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 Mostly European routes Named as Lufthansa Opened Trans-Atlantic routes Routes limited to neutral countries due to WWII Suspended all services following Germanys defeat Reborn (different from pre-war Lufthansa) as flagship airline of West Germany with majority shares held by Government Service started to Europe/Trans-Atlantic Started Jet-powered expansion Started modernized expansion program

1927 1934: 1933: 1934: 1939 1945: 1945: 1953: 1955- 1956: 1960: 1980:

The Company (Contd.)

As of 1985

Corporate HQ:
Primary Hub: Secondary Hub: Market Position: Core Business: National Corporation:

Cologne, West Germany

Frankfurt, West Germany Munich, West Germany Germanys largest, Worlds 6th largest Passenger Transportation

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 Germanys 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 2.5 2 1.5 1 0.5 0 1/2/80

DM/$

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/$

Lufthansas 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 countrys economic and political conditions and policy changes

Why not Airbus?

Facts

Subsidized price for European countries No foreign currency exposure

Boeing was chosen for

Lufthansas 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
USA YEAR Inflation 1984 4.30% 1985 3.55% Sources Bureau of Labor Statistics Prime lending Rate 8.50% 8.00% BoG Fed Reserve West Germany Prime lending Inflation Rate 2.40% 4.50% 2.00% 4.50% Bundersbunk Bundersbunk

YEAR 1984 1985 Sources

Spot Rates DM/$ 2.76 3.17 Federal Reserve

YEAR Method 1986 International Fischer Effect 1986 1986 Purchase Power Parity Forward Rate

et=eo (1 + rh) / (1 + rf)

Projected Rate 3.07 3.12 3.20

et=eo (1 + ih)t / (1 + if)t stated

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
Urgency

High

Political Risk
Low

Foreign Exchange Exposure

High

Leveraging Decisions

Expansion Program

Immediate Issues

Importance

Low
Urgency

High

Low

Supplier Relationships

Debt Covenants

High

Timing of the Purchase

Create a Hedging Strategy

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

Herrs 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 Worse Case 3.96 1,980.00

Level of Risk 10

Cost: High unless the dollar depreciates

Risk: Extremely high

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 2 Guaranteed 3.20 1,600.00 0.00 Worst Case 2.44 1,219.00 -381.00

Cost: Only an opportunity cost if the US Dollar depreciates Risk: low

Alternative 3 50% Covered, 50% Uncovered

1986 x-rate Covered Uncovered Contract Price (DM) Level of Risk 5 Best Case 2.438 800 609.5 1,409.50 Expected 3.20 800 800 1,600.00 Worse Case 3.96 800 990 1,790.00

Cost: High unless the dollar depreciates Risk: Moderately high

Alternative 4 Purchase an Option

Option Rate Option Cost 1986 x-rate Contract Price (DM) Total Contract Cost Level of Risk 2 Best Case 6% 96.00 2.438 1,219.00 1,315.00 Expected 6% 96.00 3.20 1,600.00 1,696.00 Worse Case 6% 96.00 5.97 2,982.50 1,696.00

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 Exercised one option 96.00 1 Worst case 6% 96.00 96.00 192.00 Did not exercise either 192.00

Opportunity cost Level of Risk

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

Full Forward

Cost

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 Lufthansas 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 Lufthansas 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 companys existence or long time to recover, if the market moves to opposite direction Prestigious company like Lufthansa shouldnt 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 shouldnt 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???