Lufthansa

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Lufthansa

• Is it Hedging or Speculating?

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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.

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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.

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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.

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Hedging alternatives

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

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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.

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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.

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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.

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Money market hedge

• Obtain the 500 million now and hold those funds
  in an interest-bearing 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.

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Heinz Ruhnau's decision

• Ruhnau covered forward half of the exposure (250
  million) at DM 3.2/, and left the remaining half
  uncovered.

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Expected cost as of January 1985
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Expected cost as of January 1985
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Expected cost as of January 1985
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Expected cost as of January 1985
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Expected cost as of January 1985
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Outcome

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

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Outcome Perfect hindsight
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Outcome Perfect hindsight
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Outcome Perfect hindsight
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Outcome Perfect hindsight
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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.

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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

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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

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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?

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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

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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.