Case Study: Lufthansa’s Purchase of Boeing

737s

» Analysis by: Rajan Thakur

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 History of Lufthansa
• Lufthansa was originally founded in 1926 in Berlin as
the result of merger between "Deutsche Aero Lloyd”
and "Junkers Luftverkehr"
Luft – “Air” Hansa – “Company”
• 1927 The event of the year first flight to China
• 1930-1934 The first trans-ocean service was schedule across the South
Atlantic
 1939 expansion of network route to Bangkok and Santiago de Chile
 1945 suspension of all flights due to War II
 1960 Lufthansa enters jet age with an arrival of the Boeing 707
 Today Lufthansa is sixth largest airline in the world and second largest in
Europe.
 The fiscal revenue as of 2006 was $23.6 billion

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 The Case Overview
The Deal
• In January 1985 Lufthansa’s Chairman Herr Heinz Ruhnau acquired 20
Boeing 737 jets
• The total cost of the purchase = $500 million delivered by January 1986
• With respect to the spot rate of DM 3.2/$ the size of the deal = DM1.6 Billion

The Problem

• Transaction risk exposure

• Persistent Dollar appreciation against deutschemark for several years
• Mass believe in dollar overvaluation and its coming value decline
• The strategy of currency management to hedge probability of losses

*DM German Currency

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 Various Alternatives
1. Remained Uncovered
Alternative Total Cost Degree of Risk

A $500 Million @ 2.2 DM 1,100,000,000 High

B $500 Million @ 4.0 Dm 2,000,000,000 High

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 Various Alternatives
2. Full Forward Contract

Alternative Total Cost Degree of Risk

A $500 Million@ 3.2DM 1,600,000,000 Low

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 Various Alternatives
4. Foreign Currency Option /Put Option
Alternatives Total Cost Degree Of Risk

A $500 Millions @3.2 1,632,000,000 Low

+2% premium

B $500 Million @ 2.2 1,122,000,000 Low

+ 2% premium

C $500 Million @ 4.0 2,040,000,000 Low

+ 2% premium

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 Various Alternatives
5. Buy Dollars Now/Money Market

Alternatives Total Cost Degree of Risk

A $500 Million @ 3.2 1,600,000,000 N/A

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 Combination

Of

Different

Strategies

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 Ruhnau Decision

Decision

• Ruhnau compromised by hedging half of the total exchange risk exposure

and leaving the other half uncovered.

Possible Benefits

• To reduce total exchange risk exposure plus keeping the chance of

benefiting if dollar depreciates against deutschemark as was expected by
currency advisors.

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 The Outcome
• January ,1986 Dollar did depreciate against deutschemark to DM2.3/$
• The total cost for Lufthansa to Boeing as the result:

- $250,000,000xDM 3.2/$= DM 800,000,000

(covered half)
- $250,000,000xDM 2.3/$=DM 575,000,000
(uncovered half)
- DM 800,000,000+ DM 575,000,000 = 1,375.000,000

• The extra cost incurred due to the forward contract agreement

- 500,000,000x 2.3/$ = 1,150,000,000
-1,375,000,000 – 1,150,000,000= DM 225,000,000 Higher

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 The Consequences

Herr Ruhnau was accused of:

• Speculating actions with the forward contract

• 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

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 Do you think Heinz strategy made sense?

• Ruhanu did the same by hedging half of the amount by forward contract and
left the rest half uncovered. Since he expected the dollar to fall he would
have used a different strategy for hedging, but no one at that time knew that
dollar would plummet so sharply.

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 To what degree did he limit the upside and downside
exposure of the transaction by hedging one half of it?

• Out of 500 million dollars, 250 million was locked in the full forward contract
at 3.2DM/$ resulting into 800,000,000 DM.

• Now rest of it was uncovered if we take two different possible rate for the
uncovered,

• a) If DM 2.2/$ then 250 million result into 250 million $ into DM2.2/$ is equal
to 0.55billion total cost would be 1.35 billion.
• b) If DM4.0/$ then 250 million result into 250 million $ into DM4.0/$ is equal
to 1 billion.
• The total cost would be 1.8 billion .

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 Do you agree with Ruhnau’s critics that he was
“speculating”?

• Speculation is done for maximum profit and carries maximum risk, yes
Ruhnaus was speculating because half of the amount he left uncovered,
which carried maximum risk and had potential of maximum profit or
maximum loss. He was successful in his attempt but he was blamed by his
critics for the selection of forward contract over options, because of which
company had to pay additional DM

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 Is it fair to judge transaction exposure management
effectiveness with 20/20 hindsight?

• 20/20 hindsight means that perfect understanding of an event after it has happened.

• The loss of DM225,000,000 was calculated on the basis of value of DM on

January 1986, which is not fair, because in January 1985 nobody knew what
would the value be one year later, and the $ plummeted very sharply
beyond anyone’s expectation.

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 • Questions?

• Thank you!

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