2. Lufthansa Is it Hedging or Speculating?

3. 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.

4. 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.

5. Herr Ruhnau’s 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.”

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

7. 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.

8. 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.

9. 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.

10. 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.

11. Heinz Ruhnau's decision Ruhnau covered forward half of the exposure ($250 million) at DM 3.2/$, and left the remaining half uncovered.

12. Expected cost as of January 1985

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

18. Outcome: Perfect hindsight

22. 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.”

23. 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

24. What went wrong? Lufthansa’s 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

25. 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?

26. Concept check #2 You want your exams to be assessed based on: a. a pre-determined, objective exam key b. instructor’s inspiration at the time of grading

27. 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.