LufthansaLufthansa

Is it Hedging or Speculating?

Case synopsisCase 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.

Case synopsisCase 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.

Herr Ruhnau’s expectationsHerr 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.”

Hedging alternativesHedging alternatives

Remain uncovered

Full forward cover

Option hedging

Money market hedge

Some combination of the above alternatives

Remain uncoveredRemain 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.

Full forward coverFull 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.

Foreign currency optionsForeign 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.

Money market hedgeMoney 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.

Heinz Ruhnau's decisionHeinz Ruhnau's decision

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

Expected cost as of January 1985Expected cost as of January 1985 Alternative Benchmark

rateDollar up No change

in spotDollar down

Uncovered DM 3.2/$ Cannot tell DM 1.6 b Cannot tell

Full forwardcover

DM 3.2/$ DM 1.6 b DM 1.6 b DM 1.6 b

Partialforwardcover, 50/50

DM 3.2/$ Cannot tell + DM 0.8 b

DM 1.6 b Cannot tell + DM 0.8 b

Put options DM 3.2/$ DM 1.696 b DM 1.696 b Cannot tell + DM 69 m

Expected cost as of January 1985Expected cost as of January 1985 Alternative Benchmark

rateDollar up No change

in spotDollar down

Uncovered DM 3.2/$ Cannot tell DM 1.6 b Cannot tell

Full forwardcover

DM 3.2/$ DM 1.6 b DM 1.6 b DM 1.6 b

Partialforwardcover, 50/50

DM 3.2/$ Cannot tell + DM 0.8 b

DM 1.6 b Cannot tell + DM 0.8 b

Put options DM 3.2/$ DM 1.696 b DM 1.696 b Cannot tell + DM 69 m

Expected cost as of January 1985Expected cost as of January 1985 Alternative Benchmark

rateDollar up No change

in spotDollar down

Uncovered DM 3.2/$ Cannot tell DM 1.6 b Cannot tell

Full forwardcover

DM 3.2/$ DM 1.6 b DM 1.6 b DM 1.6 b

Partialforwardcover, 50/50

DM 3.2/$ Cannot tell + DM 0.8 b

DM 1.6 b Cannot tell + DM 0.8 b

Put options DM 3.2/$ DM 1.696 b DM 1.696 b Cannot tell + DM 69 m

Expected cost as of January 1985Expected cost as of January 1985 Alternative Benchmark

rateDollar up No change

in spotDollar down

Uncovered DM 3.2/$ Cannot tell DM 1.6 b Cannot tell

Full forwardcover

DM 3.2/$ DM 1.6 b DM 1.6 b DM 1.6 b

Partialforwardcover,50/50

DM 3.2/$ Cannot tell + DM 0.8 b

DM 1.6 b Cannot tell + DM 0.8 b

Put options DM 3.2/$ DM 1.696 b DM 1.696 b Cannot tell + DM 69 m

Expected cost as of January 1985Expected cost as of January 1985 Alternative Benchmark

rateDollar up No change

in spotDollar down

Uncovered DM 3.2/$ Cannot tell

DM 1.6 b Cannot tell

Full forwardcover

DM 3.2/$ DM 1.6 b DM 1.6 b DM 1.6 b

Partialforwardcover, 50/50

DM 3.2/$ Cannot tell + DM 0.8

b

DM 1.6 b Cannot tell + DM 0.8 b

Put options DM 3.2/$ DM 1.696 b DM 1.696 b Cannot tell + DM 69 m

OutcomeOutcome

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

Outcome: Perfect hindsightOutcome: Perfect hindsight

Alternative Benchmark rate Total DM cost

Uncovered DM 2.3/$ $1.15 billion

Full forward cover DM 3.2/$ $1.6 billion

Partial forward cover,50/50

DM 2.75/$ 1.375 billion

Put options DM 3.2/$ (strike) 1.246 billion

Outcome: Perfect hindsightOutcome: Perfect hindsight

Alternative Benchmark rate Total DM cost

Uncovered DM 2.3/$ $1.15 billion

Full forward cover DM 3.2/$ $1.6 billion

Partial forward cover,50/50

DM 2.75/$ 1.375 billion

Put options DM 3.2/$ (strike) 1.246 billion

Outcome: Perfect hindsightOutcome: Perfect hindsight

Alternative Benchmark rate Total DM cost

Uncovered DM 2.3/$ $1.15 billion

Full forward cover DM 3.2/$ $1.6 billion

Partial forward cover,50/50

DM 2.75/$ 1.375 billion

Put options DM 3.2/$ (strike) 1.246 billion

Outcome: Perfect hindsightOutcome: Perfect hindsight

Alternative

Benchmark rate

Total DM cost

Uncovered

DM 2.3/$

DM1.15 billion

Full forward cover

DM 3.2/$

DM1.6 billion

Partial forward cover, 50/50

DM 2.75/$

DM1.375 billion

Put options

DM 3.2/$ (strike)

DM1.246 billion

The AftermathThe 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.”

Herr Ruhnau was accused of making the following Herr Ruhnau was accused of making the following mistakes: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

What went wrong?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

Concept check #1Concept 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?

Concept check #2Concept 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

ConclusionsConclusions

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.