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

2. 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
: Service started to Europe/Trans-Atlantic
1960: Started Jet-powered expansion
1980: Started modernized expansion program

3. 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

4. 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

5. The Chairman Herr Heinz Ruhnau A career bureaucrat:
: Member of the Hamburg State Parliament
: 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

6. 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

7. Deutschmark vs. US Dollar January 1980-January 1985

8. 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

9. 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.

10. 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

11. 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

12. 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)

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

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

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

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

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

18. 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

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

20. 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.

21. 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

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

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

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

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

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

27. 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

28. 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.

29. 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

30. The Invisibles

31. 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

32. 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

33. 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

34. 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

35. 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

36. Questions Please???