Running head: LUFTHANSA

Lufthansa Bus 5840 Case Study Week 6 Paper Calvin E. Amos Florida Institute of Technology Instructor: Dr. Ana Machuca October 7, 2012

LUFTHANSA Lufthansa Bus 5840 Case Study Week 6 Paper On February 14, 1986 Herr Heinz Ruhnau, Chairman of Lufthansa (Germany) was summoned to meet with Lufthansas board. The board was evaluating his decision to purchase

twenty 737 jets from Boeing Aircraft (U.S.), and specifically the risk and reward alternative that was chosen for the one year future delivery payment (Moffet, 1999, p.1). In my opinion, based on Herr Ruhnaus calculated expectation that the dollar would weaken over the coming year, his choice of a partial Deutschemark (DM) coverage (50 % covered to 50% uncovered ratio) was the best risk to reward alternative. The reasons for this is that leaving the $500,000,000 accounts payable transaction 100% uncovered would be irresponsibly risky; and a 100% coverage of the transaction (via forward contract or money market hedge) would have been to conservative, especially considering Ruhnaus high expectation of a weakening dollar trend (resulting in a lower final cost payment). If these first two alternative are eliminated, the two remaining alternatives are a partial forward contract coverage, or the purchase of a DM3.2/$ put option. The put option was a very attractive alternative. It had the benefit of an unlimited reward factor if the dollar weakened as expected, and it had a limited risk factor ( the cost of the premium) if the dollar actually strengthened. However, the option premium would be costly at a nonrefundable cost of $30,000,000 (96,000,000 DM). As illustrated below, Exhibit 1, Net Cost By Hedging Alternative (Moffet, 1999, p.2) this high premium would not start providing advantageous benefits until the exchange rate had risen to a rate above DM3.6/$ or fell to a rate below DM2.8/$ (i.e., twelve and one-half percent above or below the put options DM3.2/$ strike price or the 100% forward coverage DM3.2/$ contract price).

LUFTHANSA

Also, at the time foreign currency options were a relatively new tool for exposure management (Moffet, 1999, p.4). If the dollar weakened by more than twelve and one-half percent of the option strike price (or the fully covered forward contract price), then the Partial Forward Coverage alternative would still have the potential to capture much of the cost saving benefits, although at a somewhat smaller cost saving rate than the Put Option or Uncovered alternatives. The greatest risk with the Partial Forward Coverage alternative was that if the dollar strengthened by more than twelve and one-half percent of the put option strike price, then the additional DM cost of the final payment would increase greater than the DM cost of the Put Option premium (which is the maximum risk exposure for this alternative). However, with the high expectation of a weakening dollar, accepting this risk seems very reasonable. In view of these considerations, I disagree with critics who believe Ruhnau was speculating. It could be concluded that Ruhnaus decision was the most prudent without the benefit of 20/20 hindsight. Of course, if you had the benefit of 20/20 hindsight, it can be seen from the calculations in Appendix A that the Uncovered alternative resulted in the lowest cost at a 1,150,000,000 DM, followed by the Put Option alternative with a 1,246,000,000 DM cost, then

LUFTHANSA

followed by Partial Forward Cover alternative with a 1,375,000,000 DM cost, and finally the Full 100% Covered alternative being the highest cost at 1,600,000,000 DM. The greatest surprise from most critics is that many of them considered the covered portion of the dollars to be the reckless speculation, and not the amount of dollars left uncovered for the full year (Moffet, 1999, p.5). It appears that these critics are mostly using the benefit of 20/20 hindsight in making these accusations. Indeed, there is a great likelihood that all of these same critics would have also accused Ruhnau of reckless speculation if he had left all dollars uncovered, and in turn, the dollar had dramatically strengthened against the Deutschemark (instead of weakening). Other critics blamed Ruhnau for making the decision to purchase U.S. aircraft when the U.S. dollar was at an all time high against the Deutschemark (Moffet, 1999, p.5). Assuming the Boeing 737 jets offered the best long term value to the company, then from a long term business positioning standpoint, the purchase of long lead items such as aircraft can not be done on the basis of exchange rates, but rather on the projected future needs and industry outlook. In conclusion, the Board of Lufthansa should retain Herr Heinz Ruhnau as chairman. Most of the boards criticisms were based on the benefit of 20/20 hindsight or political reasons (Moffet, 1999, p.5). Only the reasonableness of a transaction exposure management decision should be made based on 20/20 hindsight, and not which decision should have been made before the benefit of 20/20 hindsight. Consequently, Herr Ruhnau should not have been called to justify his decision, as his research and tradeoff analysis should be ample justification to any non-biased evaluator.

LUFTHANSA References Moffet, M. H. (1999). Lufthansa. Thunderbird, The American Graduate School of International Management. A06-99-0028

LUFTHANSA Appendix A Hedging Alternatives Final Cost Calculations 1. Uncovered = $500,000,000 x 2.3DM/$ = 1,150,000,000 (DM cost) 2. DM Put Options = 6% x $500,000,000 x 3.2DM/$ = 1,246,000,000 (DM cost) 3. Full Forward Cover (100%) = $500,000,000 x 3.2DM/$ = 1,600,000,000 (DM cost) 4. Partial Forward Cover (100%) = ($250,000,000 x 2.3DM/$) + ($250,000,000 x 3.2DM/$) =1,600,000,000 (DM cost)