Lufthansa

Is it Hedging or Speculating?

Case synopsis
In January 1985, Lufthansa,
under the chairmanship of Heinz
Ruhnau purchased twenty 737
jets from Boeing.
The agreed upon price was
$500 million, payable in US$ on
delivery of the aircrafts in one
year, that is in January 1986.

Case synopsis

The US$ had been rising steadily and rapidly since 1980, and was
approximately DM3.2/$ in January 1985.
Worst case scenario: US$ continues to appreciate.

Herr Ruhnaus expectations

Like others at that time, he believed that the US$ had risen about
as far as it was going to go, and would probably begin to fall by the
time January 1986 rolled around.

Hedging alternatives

Remain uncovered
Full forward cover
Option hedging
Money market hedge
Some combination of the above alternatives

Remain uncovered
It is the maximum risk approach.
If e = DM 2.2/$ by January 1986, the purchase of the jets would be
only DM 1.1 billion.
If e = DM 4/$ the total cost would be DM 2 billion.
Many firms believe that:
uncovered position = currency speculation.

Full forward cover

This approach would have locked in an exchange rate of DM 3.2/$,

with a known final cost of DM 1.6 billion.

Foreign currency options

A put option on the DM at DM 3.2/$, could locked in DM 1.6 billion

plus the cost of the option premium (DM 96 million).
The total cost of the purchase in the event the put was exercised
would be DM 1.696 billion.

Money market hedge

Obtain the $500 million now and hold those funds in an interestbearing account or asset until payment was due.
What ultimately eliminated this alternative for consideration was
that Lufthansa had several covenants that limited the types,
amounts, and currencies of denomination of the debt it could carry
on its balance sheet.

Heinz Ruhnau's decision

Ruhnau covered forward half of the exposure ($250 million) at DM

3.2/$, and left the remaining half uncovered.

Expected cost as of January 1985

Alternative Benchmark
rate

Dollar up

No change
in spot

Dollar down

Uncovered

DM 3.2/$

Cannot tell

DM 1.6 b

Cannot tell

Full forward
cover

DM 3.2/$

DM 1.6 b

DM 1.6 b

DM 1.6 b

Partial
forward
cover, 50/50

DM 3.2/$

Cannot tell
+ DM 0.8 b

DM 1.6 b

Cannot tell
+ DM 0.8 b

Put options

DM 3.2/$

DM 1.696 b

DM 1.696 b

Cannot tell
+ DM 69 m

Expected cost as of January 1985

Alternative Benchmark
rate

Dollar up

No change
in spot

Dollar down

Uncovered

DM 3.2/$

Cannot tell

DM 1.6 b

Cannot tell

Full forward
cover

DM 3.2/$

DM 1.6 b

DM 1.6 b

DM 1.6 b

Partial
forward
cover, 50/50

DM 3.2/$

Cannot tell
+ DM 0.8 b

DM 1.6 b

Cannot tell
+ DM 0.8 b

Put options

DM 3.2/$

DM 1.696 b

DM 1.696 b

Cannot tell
+ DM 69 m

Expected cost as of January 1985

Alternative

Benchmark
rate

Dollar up

No change
in spot

Dollar down

Uncovered

DM 3.2/$

Cannot tell

DM 1.6 b

Cannot tell

Full forward
cover

DM 3.2/$

DM 1.6 b

DM 1.6 b

DM 1.6 b

Partial
forward
cover, 50/50

DM 3.2/$

Cannot tell
+ DM 0.8 b

DM 1.6 b

Cannot tell
+ DM 0.8 b

Put options

DM 3.2/$

DM 1.696 b

DM 1.696 b

Cannot tell
+ DM 69 m

Expected cost as of January 1985

Alternative Benchmark
rate

Dollar up

No change
in spot

Dollar down

Uncovered

DM 3.2/$

Cannot tell

DM 1.6 b

Cannot tell

Full forward
cover

DM 3.2/$

DM 1.6 b

DM 1.6 b

DM 1.6 b

Partial
forward
cover,
50/50

DM 3.2/$

Cannot tell
+ DM 0.8 b

DM 1.6 b

Cannot tell
+ DM 0.8 b

Put options

DM 3.2/$

DM 1.696 b

DM 1.696 b

Cannot tell
+ DM 69 m

Expected cost as of January 1985

Alternative

Benchmark
rate

Dollar up

No change
in spot

Dollar down

Uncovered

DM 3.2/$

Cannot tell

DM 1.6 b

Cannot tell

Full forward
cover

DM 3.2/$

DM 1.6 b

DM 1.6 b

DM 1.6 b

Partial
forward
cover, 50/50

DM 3.2/$

Cannot tell
+ DM 0.8
b

DM 1.6 b

Cannot tell
+ DM 0.8 b

Put options

DM 3.2/$

DM 1.696 b

DM 1.696 b

Cannot tell
+ DM 69 m

Outcome

The dollar weakened from DM 3.2/$ to DM 2.3/$.

Outcome: Perfect hindsight

Alternative

Benchmark rate Total DM cost

Uncovered

DM 2.3/$

$1.15 billion

Full forward cover

DM 3.2/$

$1.6 billion

Partial forward cover,

50/50

DM 2.75/$

1.375 billion

Put options

DM 3.2/$ (strike) 1.246 billion

Outcome: Perfect hindsight

Alternative

Benchmark rate Total DM cost

Uncovered

DM 2.3/$

$1.15 billion

Full forward cover

DM 3.2/$

$1.6 billion

Partial forward cover,

50/50

DM 2.75/$

1.375 billion

Put options

DM 3.2/$ (strike) 1.246 billion

Outcome: Perfect hindsight

Alternative

Benchmark rate Total DM cost

Uncovered

DM 2.3/$

$1.15 billion

Full forward cover

DM 3.2/$

$1.6 billion

Partial forward cover,

50/50

DM 2.75/$

1.375 billion

Put options

DM 3.2/$ (strike) 1.246 billion

Outcome: Perfect hindsight

The Aftermath
On February 14, 1986, Heinz Ruhnau was summoned to meet
with Lufthansa's board and with Germany's transportation minister
to explain his supposed speculative management of Lufthansa's
exposure in the purchase of Boeing jets.
Herr Ruhnau was accused of recklessy speculating with
Lufthansa's money, but the speculation was seen as the
forward contract, not the amount of the exposure left uncovered
for the full year.

Herr Ruhnau was accused of making the following

mistakes:

Purchasing the Boeing aircraft 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

What went wrong?

Lufthansas board should have chosen DM1.6 b as a benchmark

(DM3.2/$)
Herr Ruhnau expected the dollar to fall; hence, he should have
used option hedging

Concept check #1

If you believe there is a 80% probability that your house will be

destroyed by floods, would you buy insurance or move to another
location?

Concept check #2

You want your exams to be assessed based on:

a. a pre-determined, objective exam key
b. instructors inspiration at the time of grading

Conclusions
Expect the exchange rate to move against you? Use forward
hedging.
Expect the exchange rate to move in your favor? Use option
hedging.
The benchmark has to be ex-ante not ex-post.