Lufthansa Case Study

Synopsis
Lufthansa, purchased twenty 737 Boeing aircraft
in January of 1985 for $500 million.
The payment was due in January of 1986 upon
delivery of the aircraft from the U.S.
manufacturer.
At the time of the purchase, the U.S. dollar was
at a record high versus the Deutschemark, and
had been steadily appreciating against the
Deutschemark for 5 years.
The CEO of Lufthansa, Herr Heinz Ruhnau, was
responsible for determining what hedging if any
would be use.

Focus of The Case

The focal point of of this case is the managerial
decision-making, the formation of expectations,
and the value and leadership of senior
management.
Arguing over what Herr Heinz Ruhnau did in
retrospect and what we may think he should
have done is not the point.
The more general lesson is whether the firms
best interests are found in accepting open
uncovered positions or not.

Question 1
T dollar was high at this point, and therefore
the decision to purchase now seems to be a bit
late.
Yet, given the trend in the movement of the DM/
$ rate over the previous years, it appears (using
the graphic available to Herr Heinz Ruhnau in
January 1985, Exhibit 2), that postponing the
purchase would only result in a higher dollar and
therefore a higher expense.

Question 2
Should Herr Ruhnau have gone whole hog?
There are two views
Since he is paid the big bucks to make the big decisions,
and if he believed the dollar was about to fall he should
have remained completely uncovered.
Or, on the contrary, he is also paid the big bucks to pursue
Lufthansas strategic future, and that does not include the
gambling on exchange rate movements.
Both views are valid, however, that the 50/50 result is
difficult to defend itself.
(This is equivalent to covering one exposure and leaving
an identical exposure completely uncovered; a somewhat
schizophrenic view on the direction of exchange rate
movements.)

Question 3
The purchase of a put option would have indeed provided
solid insurance. Yet, it is difficult to explain why one should
spend millions on the purchase of protection which one hopes
not to use.
This is a flawed argument as it is obvious if we extend it to
any insurance policy. However, it has real meaning in many
boardrooms even today.
As a matter of fact, few private firms were actually using
currency options for risk management in 1985 when this
situation arose.
Herr Ruhnau could have purchased an out-of-the-money put
option on Deutschemarks to reduce the premium paid.
He could also have purchased a collar, i.e., sold a call to
finance the purchase of the put option hedge on
Deutschemarks to reduce the premium further.

Question4
4. Why Boeing instead of Airbus?
We have no information for a factual
evaluation of this issue.
But it is important to notice that the choice
of purchase and the terms of a purchase
give rise to the exposure itself.

Other Points
The initial decision is made with a highly overvalued dollar
but a trend line which was hard to argue with. What do you
expect, and which hedging alternative would you pick?
With the 50/50 hedge position he cannot possibly win.
One sides gains will always offset the losses on the other.
Why did Ruhnau not change his position when it became
clear that the dollar had indeed peaked and was on its way
back down?
This may be the most legitimate criticism of Herr Ruhnaus
management: the failure to re-position the hedge when new
information is incontrovertible. Although this would not
recoup previous exchange rate losses, it would allow
Lufthansa to enjoy any further drop in the value of the dollar
(or suffer any increases if the value of the dollar turned once
again).