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 Boeing aircrafts aircrafts which cost cost Lufthansa Lufthansa an additi additional onal DM 225M 225M back in in Jan. 1985. 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, Ruhnau, purchased twenty Boeing Boeing 737 jets at a hefty price of $25,000,000 $25,000,000 per for a total transacti transaction on of $500,000,00 $500,000,000. 0. The term of of the purchase purchase is for Lufthansa Lufthansa to pay pay the entire amount in US dollats upon delivery delivery one year later in January January 1986.
As of Jan. 1985, the conversion rate stood at DM 3.2/$ and with the U.S. dollar on a rise agains againstt the German German DM since since 1980, 1980, Ruhnau Ruhnau had several several financial financial hedgin hedging g option options s to undertake in order to minimize Lufthansa’s foreign exchange exposure risk for the next 12 months months.. These These financi financial al instrumen instruments ts include include the basic hedgin hedging g altern alternati atives ves 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 the U.S. dollar had been steadily steadily appreciating appreciating against the German mark. mark. In January January 1982, the dollar 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%.
Althou Although gh many many analys analysts ts had conclu concluded ded that that the U.S U.S.. dollar dollar was overva overvalue lued d during during this this period, period, it continued continued to show strength. strength. Government Government interventi intervention on 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 -rat e Cont rac t Pric e (DM)
Best Cas e 2. 438 1,219. 00
Ex pec ted 3.20 1,600.00
W ors e C 3.96 1, 980.0
Level of of Risk 10 Cost: High unless the dollar depreciates Risk: Extremely high
Full forward cover
1986 x -rate Cont ract Pric e (DM) Oportunit y Cost s
Best Cas e 3.96 1, 980.00 380.00 Level of Ris k
Guarant eed 3.20 1, 600. 00 0.00 2
Cost: Only an opportunity cost if the US Dollar depreciates
Wors t C 2.44 1,219. -381. 0
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 $500 million now and hold those funds in an interest-bearing account or asset until payment was due. What ultimately eliminated this alternative for consideration was that Lufthansa had several covenants that limited the types, amounts, and currencies of denomination of the debt it could carry on its balance sheet.
50% Covered, 50% Uncovered Cost: High unless the dollar depreciates Risk: Moderately high
Lufthansa’s Decision and Outcome As noted the size of the contract, which was denominated in U.S. dollars, was seen as a too large large of an uncove uncovered red transact transaction ion exposur exposure e for Lufthan Lufthansa. sa. On the other hand, hand, mos mostt analysts were predicting a weakening weakening of the U.S. U.S. dollar. If this were to occur, it could result in a smaller deutschmark denominated payment for Lufthansa. Recall, Lufthansa’s liability was denominated in U.S. dollars, thus a weakening dollar would have required fewer marks.
Decision Lufthansa Lufthansa decided decided to hedge 50% of its exposure exposure with a forward contract. contract. This forward forward contract contract was set at DM3.2/$; DM3.2/$; thus Lufthansa would purchase $250 million in January 1985 for 800 million million marks. marks. The remaini remaining ng 50% was left uncover uncovered ed to take take advant advantage age of a possible weakening of the dollar.
Outcome During the 12 month period, period, the U.S. dollar did weaken against the mark. In January 1985, it was tradi trading ng arou around nd 3.2 and by Janua January ry 1986 1986,, it was tradi trading ng arou around nd 2.45. 2.45. This 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 Lufthansa had guessed correctly. correctly. The mark had strengthened strengthened and they they were able to take advantage of that with an uncovered position. If they had covered 100% 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 authority over the airline), airline), criticized Ruhnau for hedging hedging 50% of the exposure exposure which resulted resulted in 187,500,000 187,500,000
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: •
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Herr Heinz Ruhnau had such a strong gut feeling, but it was based on no hard evid eviden ence, ce, that the the U.S U.S exch exchan ange ge rate rate was was goin going g to drop drop that that he shou should ld have 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 dollar was “high” “high” at this this point, point, and therefo therefore re the decision decision to purcha purchase se 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 postponing the purchase would only result in a higher dollar and therefore therefore a higher higher expense.
Mistake 2: There are two views •
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Since he is paid the big bucks to make the big decisions, and if he believed the dollar was about to fall he should s hould 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 e xchange 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 uncove uncovered; red; a som somewh ewhat at schizo schizophr phreni enic c “view” “view” on the directi direction on of exchan exchange ge rate rate movements.)
Mistake 3: •
Since he did purchase the planes, regardless of any feelings feelings he had about dropping 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. 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 Herr Ruh Ruhnau nau coul could d have ave purc purcha hase sed d an Deutschemarks to reduce the premium paid.
outout-o of-th f-thee-mo mon ney
put
opt option ion
on
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 •
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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 w ay back down? This may be the most legitimate criticism of Herr Ruhnau’s management: the failure to re-position the hedge hedge when new information information is incontrovert incontrovertible. ible. Although 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
