard Long-term Bond ETF

• Vanguard Total Bond Market ETF

Equity portfolio breakdown

1. All of the exposure is to US bond market

2. Expectations of an increase in interest rates3. US equity market expected to outperform Canadian

Bond Portfolio

Key Concerns

1. Underfunded pension fund2. Long term results

Key Considerations

40%

40%

20%

iShares Barclays 20+ Yr T.Bonds Vanguard Long-term Bond ETFVanguard Total Bond Market ETF

Proposed Bond Portfolio

New Bond Portfolio Allocations

• iShares Barclays 20+Yr T.Bonds – 40%

• iShares DEX Long Term Bond Index – 40%

• Vanguard Total International Bond ETF – 20%

Rationale

• US market to outperform Canadian broad market

• Diversify geographic exposure even further

Diversify geographic exposure and focus on long-term results

Active Management

• Carnival Corp• Transat AT• iShares S&P/TSX 60

Equity portfolio breakdown

1. 68% of the equity portfolio tied to 2 stocks

2. Combined beta of 1.43. All of the exposure is to 1 sector

Equity Portfolio

Key Concerns

1. Underfunded pension fund2. Long term results

Key Considerations

32%

26%

42%

Carnival Corp Transat AT iShares S&P/TSX 60Far from ideal for an underfunded defined benefit pension fund

Equity Portfolio

Other Assets Consideration

Stable business with predictable cash flows to reduce variability of returns

Inflation indexed returns

Low correlation with the general market

Equity Portfolio

Other Assets Consideration

Stable business with predictable cash flows to reduce variability of returns

Inflation indexed returns

Low correlation with the general market

Propose real return assets

Equity Portfolio

New Equity Portfolio Allocations

• S&P 500 ETF – 50%

• Infrastructure Index – 45%

• Emerging Markets Index – 5%

Rationale

• US market to outperform Canadian broad market

• Reduce portfolio volatility

• Capture emerging markets upside

Diversify risk and capture upside from global macroeconomic trends

Conclusion

Implement hedging strategies• Mitigate commodity price volatility• Concentrate on core competencies

Rebalance pension portfolio• Avoid further deficits• Maintain long-term safety of pension

assets

January 23th 2015

Team FO

Thank YouQuestions?