Hedging, Speculation, or Both
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Hedging, Speculation, or Both. Brent Henderson Travis Harlan Sulaiman Habeebulla FIN 570 – International Financial Management FEMBA, Fall 2008 California State University, Fullerton. The Company.

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Hedging, Speculation, or Both

Brent Henderson

Travis Harlan

Sulaiman Habeebulla

FIN 570 – International Financial Management

FEMBA, Fall 2008

California State University, Fullerton


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The Company

  • 1926: Founded following a merger between “Deutsche Aero Lloyd” (DAL) and “Junkers Luftverkehr”, originally named as “Deutsche Luft Hansa Aktiengesellschaft”

  • 1927 – 1934: Mostly European routes

  • 1933: Named as “Lufthansa”

  • 1934: Opened Trans-Atlantic routes

  • 1939 – 1945: Routes limited to neutral countries due to WWII

  • 1945: Suspended all services following Germany’s defeat

  • 1953: Reborn (different from pre-war Lufthansa) as flagship airline of West Germany with majority shares held by Government

  • 1955- 1956: Service started to Europe/Trans-Atlantic

  • 1960: Started Jet-powered expansion

  • 1980: Started modernized expansion program


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The Company (Contd.)

As of 1985

  • Corporate HQ: Cologne, West Germany

  • Primary Hub: Frankfurt, West Germany

  • Secondary Hub: Munich, West Germany

  • Market Position: Germany’s largest, World’s 6th largest

  • Core Business: Passenger Transportation

  • National Corporation:

    • 74.31% held by Federal Government

    • 7.85% held by Government Agencies

    • 17.84% held by Private Ownership


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The Airline Industry

As of Early 1980s

  • October 1978, Airline Deregulation Act signed in US

  • Access to deregulated countries opened up to all airlines

  • Price fixing was eliminated

  • Ticket pricing became equally important as customer service

  • Stimulus of deregulation created highly competitive market

  • Caused global smaller airline meltdown

  • Forced massive restructuring in most international airlines

    • Undertaken aggressive expansion plans

    • Fleet modernization


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The Chairman

Herr Heinz Ruhnau

  • A career bureaucrat:

    • 1963-1976: Member of the Hamburg State Parliament

    • 1976-1982: Undersecretary of the Federal Transport Ministry

    • Former chief assistant to the head of West Germany’s largest trade Union, IG Matall

  • Strongly affiliated with the West German Democratic Party

  • No private enterprise experience

  • Assumed post since July 1, 1982


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Global Finance Market

As of Jan 1985

  • US Dollar was rising steadily and rapidly against DM since 1980

  • Spot rate reached approximately DM3.2/$

  • Forwards were primary hedging tool

  • Futures options were considered new and complicated hedging tool


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Deutschmark vs. US DollarJanuary 1980-January 1985


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Lufthansa Fleet

As of Jan 1985

  • Lufthansa maintained a balanced mix of Airbus, Boeing, and other smaller aircrafts

  • Lufthansa believed that having more than one supplier creates competition and better for purchaser

  • Global pressures posed Lufthansa to expand routes, efficiency, and cost cutting

  • Highly leveraged Lufthansa started fleet modernization program


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The Case

In Jan 1985

  • Lufthansa, purchased twenty 737 jets from Boeing.

  • Total cost = $500 million

  • Payable in US$

  • Payments due in January 1986 upon delivery.


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Why now (Jan 1985)?

  • Facts

    • US Dollar was rising steadily and rapidly against DM since 1980

    • In Jan 1985 spot rate was approximately DM3.2/$

  • Lufthansa’s decision based on:

    • Purchase of operating assets must be based on current/expected market conditions

    • Delay may adversely affect its operations

    • Price could be increased to offset decline in the dollar, If purchased when the dollar was weakening

      • Foreign currency will fluctuate based on the host country’s economic and political conditions and policy changes


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Why not Airbus?

  • Facts

    • Subsidized price for European countries

    • No foreign currency exposure

  • Boeing was chosen for

    • Lufthansa’s policy was to maintain a fleet of both Boeing and Airbus aircrafts

    • Prior to this deal, Lufthansa acquired 15 aircrafts from Airbus with option to acquire 7 more

    • Having more than one supplier creates competition

    • Better for purchaser


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Foreign Currency Exposure

  • Definition

    • Impact of unexpected exchange rate changes upon the cash flows from existing (and typically short-term) contractual obligations

  • Measure Exposure

    • Use best measurement techniques

    • Calculate expected future exchange rates

  • Manage Exposure

    • Consider all available methods to mitigate exposure

      • Countertrade

      • Hedging

  • Simulate all methods (alternatives)


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The Economics

Both IFE and PPP forecast that the USD will depreciate


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The Economics (Contd.)

Comparisons of the Forward Rate

The English forward rates also anticipate a depreciating US dollar




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Cause and Effect

Understanding the Economic Environment

Hedging Strategy

Payment Due Date

Reducing Exposure

Contract Date

Financing Strategy (considering covenants)

Aversion Threshold


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Concerns

  • Herr Ruhnau was concerned over the exchange rate exposure Lufthansa was bearing in this transaction

  • The U.S. dollar had been steadily appreciating in value against the Deutschemark since 1980

  • Ruhnau, as many currency analysts, believed that dollar was overvalued, it is expected to be depreciated soon

  • Regardless, Herr Ruhnau felt this was too large a transaction to be left unhedged


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Constraints

  • Debt Covenant

  • Payment due date

  • Limited US Dollars available via ticket sales

  • US Dollar appreciating

  • The cost of hedging


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Opportunities

  • Management is in support of the expansion strategy

  • New hedging instrument: Options

  • Herr’s expectation that the US Dollar will depreciate. This is validated by IFE and PPP.


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Decision Criteria

Choose the hedging alternative that is the lowest mix of the Following:

Cost: What is the cost based on our worst case calculation

Risk: How much exposure risk remains by implementing this alternative


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Alternatives

  • Remain uncovered

  • 100% forward cover

  • 50% forward cover – 50% uncovered

  • 100% Option cover

  • 100% Option Straddle


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Alternative 1Remain Uncovered

Cost: High unless the dollar depreciates

Risk: Extremely high


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Alternative 2Full Forward Contract

Cost: Only an opportunity cost if the US Dollar depreciates

Risk: low


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Alternative 350% Covered, 50% Uncovered

Cost: High unless the dollar depreciates

Risk: Moderately high


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Alternative 4Purchase an Option

Cost: DM 96 million. The option is an unfavorable alternative in the event of the dollar depreciating

Risk: low


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Alternative 5Purchase an Option Straddle

Cost: DM 192 million. The option is an unfavorable alternative in the event of the dollar remains flat

Risk: low


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Evaluating Alternatives

  • The Option is the best alternative

  • Cost: The Option alternative has the lowest cost

  • Risk: Because the dollar is appreciating, but is forecasted to depreciate the risk is very low.


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The Decision & Outcome

  • Ruhnau covered forward $250 million at DM 3.2/$, and left the remaining $250 million uncovered.

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

  • Ruhnau was summoned to meet with Lufthansa’s Board and West German Transportation Ministry on February 14, 1986 to explain his speculative exposure management decision on this transaction



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The Accusations

  • 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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The Rationale

  • Purchase of Boeing aircrafts was mandated according to the expansion program

  • Ruhnau took a middle ground approach by half covered and half uncovered, looks better in this case, but risky

  • He considered the upfront cost of option premium (6% - DM96m) is expensive and the tool was relatively new to market and complicated

  • To comply Lufthansa’s policy for a mix of Boeing and Airbus aircrafts


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The Conclusion

  • Hedging should be considered as a corporate strategy

  • Single transaction like this one can jeopardous the company’s existence or long time to recover, if the market moves to opposite direction

  • Prestigious company like Lufthansa shouldn’t have left any exposure (big or small) uncovered

  • If all predictions towards no exchange rate movement or further US$ appreciation, use full cover futures

  • If all predictions towards US$ depreciation, use full cover options


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The Conclusion (Contd.)

Ruhnau should be retained or fired?

  • The Board should choose DM 1.6b (DM3.2/$) as benchmark

  • With this benchmark, there are no damage caused to Lufthansa by his decision

  • The 1985 decision must have been taken in accordance with the Board. In that case, Ruhnau has only partial responsibility

    So, Ruhanau shouldn’t be fired


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The Concept

Speculation is generally a trading strategy

In the event of exposure management, corporations should rather consider a full cover hedging strategy than speculation



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