Hedging, Speculation, or Both Brent Henderson Travis Harlan Sulaiman Habeebulla FIN 570 – International Financial Management FEMBA, Fall 2008 California State University, Fullerton

The Company 1926: Founded following a merger between “Deutsche Aero Lloyd” (DAL) and “Junkers Luftverkehr”, originally named as “Deutsche Luft Hansa Aktiengesellschaft” 1927 – 1934: Mostly European routes 1933: Named as “Lufthansa” 1934: Opened Trans-Atlantic routes 1939 – 1945: Routes limited to neutral countries due to WWII 1945: Suspended all services following Germany’s defeat 1953: Reborn (different from pre-war Lufthansa) as flagship airline of West Germany with majority shares held by Government 1955- 1956: Service started to Europe/Trans-Atlantic 1960: Started Jet-powered expansion 1980: Started modernized expansion program

The Company (Contd.) As of 1985 Corporate HQ: Cologne, West Germany Primary Hub: Frankfurt, West Germany Secondary Hub: Munich, West Germany Market Position: Germany’s largest, World’s 6th largest Core Business: Passenger Transportation National Corporation: 74.31% held by Federal Government 7.85% held by Government Agencies 17.84% held by Private Ownership

The Airline Industry As of Early 1980s October 1978, Airline Deregulation Act signed in US Access to deregulated countries opened up to all airlines Price fixing was eliminated Ticket pricing became equally important as customer service Stimulus of deregulation created highly competitive market Caused global smaller airline meltdown Forced massive restructuring in most international airlines Undertaken aggressive expansion plans Fleet modernization

The Chairman Herr Heinz Ruhnau A career bureaucrat: 1963-1976: Member of the Hamburg State Parliament 1976-1982: Undersecretary of the Federal Transport Ministry Former chief assistant to the head of West Germany’s largest trade Union, IG Matall Strongly affiliated with the West German Democratic Party No private enterprise experience Assumed post since July 1, 1982

Global Finance Market As of Jan 1985 US Dollar was rising steadily and rapidly against DM since 1980 Spot rate reached approximately DM3.2/$ Forwards were primary hedging tool Futures options were considered new and complicated hedging tool

Deutschmark vs. US Dollar January 1980-January 1985

Lufthansa Fleet As of Jan 1985 Lufthansa maintained a balanced mix of Airbus, Boeing, and other smaller aircrafts Lufthansa believed that having more than one supplier creates competition and better for purchaser Global pressures posed Lufthansa to expand routes, efficiency, and cost cutting Highly leveraged Lufthansa started fleet modernization program

The Case In Jan 1985 Lufthansa, purchased twenty 737 jets from Boeing. Total cost = $500 million Payable in US$ Payments due in January 1986 upon delivery.

Why now (Jan 1985)? Facts Lufthansa’s decision based on: US Dollar was rising steadily and rapidly against DM since 1980 In Jan 1985 spot rate was approximately DM3.2/$ Lufthansa’s decision based on: Purchase of operating assets must be based on current/expected market conditions Delay may adversely affect its operations Price could be increased to offset decline in the dollar, If purchased when the dollar was weakening Foreign currency will fluctuate based on the host country’s economic and political conditions and policy changes

Why not Airbus? Facts Boeing was chosen for Subsidized price for European countries No foreign currency exposure Boeing was chosen for Lufthansa’s policy was to maintain a fleet of both Boeing and Airbus aircrafts Prior to this deal, Lufthansa acquired 15 aircrafts from Airbus with option to acquire 7 more Having more than one supplier creates competition Better for purchaser

Foreign Currency Exposure Definition Impact of unexpected exchange rate changes upon the cash flows from existing (and typically short-term) contractual obligations Measure Exposure Use best measurement techniques Calculate expected future exchange rates Manage Exposure Consider all available methods to mitigate exposure Countertrade Hedging Simulate all methods (alternatives)

The Economics Both IFE and PPP forecast that the USD will depreciate

Comparisons of the Forward Rate The Economics (Contd.) Comparisons of the Forward Rate The English forward rates also anticipate a depreciating US dollar

Foreign Exchange Exposure Basic Issues Importance Urgency Low High Political Risk Foreign Exchange Exposure Leveraging Decisions Expansion Program

Supplier Relationships Create a Hedging Strategy Immediate Issues Importance Urgency Low High Supplier Relationships Debt Covenants Timing of the Purchase Create a Hedging Strategy

Cause and Effect Understanding the Economic Environment Hedging Strategy Payment Due Date Reducing Exposure Contract Date Financing Strategy (considering covenants) Aversion Threshold

Concerns Herr Ruhnau was concerned over the exchange rate exposure Lufthansa was bearing in this transaction The U.S. dollar had been steadily appreciating in value against the Deutschemark since 1980 Ruhnau, as many currency analysts, believed that dollar was overvalued, it is expected to be depreciated soon Regardless, Herr Ruhnau felt this was too large a transaction to be left unhedged

Constraints Debt Covenant Payment due date Limited US Dollars available via ticket sales US Dollar appreciating The cost of hedging

Opportunities Management is in support of the expansion strategy New hedging instrument: Options Herr’s expectation that the US Dollar will depreciate. This is validated by IFE and PPP.

Decision Criteria Choose the hedging alternative that is the lowest mix of the Following: Cost: What is the cost based on our worst case calculation Risk: How much exposure risk remains by implementing this alternative

Alternatives Remain uncovered 100% forward cover 50% forward cover – 50% uncovered 100% Option cover 100% Option Straddle

Alternative 1 Remain Uncovered Cost: High unless the dollar depreciates Risk: Extremely high

Alternative 2 Full Forward Contract Cost: Only an opportunity cost if the US Dollar depreciates Risk: low

Alternative 3 50% Covered, 50% Uncovered Cost: High unless the dollar depreciates Risk: Moderately high

Alternative 4 Purchase an Option Cost: DM 96 million. The option is an unfavorable alternative in the event of the dollar depreciating Risk: low

Alternative 5 Purchase an Option Straddle Cost: DM 192 million. The option is an unfavorable alternative in the event of the dollar remains flat Risk: low

Evaluating Alternatives The Option is the best alternative Cost: The Option alternative has the lowest cost Risk: Because the dollar is appreciating, but is forecasted to depreciate the risk is very low.

The Decision & Outcome Ruhnau covered forward $250 million at DM 3.2/$, and left the remaining $250 million uncovered. The dollar weakened from DM 3.2/$ to DM 2.3/$. Ruhnau was summoned to meet with Lufthansa’s Board and West German Transportation Ministry on February 14, 1986 to explain his speculative exposure management decision on this transaction

The Invisibles

The Accusations Purchasing the Boeing aircrafts at the wrong time. Choosing to hedge half of the exposure when he expected the dollar to fall. Choosing forward hedging over options Purchasing Boeing jets at all

The Rationale Purchase of Boeing aircrafts was mandated according to the expansion program Ruhnau took a middle ground approach by half covered and half uncovered, looks better in this case, but risky He considered the upfront cost of option premium (6% - DM96m) is expensive and the tool was relatively new to market and complicated To comply Lufthansa’s policy for a mix of Boeing and Airbus aircrafts

The Conclusion 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 Conclusion (Contd.) Ruhnau should be retained or fired? The Board should choose DM 1.6b (DM3.2/$) as benchmark With this benchmark, there are no damage caused to Lufthansa by his decision The 1985 decision must have been taken in accordance with the Board. In that case, Ruhnau has only partial responsibility So, Ruhanau shouldn’t be fired

Speculation is generally a trading strategy The Concept Speculation is generally a trading strategy In the event of exposure management, corporations should rather consider a full cover hedging strategy than speculation

Questions Please???