Case Study: Managing Financial Risk, Lufthansa Airways

In January 1985, the German airline company, Lufthansa, signed a contract with
Boeing, to purchase 20 Boeing 737 airplanes. Boeing agreed to deliver the airplanes to
Lufthansa in one year later, in January 1986. Lufthansa agreed to make a single payment,
of $500 million, when the planes were delivered. The spot exchange rate at the time the
contract was signed was DM3.2/$, which corresponded to a Deutschmark liability of 1.6
billion.

Overview-Since 1982, the U.S. dollar had been steadily appreciating against the German
mark. In January 1982, the dollar was trading around 2.3 marks, and by January 1985, it
had risen to 3.2. This represented an appreciation of the dollar of roughly about 40%.

Although many analysts had concluded that the U.S. dollar was overvalued during this
period, it continued to show strength. Government intervention to weaken the dollar was
not being discussed at this time. See chart which follows.

The Issue-While many forecasters were predicting an eventual weakening in the U.S.
dollar, for Lufthansa, the size of the contract, which was denominated in U.S. dollars,
was seen as a too large of an uncovered transaction exposure.

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Source- Colorado.edu

Transaction Exposure Issue for Lufthansa

As noted the size of the contract, which was denominated in U.S. dollars, was seen as a
too large of an uncovered transaction exposure for Lufthansa. On the other hand, most
analysts were predicting a weakening of the U.S. dollar. If this were to occur, it could
result in a smaller deutschmark denominated payment for Lufthansa. Recall, Lufthansas
liability was denominated in U.S. dollars, thus a weakening dollar would have required
fewer marks.
Lufthansas Decision

Lufthansa decided to hedge 50% of its exposure with a forward contract. This forward
contract was set at DM3.2/$; thus Lufthansa would purchase $250 million in January
1985 for 800 million marks. The remaining 50% was left uncovered to take advantage of
a possible weakening of the dollar.
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Outcome

During the 12 month period, the U.S. dollar did weaken against the mark. In January
1985, it was trading around 3.2 and by January 1986, it was trading around 2.45. This
represented a decline of 23%. See chart below.

Source- Colorado.edu

Cost of the 20 Airplanes

The cost of the 20 airplanes to Boeing was as follows:

50% covered with a forward contract, or

$250,000,000 x 3.2 = 800,000,000 marks
50% uncovered and purchased at spot, or
$250,000,000 x 2.45 = 612,500,000 marks
Total mark liability in January 1986 = 1,412,500,000
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Analysis

Lufthansa had guessed correctly. The mark had strengthened and they were able to take
advantage of that with an uncovered position.

If they had covered 100% of their

exposure, their cost would have been 1.6 billion marks, or 13% more.

On the other hand, if Lufthansa had not covered any of their liability, their cost in January
1986 would have been 1.225 billion, or 13% less.

Follow up

The Chairman of Lufthansa, Heinz Ruhnau, was criticized for his handling of the
companys exposure. The Minister of Transportation in Germany (who had ultimate
authority over the airline), criticized Ruhnau for hedging 50% of the exposure which
resulted in 187,500,000 marks more than if the company had not covered. As a result,
Ruhnau was only offered a short term renewal contract as Chairman by the Minister of
Transportation.

An Alternative

Another view point in this case is, that Lufthansa could also have gone for an Option, a
Put Option to be specific. If the problem was approached this way, then Lufthansa would
have had the freedom to let the Option expire and purchase the dollars at the Spot Rate.
Rehnau could have purchased an out-of-the money put option in order to reduce the
premium paid.

Also, there is no conclusive explanation for the fact as to why, Boeing was chosen over
Airbus. One possible explanation is that Boeing Flights are lighter and can achieve high
altitudes in a short period of time. This actually justifies their purchase.

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Case Study By:

GV Abhinav Kumar

T Sai Harish Kumar

B.Tech, (PGDM-BIF)

B.Sc-Eco Hons, (PGDM-BIF)

Institute of Public Enterprise,

Institute of Public Enterprise,

Hyderabad

Hyderabad

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