Transcript Document 7496921

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
3.5
3
DM/$
2.5
2
1.5
1
0.5
0
1/2/80
1/2/81
1/2/82
1/2/83
1/2/84
1/2/85
1/2/86
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



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



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


Measure Exposure



Impact of unexpected exchange rate changes upon the cash flows from existing
(and typically short-term) contractual obligations
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
USA
YEAR
Inflation
1984
4.30%
1985
3.55%
Sources Bureau of Labor Statistics
YEAR
1984
1985
Sources
West Germany
Prime lending
Inflation
Rate
2.40%
4.50%
2.00%
4.50%
Bundersbunk
Bundersbunk
Prime lending Rate
8.50%
8.00%
BoG Fed Reserve
Spot Rates DM/$
2.76
3.17
Federal Reserve
YEAR
Method
1986 International Fischer Effect
et=eo (1 + rh) / (1 + rf)
1986
1986
et=eo (1 + ih)t / (1 + if)t
stated
Purchase Power Parity
Forward Rate
t
t
Projected Rate
3.07
3.12
3.20
Both IFE and PPP forecast that the USD will depreciate
The Economics (Contd.)
Comparisons of the Forward Rate
$/£
SPOT
1.158
30
1.159
90
1.161
360
1.161
Source: Financial Times
Using the stated forward rate, we determine the x-rate
£/$
£/DM
DM/£
0.864
0.273
3.669275
DM/$
SPOT
30
90
360
3.170
3.166
3.160
3.160
The English forward rates also anticipate a depreciating US dollar
Basic Issues
Importance
Low
High
Political Risk
Foreign Exchange
Exposure
Leveraging
Decisions
Expansion
Program
Urgency
Low
High
Immediate Issues
Importance
Low
High
Debt Covenants
Low
Supplier
Relationships
High
Timing of the
Purchase
Create a Hedging
Strategy
Urgency
Cause and Effect
Payment
Due Date
Understanding
the Economic
Environment
Hedging
Strategy
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
1986 x-rate
Contract Price (DM)
Best Case
2.438
1,219.00
Expected
3.20
1,600.00
Level of Risk 10
Cost: High unless the dollar depreciates
Risk: Extremely high
Worse Case
3.96
1,980.00
Alternative 2
Full Forward Contract
1986 x-rate
Contract Price (DM)
Oportunity Costs
Best Case
3.96
1,980.00
380.00
Level of Risk
Guaranteed
3.20
1,600.00
0.00
Worst Case
2.44
1,219.00
-381.00
2
Cost: Only an opportunity cost if the US Dollar depreciates
Risk: low
Alternative 3
50% Covered, 50% Uncovered
Best Case
2.438
800
609.5
1,409.50
1986 x-rate
Covered
Uncovered
Contract Price (DM)
Level of Risk
Expected
3.20
800
800
1,600.00
5
Cost: High unless the dollar depreciates
Risk: Moderately high
Worse Case
3.96
800
990
1,790.00
Alternative 4
Purchase an Option
Option Rate
Option Cost
1986 x-rate
Contract Price (DM)
Best Case
6%
96.00
2.438
1,219.00
Expected
6%
96.00
3.20
1,600.00
Worse Case
6%
96.00
5.97
2,982.50
Total Contract Cost
1,315.00
1,696.00
1,696.00
Level of Risk
2
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
Option Rate
Option Cost 1
Option Cost 2
Total Option Cost
Expected
6%
96.00
96.00
192.00
Worst case
6%
96.00
96.00
192.00
Opportunity cost
Exercised one option
96.00
Did not exercise either
192.00
Level of Risk
1
Cost: DM 192 million. The option is an unfavorable
alternative in the event of the dollar remains flat
Risk: low
Evaluating Alternatives
Cost and risk of alternatives
Remain
Uncovered
Cost
Full Forward
Partial
Straddle
Option
Option
Risk
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
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???