Ming Yu Chan Sunil K. Dixit Alex Galiu Kevin Han Baban Pal Singh FIN 570- International Financial Management Summer 2008 California State University, Fullerton

Company History 1926: Formed from a merger between Deutsche Aero Lloyd (DAL) and Junkers Luftverkehr : Opens first trans-oceanic : (War-time) All flights discontinued in : Post war air transport resumes 1960: Enters the jet age 2005: Celebrates the 50th anniversary of its postwar re-entry

Company Background Corporate headquarters - in Cologne Main base and primary traffic hub - Frankfurt International Airport in Frankfurt am Main Second hub - Munich International Airport Largest airline in Europe World’s sixth largest airline

Company Background Five business segments – Passenger Transportation, Logistic, MRO Business, Catering and IT Service Core Business - Passenger Transportation Founding member of Star Alliance, the world's largest airline alliance Services to 209 destinations in 81 countries

Herr Heinz Ruhnau Lufthansa Chairman on July 1, 1982 – Sept 1, No private enterprise experience Undersecretary in the Transport Ministry of West Germany Strong affiliations with the West German Social Democratic Party Immediate task - improve Lufthansa's thin profit margin

Herr Heinz Ruhnau - Contd Chairman – Supervisor Board - Mitteldeutsche Flughafen AG ( ) Now a honorary Professor - Technical University Dresden - Institute of Economics and Logistics Frequent speaker – on Transport and Eastern European Economies

Case Overview January purchased twenty Boeing 737 Trading price: US$500 million due in January 1986 Exchange rate: DM3.2/$ - January 1985

Exchange Rate Fluctuation Upward USD since 1980 If USD continued to rise, the total cost to Lufthansa would also rise Spot rate, DM 2.8/$

Economic Environment USA GDP Growth Rate – 1984: 6.8% – 1985: 2.4%* Inflation – 1984: 4.3% – 1985: 3.55% Banks Prime Lending Rate. – 1985: 10.61% Sources: 1984 – OECD; 1985 – Private Bank Forecasts (WSJ) Germany GDP Growth Rate – 1984: 2.6% – 1985: 3.%* Inflation – 1984: 2.4% – 1985: 2.5%* Banks Prime Lending Rate – 1985: 9.53% * Forecast

Economic Environment - Contd Predictions Based on key economic Data – US Dollar - expected to Depreciate against German DM in 1986 – German DM - expected to Appreciate against US Dollar in 1986

Decision Outcome 50% forward DM3.2/$ The remaining 50% uncovered The spot rate in January 1986 = DM 2.3/$ Total DM Cost Forward Contract (DM3.2/$)800 million Uncovered (DM2.3/$)575 million Total1,375 million

Decision Outcome Herr Ruhnau was summoned to meet with Lufthansa’s board Was accused of recklessly speculating with Lufthansa’s money

DM Rate Forecast International Fisher Effect US prime rate in Jan 1985: 10.61% German banks’ prime lending rate in Jan 1985: 9.53% Spot rate in Jan 1985: DM3.2/$ Projected spot rate in Jan 1986: = DM 3.168/$

DM Rate Forecast Purchasing Power Parity US inflation in 1985: 3.55% German inflation in 1985: 2.5% Spot rate in Jan 1985: DM3.2/$ Projected spot rate in Jan 1986: = DM 3.168/$

January DM Spot Rate Projections Purchasing power parity: DM3.168/$ International fisher effect: DM3.168/$ Forward rate (Given in the case): DM3.2/$

Lufthansa’s Issues - Basic Importance Urgency LowHigh Low I Level of FX Transaction Risk/Management Competency II Economic Environment (You cannot control) High III Risk Aversion/ company’s FX policy IV Hedging Solution and Forecast

Lufthansa’s Issues - Immediate Importance Urgency LowHigh Low I Timing of Purchase (1 Year to Delivery) II Adequacy of Funds/Capital High III Delivery of Airplanes IV Cost of Hedging

Cause/Effect Analysis Basic Issues FX Rate Forecast Economic Environment Adequacy of Funds Hedging Decision Purchase Contract FX Risk Aversion Cost of Hedging

Cause/Effect Analysis Immediate Issues Hedging Method Cost of Hedging Contract Date Covenants Restrictions Delivery Date

FX Transaction Risk FX Exposure - Acquisition of assets - Proceeds payable in foreign currency (US $) - May result in higher costs – if DM depreciates against US $ - Reduce/manage FX Risk

Decision Criteria Sound hedging policy - desirable for FX transaction risks Our Forecast - US $ was to depreciate Lufthansa’s covenants – restrictions on debt amounts & currencies of denomination Assumption - jets would be delivered on time US Operations – US $ cash inflows insufficient Not enough facts - Boeing vs. Airbus issue or timing or purchase – Assumed Sound Business Decisions

Hedging Alternatives Uncovered Forward contract cover Partial forward uncovered Foreign currency option Buy dollar now

Alternative Analysis #1 Uncovered Option USD (Million) Rate TypeDM/$ Total DM cost (Million) Risk Uncovered 500 Spot - Actual Jan ,150High Uncovered 500 Spot Forecast Jan 1986 (PPP) ,584High Uncovered500 Spot Forecast Jan 1986 (IFE) ,584High Maximum Risk – Speculative Gain/Loss Possible

Alternative Analysis #2 Full Forward Cover Option USD (Million) Rate TypeDM/$ Total DM cost (Million)Risk Full Forward Cover 500Forward3.21,600Low Minimum Risk – Costs higher

Alternative Analysis #3 Partial Forward Cover OptionUSD (Million)Rate TypeDM/$ Total DM cost (Million)Risk 250Forward Medium Partial Forward Cover 50:50250 Spot - Actual Jan Medium 250 Spot Forecast Jan 1986 (PPP) Medium 250Spot Forecast Jan 1986 (IFE) Medium Medium Risk – Partial Hedge

Alternative Analysis #4 DM Put Options Option USD (Million)Rate TypeDM/$ Total DM cost (Million)Risk DM Put Options500Strike Price3.21,600 Low Premium 6% 96 If Not Exercised (6%) 96 Spot - Actual Jan ,150 Total1,246Low Low Risk – Freedom to Walk Away – Sunk Cost (Premium)

Alternative Analysis #5 Buy Dollar Now Option USD (Million)Rate TypeDM/$ Total DM cost (Million)Risk Buy Dollar Now & Invest DM (Full Contract)500Spot3.21,600Low DM % p.a.101 Total1,701 USD % (US$ Million) Total1,591Low No Risk – Availability of cash? – Covenants’ Restrictions on debt

Alternatives Summary AlternativeScenarioCost (DM) -MillionTotal CostsRisk Uncovered$ 500 x 2.31,150 High $ 500 x ,584 Full Fwd$ 500x3.21,600 Low Partial FWD$ 250x (50:50)$ 250x ,375Medium $ 250x $ 250x ,592High DM Put Options$ 500x3.2 plus 6% prem1,696 Low $ 500x2.3 plus 6% prem1,246 Low $ 500 x plus 6% prem1,680 Low

Recommendation Uncovered position - not desirable Corporate FX hedging policy Implement 6 steps to hedge against FX exposure Corporate decision-making Experience does matter Forward not the right tool in this case Exit if US$ depreciates

Recommendation (Contd) Buy DM Put Options If US $ appreciates = USD 500 x % = DM Billion If dollar declined to DM 2.3/$ = USD 500 x DM 96 Mil = DM Billion Downside = costs DM 96 million more than uncovered position Benefit = 100% hedging

Foreign Exchange Risk Management Steps Forecasting Risk Estimation Benchmarking Hedging Reporting & Review Contingency Steps

Lufthansa’s Hedging Policy 2007 “Lufthansa Finance Cockpit” Capital expenditure on aircraft: 50% hedging Review every 6 months Hedging level revised upto 90%