Institute of Public Enterprise

(Osmania University Campus, Hyderabad)

PGP: III Semester
Financial Risk Management and Derivatives
Assignment for Internal Assessment [Max Marks: 15 Marks]
Written Case Analysis: LUFTHANSA: TO HEDGE OR NOT TO HEDGE
Date: 28/10/2014
Last Submission Date (On or Before): 12/11/2014
General Instructions
1. All questions are compulsory which are based on the LUFTHANSAs Case
2. Answer all the questions only in the space provided.
Name: Vaibhav Singhal
Course: PGDM (Finance & Marketing)
Roll Number: 1301109
1. What is the risk faced by the LUFTHANSA?
In January 1985, Lufthansa, under the chairmanship of 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.The biggest risk faced by them on the
payment date was of the rise in US dollars. If the $ rate would have increased on that day
than they would end up paying a huge amount.

2. According to you how each individual alternative to hedge the possible foreign
exchange risks may be beneficial or not beneficial to the company?
Lufthansas CEO was considering 5 alternatives:
1) Remain uncovered/Do nothing
Remaining uncovered is the maximum risk approach. It therefore represents the Greatest
potential benefits (if the dollar weakens versus the Deutschemark), and the greatest
potential cost (if the dollar continues to strengthen versus the Deutschemark). If the
exchange rate were to drop to DM2.2/$ by January 1986, the purchase of the Boeing 737s
would be only DM1.1 billion. Of course if the dollar continued to appreciate, rising to
perhaps DM4.0/$ by 1986, the total cost would be DM2.0 billion.

2) Cover the entire exposure with forward contract

If Lufthansa were very risk averse and wished to eliminate fully its currency exposure, it
could buy forward contracts for the purchase of U.S. dollars for the entire amount. This
Would have locked-in an exchange rate of DM3.2/$, with a known final cost of DM1.6
billion.
3) Cover some portion of the exposure and leave the remaining uncovered
This alternative would cover only part of the total exposure leaving the remaining
exposure uncovered. Herr Ruhnaus expectations were for the dollar to fall, so he
expected Lufthansa would benefit from leaving more of the position uncovered
4) Cover the exposure with foreign currency options
The foreign currency option is unique among the hedging alternatives due to its kinkedshape value-line. If Herr Ruhnau had purchased a put option on marks at DM3.2/$, he
could have obtained what many people believe is the best of both worlds. If the dollar
had continued to strengthen above DM3.2/$, the total cost of obtaining $500 million
could be locked-in at DM1.6 billion plus the cost of the option premium, as illustrated by
the flat portion of the option alternative to the right of DM3.2/$. If, however, the dollar
fell as Herr Ruhnau had expected, Lufthansa would be free to let the option expire and
purchase the dollars at lower cost on the spot market.
5) Obtain US dollars and hold them until it is due for payment
The fifth alternative is a money market hedge for accounts payable. Obtain $500 million
now and hold those funds in an interest bearing account or asset until it was due.
Although this would eliminate the currency exposure, it required that Lufthansa had the
capital in their hands. The purchase of Boeing jets have been made in conjunction with
ongoing plans of Lufthansa and these did not call for the capital to be made till January.

3. What alternatives did Lufthansas CEO was considering and why?

a) Lufthansas CEO alternative was to cover some portion of the exposure and
leaving the remaining uncovered so as to:
1) Avoid the cost of hedging
2) Allow the company profit from the depreciation of the US dollar or appreciation of
DM on the unhedged part of payment

b) Cover the entire exposure with forward contract

If Lufthansa were very risk averse and wished to eliminate fully its currency exposure, it
could buy forward contracts for the purchase of U.S. dollars for the entire amount. This
Would have locked-in an exchange rate of DM3.2/$, with a known final cost of DM1.6
billion.
And finally Lufthansas CEO opted to cover the entire exposure with forward contract
and suffered losses.
4. Why the Lufthansas CEO was considering to hedge a part of the purchase price?
Ruhnau chose to go with partial cover because he felt strongly that dollar would weaken.
He chose to cover 50% of exposure (250 million) with forward contract, one year rate
was DM 3.2/$ and to leave the 50% uncovered. Because foreign currency options were
yet a relatively new tool for exposure management by firms, and because of the premium
required upfront, the foreign currency option was not choosen.

5. If you were in Lufthansas CEO position which hedging strategy you would have
chosen and why? Justify?
If I was at the position of the Lufthansa CEO, I would also go for a Put Option since this
is the most effective strategy amongst all.
1) It is purchased at a put option on marks at 3.2/$.
2) If the dollar had continued to strengthen above DM 3.2/$, then the total cost of
obtaining $500 million could be locked in at DM 1.6 billion.
3) Plus the cost of premium
4) If however the dollar value had fallen, Lufthansa would be free to let the option
expire and purchase the dollars at lower cost in the spot market.