Cases in International Finance. Hedging Foreign Exchange Exposure. Case #1: Lufthansa.
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Cases in International Finance
Hedging Foreign Exchange Exposure
“If Karl Marx could see what the foreign exchange market is doing to captains of industry…a successful corporate executive of one of the world’s prestige airlines can put on a multimillion dollar currency speculation – and win – and still get lambasted by the critics. Its enough to make a capitalist cry!”
Some interesting Facts…
1926: Lufthansa was born through the merger of Deutsche Aero Lloyd and Junkers Luftverkehr – it inherits its crane logo from DAL
1934: Lufthansa offers its first transatlantic flight
1990: Lufthansa resumes flights to Berlin following German unification
1990: Lufthansa joins the star alliance with Air Canada, SAS, Thai Airlines and United Airways – the first multinational airline grouping
Lufthansa is the national carrier of Germany – headed by Wolfgang Mayrhuber (since 2003)
Lufthansa has 253 aircraft with an average age of 10.5 years.
In January 1985, under the Chairmanship of Heinz Ruhnau, Lufthansa purchased twenty 737 jets from Boeing for $25,000,000 apiece ($500M Total)
Length: 100 Feet
Wingspan: 86 Feet
Cruising Speed: 470 MPH
Max Altitude: 35,000 Feet
Range: 1000 Miles
At the time, the exchange rate was DM 3.20 per dollar. At this rate, the planes would cost Lufthansa DM1.6B
Over the previous year, the dollar had been appreciating against the Deutschmark..
Option #1: Remain Uncovered
The riskiest option with the greatest potential gain (if the dollar weakens against the Deutschmark) and the greatest potential cost (if the dollar strengthens).
Option #2: Full Forward Hedge
The safest of the options. If Lufthansa bought dollars forward at the current rate of 3.2, they could lock in a cost of DM1.6B
Option #3: Option Hedge
If Lufthansa purchased put option on DM at 3.20 DM/$ (or call options on dollars), they could take advantage of the potential gain from a dollar depreciation, but still hedge the possible appreciation risk
Option #4: Money Market Hedge
Lufthansa could obtain dollars now, by borrowing Deutschmarks, converting them to dollars at DM 3.20 and then depositing them in either a US bank or a Eurodollar account until needed. In principle, this should have the same effect as the forward hedge
Option #5: Partial Hedge
Lufthansa could purchase $250 M dollars forward at DM 3.20 at allow the remaining balance to be un-hedged.
Option #6: Cash Flow Matching
Lufthansa could try and generate $500M in ticket sales in the US – very unlikely!
Ruhnau was convinced that the dollar was going to fall and opted for the partial hedge. He was proved right as the dollar plummeted in the mid eighties.
Did Ruhnau make the right decision?
While Ruhnau was correct on the direction of the dollar, he could have saved some money using options rather than a partial hedge!
“Porsche makes most of its cars in Germany, so its costs are mainly in Euro. Yet a large chunk of its revenues come from sales in America. “
The Economist, June 5, 2003
Some interesting Facts…
Porsche was founded in 1931 by Ferdinand Porsche, a former Daimler Benz director.
One of the first Porsche models…look familiar?
Some interesting Facts…
The first real Porsche – designed in 1948
September 30, 1955: James Dean is killed driving his Porsche 550 Spyder
Porsche is led by President and CEO Dr. Wendelin Wiedeking (since 1993)
Porsche is essentially a privately held company. All 8.75M voting shares are held by the Porsche family. The remaining 8.75M non-voting shares are primarily held by institutional investors
The Jewel in the Porsche Crown has always been the 911 Series. (14 different 911 models currently)
Engine: 3.6l 6 Cylinder Engine
Power: 325 Hp @ 6,800 RPM
Acceleration: 0-60 in 4.8 Sec.
Top Speed: 177 Mph
Porsche 911 Carrera
Units Sold (2003): 27,789
Average Price: E 92,000
Cost: E 78,000
Profit Margin: 16%
The 911 commands almost exclusive ownership of its market segment (high end sports cars). While sales are cyclical, price elasticity is very low.
The Boxster was introduced in 1996 to compete with the lowers end sport scars already on the market.
Engine: 2.7l 6 Cylinder Engine
Power: 240 Hp @ 6,400 RPM
Acceleration: 0-60 in 5.9 Sec.
Top Speed: 160 Mph
Units Sold (2003): 18,411
Average Price: E 44,000
Cost: E 41,000
Profit Margin: 8%
The Boxster is less cyclical than the 911, but much more price sensitive – particularly since introduction of the BMW Z4 in 2003
Porsche recently gained entry into the lucrative SUV market. Fuelled by SUV crazy Americans, the launch of the Cayenne in 2002 has been hailed as one of the most successful produce launches in history
Engine: 3.2l 6 Cylinder Engine
Power: 247 Hp @ 6,000 RPM
Acceleration: 0-60 in 8.5 Sec.
Top Speed: 133 Mph
Units Sold (2003): 20,603
Average Price: E 68,000
Cost: E 61,000
Profit Margin: 10%
The Cayenne is clearly at the high end for SUVs – Porsche is quickly moving to develop a lower powered, lower cost version.
“We learned the hard way that banks are never there when you need them…” : Porsche’s anti-debt philosophy
Porsche has the heaviest US exposure (and this is increasing), yet it has the lowest rate of natural hedging in the sector…” (Citigroup)
Porsche’s Newest Model, the 911 Carrera 4s Cabriolet (2003)was priced in continental Europe at E 85,000 (a 15% markup over cost of $72,000). Simultaneously, the new Cabriolet was introduced in the US for $93,000
Implied Exchange Rate
= 1.09 $/E (.91 E/$)
At the current $1.29 per Euro exchange rate…
A profit margin of essentially zero over the cost of E 72,000!!
= E 72,093
Alternatively, Porsche could price to 911 in the US at a lower profit margin (say, that of the Boxster -8%)
E 72,000(1.08) = E 77,800(1.29) = $100,310
Price elasticity of the 911 is the lowest of the various Porsche platforms, but could the US market withstand a price increase of this magnitude? (7.8%)
Porsche has three model lines with different market characteristics – 45% of Porsche’s sales are in the US ($1.836B per year)
With the exception of an assembly plant in Finland (also a Euro country), all Porsche’s are manufactured in Germany
As the dollar continues to decline, what options does Porsche have to cover its currency exposure?
Porsche chose an aggressive strategy of put options on dollars (i.e. contracts to sell dollars at a fixed price). Porsche maintains a 3 year rolling portfolio of put options with strike prices based on currency forecasts. - Sales revenues through model year 2006 are completely hedged.
Is this the best strategy?