Case Study Analysis: Lufthansa: To Hedge or Not to Hedge… By Mathew Stubbs and Michael Homewood
In January 1985, Lufthansa, a German airline company procured twenty new 737 airplanes from Boeing. Under the chairmanship of Heinz Ruhnau, a price of US$500 million was negotiated. The agreed price was payable in United States Dollars (USD) upon delivery of the aircraft in one years time, on January 1986. Since Lufthansa’s operating revenues were primarily in Deutsche Marks (DM), Ruhnau needed to determine an appropriate solution to minimize the resulting foreign exchange risk. In the year preceding the expansion purchase, Lufthansa was experiencing periods of extensive growth. In 1984, the company experienced an overall increase in passenger and freight volume of seven and seventeen percent respectively. This increase in volume resulted in a 7.14% increase in revenue to US$4.5 billion, and a 134.78% increase in net profits to US$54 million. At the time, significant speculation had been surrounding the value of US dollar and its anticipated direction. By January 1985, the US dollar was at record levels against other currencies (See Exhibit 1), and the state of the interest rate differential between the US and Germany suggested it would steadily increase (See Exhibit 2). The sustained strength of the US dollar, combined with the booming US economy influenced people to believe the dollar would continue to appreciate. During this period of time, central bankers from the G-7 countries were concerned with the inflated overvaluation of the USD and determined a decrease would be beneficial for the world economy. Additionally, congress began voicing their concerns with the high value of the US dollar as it severely restricted the competitiveness of US exports in foreign markets. Additionally, the implied forward rate between the exchange rates is 3.0579DM/$ which represents what the exchange should be and the possible movement in the future. Consequently, due to the overvaluation of the US dollar, Ruhnau was undecided on the optimal business strategy to pursue. Although Ruhnau firmly believed the value of the US dollar would decrease to levels below 2.45 DM/USD, fluctuating exchange rates made it difficult to determine the appropriate solution. This scenario exposed Lufthansa to significant foreign exchange risk. The biggest factor for Lufthansa to consider is their exposure to exchange rate risk; this is typically very volatile due to both the US dollar and the Deutsche Marks being floated on the market. Therefore, instead of having a stable dollar these countries chose to keep inflation steady. However, this is not the only factor of uncertainty that Lufthansa faces with this transaction incurring foreign investment risk, market risk and operational risk. It is believed that these other risks are manageable and can be diversified away through other means as they don’t pose too much of a threat to the future of the company. As the exchange rate is extremely volatile and can affect the total cost of the investment significantly it is highly advised that this is managed effectively. As a result they are exposed to exchange rate risk if the dollar continues to appreciate, which could significantly increase the price of the airplanes if it continues to rise, exchange rate risk is a very high threat as it is highly volatile. In addition, there are covenants enforcing that the company can only take on certain risk levels in order to ensure company longevity. Therefore, it is primary for them to manage this risk especially if they want to take on more debt in the future. Furthermore, it allows them to determine their required cash flow. As a result, they are able to plan appropriately to meet repayment demands. In order to minimise exchange rate risk the objective for Lufthansa should be the to ensure that the exchange rate does not appreciate any further in order to cap the total cost of purchasing a new fleet by using different hedging strategies. Evaluation of Hedging Alternatives Ruhnau identified five possible strategies to mitigate the potential foreign exchange risk that Lufthansa was facing. The five alternatives were as follows: 1. Remain uncovered and see where the exchange is like in January 1986. 2. Cover a proportion of the exposure with a forward contract, leaving the remaining balance uncovered. 3. Cover the entire exposure with forward contracts. 4. Cover the entire exposure with foreign currency put options. 5. Obtain US dollars and invest them for one year until payment is due. The final cumulative expense of each hedging tool could not have been known beforehand. However, each possible outcome could be calculated using simulated exchange rates. Exhibit 3 exemplifies the final net costs of the possible alternatives that Ruhnau had available, which is further highlighted in the table below.
Alternative Uncovered Partial Forward Cover Full Forward Cover Put Options
Relevant Rates Min: DM2.4/$ Max: DM3.4/$ Min: 0.5(DM2.4/$) + 2(DM3.2/$) Max: 0.5(DM3.4/$) + 2(DM3.2/$) DM3.2/$ DM3.2/$ Strike
Total Deutsche Mark Cost 1,200,000,000
1,700,000,000
1,400,000,000
1,650,000,000
1,600,000,000 1,296,000,000
1. Remain Uncovered. Remaining uncovered is a risk reward approach to the scenario. This strategy has the highest risk, but the highest potential benefits. If the exchange rate was to depreciate significantly to a rate of DM2.2/$, the total purchase cost would be DM1.1 billion. However, if the dollar continued to appreciate to a rate of DM4.0/$ by the time payment is due, the total cost would be DM2.0 billion. This is clearly a considerable amount of risk to be taken on by a firm. As seen in this case, leaving large exposure is often considered currency speculation. 2. Partial Forward Cover. This strategy would cover a proportion of the exposure with a forward contract, and the remaining proportion uncovered. Firstly, a forward contract is an agreement between two firms to buy or sell an asset at an indicated time at a price agreed upon today. Ruhnau anticipated that the value of the dollar would fall, and that Lufthansa would benefit from leaving a proportion of the exposure uncovered. However, in this scenario total potential exposure is still unlimited and the dollar could potentially escalate to exorbitant levels, which results in extremely high amounts of Deutsche Marks. Additionally, it was unlikely that the dollar was to escalate meaning Ruhnau had significantly reduced the foreign exchange risk of the final Deutsche Mark required over a range of final values. Furthermore, the proportion of exposure can vary significantly, but for this case it was determined that a ratio of 50/50 would be optimal, as it resembles the decision that Ruhnau pursued in 1985. 3. Full Forward Cover. If Lufthansa needed to adopt a risk adverse strategy they could have fully eliminated its currency exposure through the purchase of forward contracts for the entire US dollar amount of the purchase. This strategy would lock in the set price of DM3.2/$, which costs DM1.6 billion. This strategy could have proven be very beneficial for Lufthansa as it completely removes any associated risk or sensitivity to the ending spot exchange rate. However, as seen in January 1986 the final exchange rate ended well below the forward contract price. This would have been very unfavorable for Lufthansa, as they would have had to pay a significantly higher figure. Firms often adopt the 100% forward cover strategy as their benchmark, as a comparison measure for actual currency costs when everything is completed. 4. Foreign Currency Put Options. This strategy was particularly unique at the time Ruhnau’s deal was constructed due to its kinked shape value line, and its ability to satisfy the best of both worlds. For example, if Ruhnau purchased a put option at the value of DM3.2/$, and the dollar continued to appreciate, the total cost of obtaining US$500 million would be locked in at DM1.6 billion plus the cost of the premium, as highlighted by the flat line of the put option alternative in Exhibit 3. However, if the value of the dollar depreciated as expected, Lufthansa would be able to let the option expire and purchase the dollars at a lower cost with a spot rate plus the cost of the premium of DM96 million. However, the downside of this alternative is if the dollar did not depreciate below the original DM3.2/$ rate, Lufthansa would be left to pay DM96 million for a hedging instrument they did not use. 5. Buy Dollars Today and Invest. This final strategy involves a money market hedge for an account payable. Lufthansa would purchase the US$500 million and invest the entire funds in a high interest bearing account until the final payment was required. This alternative eliminates all currency exposure, but requires a high capital investment immediately. It would have been very unlikely and unreasonable for Lufthansa to generate such a large investment in a reasonable amount of time. Additionally, Lufthansa had practices and covenants in place that restricted the types, amounts and currencies of denomination in which it could carry on its balance sheet. Recommendations There are two recommendations that would make Ruhnau’s strategy more appropriate and further limit Lufthansa’s degree of exchange rate risk. 1. The purchase of the aircraft from Boeing was at the wrong time. Ruhnau should have continued with his original expectation and waited until the value of the dollar decreased. The US dollar was at a record high level at the time of purchase, which consequently increased the value of the Deutsche Mark required for payment in January 1986. If Ruhnau waited he would have made significant savings for Lufthansa. 2. Ruhnau should have purchased put options. The acquisition of put options would have allowed Lufthansa to protect themselves against unfavorable exchange rate movements, while maintaining the ability to expire the put option if the dollar decreased, allowing them to exchange Deutsche mark for the spot rate if preferred.
Exhibit 1
Exhibit 2
Exhibit 3
Lufthansa's Net Cost by Hedging Alternative 2.1 2 1.9 Billions of DM
1.8 1.7
Uncovered
1.6
Partial Forward Cover
1.5
Full Forward Cover
1.4
Foreign Currency Put Options
1.3 1.2 1.1 2.2
2.4
2.6 2.8 3.0 3.2 3.4 3.6 3.8 Ending DM/$ Exchange Rate (January 1986)
4.0
