Group 4

Jennifer Choi
Tommy Fermin
Luz Pacheco
Ibrahim Shaikh
1
 Agenda
 Company Background - Tommy
 Case Details - Jennifer
 Defining the Issues - Luz
 Alternative Analysis - Ibrahim
 Recommendation - Tommy
Q&A

2
 Company Background
 Deutsche Lufthansa AG (DLAKY.PK) - founded 1926 in Berlin following merger of Deutsche Aero Lloyd
and Junkers Luftverkehr

 Luft – “Air” Hansa – “Company”

 Symbol of flying and technical expertise

 1927 – first flights to China

1934 – first trans-Atlantic flights
1945 to 1955 – air traffic suspended due to war
1960 – enters the jet aircraft age

3
 Company Background (cont.)
 Sixth largest airline in the world (Second largest in Europe)

 Lufthansa Cargo AG is the leading cargo air carrier

 Divisions in aircraft maintenance, catering, IT, and leisure/travel

businesses

 Approx. $23.6 billion 2006 Fiscal YE Revenue

4
 Company Background (cont.)
 Operations in Europe, North/South America, Africa, Middle East,
and Pac Rim regions (45 million passengers/year)

 Main hubs in Frankfurt and Munich

 437 aircraft fleet – approx. 60% Airbus, 40% Boeing

 Key Competitors: Air France-KLM, AMR Corp, and British Airways

5
 Agenda
 Company Background - Tommy
 Case Details - Jennifer
 Defining the Issues - Luz
 Alternative Analysis - Ibrahim
 Recommendation - Tommy
Q&A

6
 Case Details: Overview
 In January 1985, Lufthansa Chairman Herr Heinz Ruhnau purchased twenty Boeing 737 jets

 Total Price = $500 million USD, payable January 1986

 USD upward trend against the Deutschmark since 1980

 3.2 DM / $1

 Ruhnau believed the trend had reached a plateau and would soon decline

 Hedge to mitigate exchange rate risk / purchase cost

7
Case Details: X/C Rate Trend

DM3.2/$
Jan-85

Sourced by www.oanda.com

8
 Inflation Rate US 1980’s
 Deregulation - know as “Reagonomics”
 Low corporate tax rates & low inflation rates
 US Dollar appreciated from 1981-1985.

 PPP – U.S low inflation rate made

it a good place to invest

9
 Case Details - Decision Criteria
 Ruhnau’s belief that the dollar would depreciate against the
Deutschmark

 Tolerable level of risk using company’s funds

 Limited capital on hand

 Balance sheet currency debt restrictions

10
 Case Details - Outcome
 $250 million forward contract @ 3.2 DM / $1 ($250 million
uncovered)

 USD upward trend against the Deutschmark continued through

February 1985 and then plummeted

 2.3 DM / $1 spot rate in January 1986 (3.2 DM / $1 January 1985)

 Total Cost of Boeing Deal

USD DM
1 9 8 5 F o rw a r d C o n tra c t (3 .2 D 2M5/$
0 ,0
) 0 0 ,0 0 0 8 0 0 ,0 0 0 ,0 0 0
1 9 8 6 S p o t R a te ( 2 .3 D M /$ ) 2 5 0 ,0 0 0 ,0 0 0 5 7 5 ,0 0 0 ,0 0 0
T o ta l C o s t 1 ,3 7 5 ,0 0 0 ,0 0 0

11
 Case Details: X/C Rate Trend
3.5 Apr-85

3 DM2.9/$
Jul-85
2.5
DM3.2/$
2 Jan-85
1.5

0.5

DM/$
ay

ay

ay

ay

ay

ay
Ja p

Ja p

Ja p

Ja p

Ja p

p
83

84

85

86

87
82

Se

Se

Se

Se

Se

Se
M

M
n-

n-

n-
n-

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Ja

Sourced www.oanda.com

12
 Case Details – Outcome (cont.)
 February 1986, Ruhnau summoned to meet with Lufthansa board of
directors over management of exchange rate exposure for the
Boeing deal

 Criticized by the board for the use of forward contracts as exposure;

not for leaving half of the deal uncovered

13
 Agenda
 Company Background - Tommy
 Case Details - Jennifer
 Defining the Issues - Luz
 Alternative Analysis - Ibrahim
 Recommendation - Tommy
Q&A

14
 Defining the Issues
Importance Low High

Urgency

Low Forecast Exchange Rate Financial Health of

Company/Shareholders
High Type of Planes IV
Exchange Rate Risk
Hedging Method

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 Defining the Issues – Exchange
Rate Risk
 Importance:
 Increased cost of doing business

 Negative impact to bottom line

 Urgency:
 Timing is critical

 Volatile movement

16
 Defining the Issues – Hedging
Methods
 Importance:
 Need to control costs

 Mitigate exchange rate risk

 Urgency:
 Method selection is critical

 Method needs to provide flexibility and tolerable level of risk

17
 Defining the Issues - Hedging
Methods (cont.)
 Remain Uncovered – maximum risk; largest gain/loss possible

 Full Forward Cover – minimum risk

 Partial Forward Cover – medium risk; uncovered exposure

 Foreign Currency Option – low risk; sunk cost (premium); fairly new tool

 Buy Dollars Now – zero risk, cash availability, balance sheet currency
debt restrictions

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 Cause and Effect

Exchange
Economy People Rate

Partial Forward
Cover:
3.2DM/$ $250,000
2.2DM/$ $250,000

Risk level/Constraints Hedging Method

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 Agenda
 Company Background - Tommy
 Case Details - Jennifer
 Defining the Issues - Luz
 Alternative Analysis - Ibrahim
 Recommendation - Tommy
 Q&A

20
 Alternative Analysis
A L T E R N A T IV E
1) R e m a in U n c o ve re d
D E C IS IO N C R IT E R IA
S c e n a rio T o ta l C o s t R is k
A $ 5 00 m illio n @ 2 .2 D M 1 ,10 0 ,0 0 0 ,0 0 0 H IG H
B $ 5 00 m illio n @ 4 .0 D M 2 ,00 0 ,0 0 0 ,0 0 0

2) F u ll F o rw a rd C o ve r A $ 5 00 m illio n @ 3 .2 D M 1 ,60 0 ,0 0 0 ,0 0 0 LO W

$ 2 5 0 m illio n @ 3.2
3) P a rtia l F o rw ard C o ve r A $ 2 5 0 m illio n @ 2 .2 1 ,35 0 ,0 0 0 ,0 0 0M E D IU M
$ 2 5 0 m illio n @ 3.2
B $ 2 5 0 m illio n @ 4 .0 1 ,80 0 ,0 0 0 ,0 0 0

4 ) F o re ig n C u rre n c y O p tio n /P u t O A
p tio n$ 5 0 0 m illio n @ 3 .2 + 6 % p re m ium 1 ,69 6 ,0 0 0 ,0 0 0 LO W
B $ 5 0 0 m illio n @ 2 .2 + 6 % p re m ium 1 ,19 6 ,0 0 0 ,0 0 0
C $ 5 0 0 m illio n @ 4 .0 + 6 % p re m ium 1 ,69 6 ,0 0 0 ,0 0 0

5) B u y D o lla rs N o w / M o n e y M a rkAe t $ 5 0 0 m illio n @ 3 .2 1 ,60 0 ,0 0 0 ,0 0 0 N /A

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 Net Cost by Hedging Alternatives
2.20

Remain
2.00 Uncovered

1.80 Put Option Cover

Full Forward Cover
Billions of DM

1.60

1.40 Partial Forward Cover

1.20

1.00
2.20 2.40 2.60 2.80 3.00 3.20 3.40 3.60 3.80 4.00

Ending DM/$ Exchange Rate (Jan 1986)

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 Alternative Analysis
ALTERNATIVE DECISION CRITERIA
Scenario Total Cost Risk
1) Remain Uncovered A $500 million @ 2.2 DM 1,100,000,000 HIGH
B $500 million @ 4.0 DM 2,000,000,000

2) Full Forward Cover A $500 million @ 3.2 DM 1,600,000,000 LOW

$250 million @ 3.2

3) Partial Forward Cover A $250 million @ 2.2 1,350,000,000 MEDIUM
$250 million @ 3.2
B $250 million @ 4.0 1,800,000,000

4) Foreign Currency Option/Put OptionA $500 million @ 3.2 + 6% premium 1,696,000,000 LOW
B $500 million @ 2.2 + 6% premium 1,196,000,000
C $500 million @ 4.0 + 6% premium 1,696,000,000

5) Buy Dollars Now/ Money Market A $500 million @ 3.2 1,600,000,000 N/A

- 900 million variance; too risky

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 Alternative Analysis
ALTERNATIVE DECISION CRITERIA
Scenario Total Cost Risk
1) Remain Uncovered A $500 million @ 2.2 DM 1,100,000,000 HIGH
B $500 million @ 4.0 DM 2,000,000,000

2) Full Forward Cover A $500 million @ 3.2 DM 1,600,000,000 LOW

$250 million @ 3.2

3) Partial Forward Cover A $250 million @ 2.2 1,350,000,000 MEDIUM
$250 million @ 3.2
B $250 million @ 4.0 1,800,000,000

4) Foreign Currency Option/Put OptionA $500 million @ 3.2 + 6% premium 1,696,000,000 LOW
B $500 million @ 2.2 + 6% premium 1,196,000,000
C $500 million @ 4.0 + 6% premium 1,696,000,000

5) Buy Dollars Now/ Money Market A $500 million @ 3.2 1,600,000,000 N/A

- Negates risk; legal obligation; forego favorable movements

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 Alternative Analysis
ALTERNATIVE DECISION CRITERIA
Scenario Total Cost Risk
1) Remain Uncovered A $500 million @ 2.2 DM 1,100,000,000 HIGH
B $500 million @ 4.0 DM 2,000,000,000

2) Full Forward Cover A $500 million @ 3.2 DM 1,600,000,000 LOW

$250 million @ 3.2

3) Partial Forward Cover A $250 million @ 2.2 1,350,000,000 MEDIUM
$250 million @ 3.2
B $250 million @ 4.0 1,800,000,000

4) Foreign Currency Option/Put OptionA $500 million @ 3.2 + 6% premium 1,696,000,000 LOW
B $500 million @ 2.2 + 6% premium 1,196,000,000
C $500 million @ 4.0 + 6% premium 1,696,000,000

5) Buy Dollars Now/ Money Market A $500 million @ 3.2 1,600,000,000 N/A

- Legal obligation; forego favorable movements; uncovered at

risk

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 Alternative Analysis
ALTERNATIVE DECISION CRITERIA
Scenario Total Cost Risk
1) Remain Uncovered A $500 million @ 2.2 DM 1,100,000,000 HIGH
B $500 million @ 4.0 DM 2,000,000,000

2) Full Forward Cover A $500 million @ 3.2 DM 1,600,000,000 LOW

$250 million @ 3.2

3) Partial Forward Cover A $250 million @ 2.2 1,350,000,000 MEDIUM
$250 million @ 3.2
B $250 million @ 4.0 1,800,000,000

4) Foreign Currency Option/Put OptionA $500 million @ 3.2 + 6% premium 1,696,000,000 LOW
B $500 million @ 2.2 + 6% premium 1,196,000,000
C $500 million @ 4.0 + 6% premium 1,696,000,000

5) Buy Dollars Now/ Money Market A $500 million @ 3.2 1,600,000,000 N/A

- Flexible; cost ceiling; premium

26
 Alternative Analysis
ALTERNATIVE DECISION CRITERIA
Scenario Total Cost Risk
1) Remain Uncovered A $500 million @ 2.2 DM 1,100,000,000 HIGH
B $500 million @ 4.0 DM 2,000,000,000

2) Full Forward Cover A $500 million @ 3.2 DM 1,600,000,000 LOW

$250 million @ 3.2

3) Partial Forward Cover A $250 million @ 2.2 1,350,000,000 MEDIUM
$250 million @ 3.2
B $250 million @ 4.0 1,800,000,000

4) Foreign Currency Option/Put OptionA $500 million @ 3.2 + 6% premium 1,696,000,000 LOW
B $500 million @ 2.2 + 6% premium 1,196,000,000
C $500 million @ 4.0 + 6% premium 1,696,000,000

5) Buy Dollars Now/ Money Market A $500 million @ 3.2 1,600,000,000 N/A

- Limited capital on hand; forego favorable movements

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 Agenda
 Company Background - Tommy
 Case Details - Jennifer
 Defining the Issues - Luz
 Alternative Analysis - Ibrahim
 Recommendation - Tommy
Q&A

28
 Recommendation
 CURRENCY OPTION
 Flexibility – “option to walk away”

 Limited downside risk

 Maximum total cost is determinable whether exchange rate

remains unchanged or increases (1,696,000,000 DM)

 Cost difference between a fully uncovered position at a

decreasing exchange rate and option is the premium (96,000,000)

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Recommendation - Implementation
 Negate forward contract executed by Ruhnau
 Once exchange rate hit 3.3 DM/$, execute sell forward
contract
 Net money gain $25 million USD (10,869,565 DM @ 2.3
DM/$)

 Purchase currency option for full $500 million USD exposure

 Reduce option premium cost to 85,130,435 DM

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 Recommendation – Alternative Solution
 Examine the alternative of purchasing planes from Airbus
 Airbus is a primary European competitor of Boeing

 Bidding war creates leverage for Lufthansa

 Highly subsidized by European countries; lower operating costs

= lower price

 Common currency; no exchange rate risk

.
Airbus 320 which
competes with
Boeing 737

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THANK YOU

QUESTIONS?

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