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A Report for Forex

On

Lufthansa Case
Study
Submitted by
P Sudhakara Reddy

Indian Institute of Planning and


Management
A Brief Summary

Lufthansa CEO Herr Ruhnau was under-fired for his hedging decision on the purchase of 20
Boeing aircrafts which cost Lufthansa an additional DM 225M back in Jan. 1985. Some
criticisms are valid to a certain degree given the strict covenants and guidelines Ruhnau had
to work against however others are base-less such as forcing Ruhnau to step down as CEO.
This case analysis will discuss the hedging alternatives Ruhnau considered, the decision
that was made, an analysis of the criticisms made against Ruhnau and justifications for why
Ruhnau should continue his chairmanship of Lufthansa.

Case

In January 1985, German-based airline Lufthansa, under the direction of chairman Herr
Heinz Ruhnau, purchased twenty Boeing 737 jets at a hefty price of $25,000,000 per for a
total transaction of $500,000,000. The term of the purchase is for Lufthansa to pay the
entire amount in US dollats upon delivery one year later in January 1986.

As of Jan. 1985, the conversion rate stood at DM 3.2/$ and with the U.S. dollar on a rise
against the German DM since 1980, Ruhnau had several financial hedging options to
undertake in order to minimize Lufthansa’s foreign exchange exposure risk for the next 12
months. These financial instruments include the basic hedging alternatives such as
remaining uncovered, use of forward contracts with either partial or full coverage, matching
of currency with cash inflows of U.S. dollars,foreign currency options or buy and invest in
US dollars now.

Given the various hedging alternatives, Lufthansa could ideally choose any of these options,
however due to strict company guidelines already set in place with regards to the type of
financial hedging that could affect the company balance sheet, Ruhnau’s option were further
limited.

Background

Since 1982, the U.S. dollar had been steadily appreciating against the German mark. In
January 1982, the dollar was trading around 2.3 marks, and by January 1985, it had risen
to 3.2. This represented an appreciation of the dollar of just under 40%.
Although many analysts had concluded that the U.S. dollar was overvalued during this
period, it continued to show strength. Government intervention to weaken the dollar was
not being discussed at this time.

Hedging Alternatives

1.Remain uncovered

2.Full forward cover

3.Option hedging

4.Money market hedge

5.Some combination of the above alternatives

Remain Uncovered

Best Case Expected Worse Case


1986 x-rate 2.438 3.20 3.96
Contract Price (DM) 1,219.00 1,600.00 1,980.00

Level of Risk 10

Cost: High unless the dollar depreciates

Risk: Extremely high

Full forward cover

Best Case Guaranteed Worst Case


1986 x-rate 3.96 3.20 2.44
Contract Price (DM) 1,980.00 1,600.00 1,219.00
Oportunity Costs 380.00 0.00 -381.00

Level of Risk 2
Cost: Only an opportunity cost if the US Dollar depreciates
Risk: low

Foreign currency options

A put option on the DM at DM 3.2/$, could locked in DM 1.6 billion plus the cost of the
option premium (DM 96 million).

The total cost of the purchase in the event the put was exercised would be DM 1.696
billion.

Money Market Hedge

Obtain the $500 million now and hold those funds in an interest-bearing account or asset
until payment was due.

What ultimately eliminated this alternative for consideration was that Lufthansa had several
covenants that limited the types, amounts, and currencies of denomination of the debt it
could carry on its balance sheet.

50% Covered, 50% Uncovered

Cost: High unless the dollar depreciates

Risk: Moderately high


Lufthansa’s Decision and Outcome

As noted the size of the contract, which was denominated in U.S. dollars, was seen as a too
large of an uncovered transaction exposure for Lufthansa. On the other hand, most
analysts were predicting a weakening of the U.S. dollar. If this were to occur, it could result
in a smaller deutschmark denominated payment for Lufthansa. Recall, Lufthansa’s liability
was denominated in U.S. dollars, thus a weakening dollar would have required fewer marks.

Decision

Lufthansa decided to hedge 50% of its exposure with a forward contract. This forward
contract was set at DM3.2/$; thus Lufthansa would purchase $250 million in January 1985
for 800 million marks. The remaining 50% was left uncovered to take advantage of a
possible weakening of the dollar.

Outcome

During the 12 month period, the U.S. dollar did weaken against the mark. In January 1985,
it was trading around 3.2 and by January 1986, it was trading around 2.45. This
represented a decline of 23%. See chart below.
Cost of the 20 Airplanes

The cost of the 20 airplanes to Boeing was as follows:

50% covered with a forward contract, or

$250,000,000 x 3.2 = 800,000,000 marks

50% uncovered and purchased at spot, or

$250,000,000 x 2.45 = 612,500,000

Total mark liability in January 1985 = 1,412,500,000

Analysis

Lufthansa had guessed correctly. The mark had strengthened and they were able to take
advantage of that with an uncovered position. If they had covered 100% of their exposure,
their cost would have been 1.6 billion marks, or 13% more.

On the other hand, if Lufthansa had not covered any of their liability, their cost in January
1986 would have been 1.225 billion, of 13% less.

Follow up

The Chairman of Lufthansa, Heinz Ruhnau, was criticized for his handling of the company’s
exposure. The Minister of Transportation in Germany (who had ultimate authority over the
airline), criticized Ruhnau for hedging 50% of the exposure which resulted in 187,500,000
marks more than if the company had not covered. As a result, Ruhnau was only offered a
short term renewal contract as Chairman by the Minister of Transportation.

Case Questions: Mistakes

1.Purchase of Boeing Aircraft at wrong time.The US dollar was at an all time high at the
time of the purchase in januvary 1985.

2.Choosing the hedge half the exposure when he expected the dollar to fall. If he had gone
through with his instincts or expectations, he would have left the whole amount unhedged.

3.choosing to use forward contracts as his hedging tool instead of options. The purchase of
put options would have allowed Herr Ruhnau to protect himselves against adverse exchange
rate movements while preserving the flexibility of exchanging DM for US dollar spot if the
market moved in his favor.

4.Purchasing Boeing Aircraft at all. Germany, as well as other major European economic
community countries, has a vested interest in the joint venture Airbus. Airbus’s chief rival
was Boeing in the manufacture of large long distance civil aircrafts.

Answers:

Mistake1:

• Herr Heinz Ruhnau had such a strong gut feeling, but it was based on no hard
evidence, that the U.S exchange rate was going to drop that he should have
postponed buying the planes until after the rate had actually dropped in order to
save the company from losing money based on speculation.

• Purchase of Boeing aircrafts was mandated according to the expansion program.

• The dollar was “high” at this point, and therefore the decision to purchase now
seems to be a bit late.

• Yet, given the trend in the movement of the DM/$ rate over the previous years, it
appears (using the graphic available to Herr Heinz Ruhnau in January 1985), that
postponing the purchase would only result in a higher dollar and therefore a higher
expense.
Mistake 2:

There are two views

• Since he is paid the big bucks to make the big decisions, and if he believed the dollar
was about to fall he should have remained completely uncovered.

• Or, on the contrary, he is also paid the big bucks to pursue Lufthansa’s strategic
future, and that does not include the gambling on exchange rate movements.

• Both views are valid, however, that the 50/50 result is difficult to defend itself.(This
is equivalent to covering one exposure and leaving an identical exposure completely
uncovered; a somewhat schizophrenic “view” on the direction of exchange rate
movements.)

Mistake 3:

• Since he did purchase the planes, regardless of any feelings he had about dropping
exchange rates, it was only speculation so he should have put options on the money
in order to save the company from higher losses.
• The purchase of a put option would have indeed provided solid insurance. Yet, it is
difficult to explain why one should spend millions on the purchase of protection which
one hopes not to use.

• This is a flawed argument as it is obvious if we extend it to any insurance policy.


However, it has real meaning in many boardrooms even today.

• As a matter of fact, few private firms were actually using currency options for risk
management in 1985 when this situation arose.

• Herr Ruhnau could have purchased an out-of-the-money put option on


Deutschemarks to reduce the premium paid.

• He could also have purchased a collar, i.e., sold a call to finance the purchase of the
put option hedge on Deutschemarks to reduce the premium further.

Mistake 4:

By not considering the financial risk he was putting the company in by purchasing a plane
from their biggest competitor he potentially cut into the company's profits.

The Conclusions

• Hedging should be considered as a corporate strategy

• Single transaction like this one can jeopardous the company’s existence or long time
to recover, if the market moves to opposite direction

• Prestigious company like Lufthansa shouldn’t have left any exposure (big or small)
uncovered

• If all predictions towards no exchange rate movement or further US$ appreciation,


use full cover futures

• If all predictions towards US$ depreciation, use full cover options

• The initial decision is made with a highly overvalued dollar but a trend line which was
hard to argue with. What do you expect, and which hedging alternative would you
pick?

• With the 50/50 hedge position he cannot possibly win. One side’s gains will
always offset the losses on the other.

• Why did Ruhnau not change his position when it became clear that the dollar had
indeed peaked and was on its way back down?

• This may be the most legitimate criticism of Herr Ruhnau’s management: the failure
to re-position the hedge when new information is incontrovertible. Although this
would not recoup previous exchange rate losses, it would allow Lufthansa to enjoy
any further drop in the value of the dollar (or suffer any increases if the value of the
dollar turned once again).

So, Ruhanau should be fired