2. 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.
3. WHY NOW (JAN 1985)?
Facts
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
4. 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)
5. 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
6. CONSTRAINTS
Debt Covenant
Payment due date
Limited US Dollars available
US Dollar appreciating
The cost of hedging
7. 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.
8. 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
10. 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/$.
Ruhnau was summoned to meet with Lufthansa’s
Board and West German Transportation Ministry
on February 14, 1986 to explain his speculative
exposure management decision on this transaction
12. THE ACCUSATIONS
Purchasing the Boeing aircrafts at the wrong time.
Choosing to hedge half of the exposure when he
expected the dollar to fall.
Choosing forward hedging over options
Purchasing Boeing jets at all
13. THE RATIONALE
Purchase of Boeing aircrafts was mandated according to the
expansion program
Ruhnau took a middle ground approach by half covered and
half uncovered, looks better in this case, but risky
He considered the upfront cost of option premium (6% -
DM96m) is expensive and the tool was relatively new to market
and complicated
To comply Lufthansa’s policy for a mix of Boeing and Airbus
aircrafts
14. THE CONCLUSION
Hedging should be considered as a corporate strategy
Single transaction like this one can jeopardous the company’s existence
or long time to recover, if the market moves to opposite direction
Prestigious company like Lufthansa shouldn’t have left any exposure (big
or small) uncovered
If all predictions towards no exchange rate movement or further US$
appreciation, use full cover futures
If all predictions towards US$ depreciation, use full cover options
15. 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