Luftansa Case Study 6o1s4g

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

1986 x-rate Contract Price (DM)

Best Case 2.438 1,219.00

Expected 3.20 1,600.00

Worse Case 3.96 1,980.00

Level of Risk 10 Cost: High unless the dollar depreciates Risk: Extremely high Full forward cover

1986 x-rate Contract Price (DM) Oportunity Costs

Best Case 3.96 1,980.00 380.00 Level of Risk

Guaranteed 3.20 1,600.00 0.00 2

Cost: Only an opportunity cost if the US Dollar depreciates

Worst Case 2.44 1,219.00 -381.00

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 (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 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 (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. , as well as other major European economic community countries, has a vested interest in the t 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.

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

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

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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.

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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.

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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.

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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.

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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.

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

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Herr Ruhnau could have purchased an Deutschemarks to reduce the paid.

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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 further.

out-of-the-money

put

option

on

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

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

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

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If all predictions towards no exchange rate movement or further US$ appreciation, use full cover futures

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

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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?

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

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

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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