Lufthansa Case Analysis 1

1 Executive Summary
By using a partial forward cover, Herr Heinz acted to mitigate risk from further DM depreciation
while also taking advantage of DM appreciation should it occur as he expected. The DM did
appreciate from 3.2DM/$ to 2.3DM/$. The total cost to Lufthansa dropped from DM1.6 billion
to DM1.375M, a savings of DM225 million, by using the partial forward cover. However given
the significant volatility in DM/$ rate, the put option method would have saved an additional
DM129 million for a total savings of DM354 million. Had DM appreciated less than 12%, the
partial forward cover would have saved Lufthansa more money than put option.

2 Detailed Analysis

2.1 Timing of Boeing Purchase

2.2 Partial Forward Coverage

2.3 Use of Put Options

Since 1980, the DM had depreciated significantly in regards to the US dollar. Herr Heinz
believed that DM/$ exchange would fall between when the contract was signed in January 1985
and payment due at aircraft delivery in January 1986. Herr Heinz did not want to lock in the DM/
$ at the current spot rate as he anticipated significant cost savings as the DM appreciated.
However, he was not certain about this prediction as forward exchange rates are notoriously
difficult to predict. Thus, Herr Heinz sought to mitigate risk and limit potential cost increases if
he was wrong and the DM continued to depreciate. Lufthansa primary business is as an airline,
and Herr Heinz wanted to limit his exposure in the currency market as currency speculation was
not a Lufthansa core competency.

Herr Heinz’s two main alternatives to take advantage of the expected DM appreciation while
limiting risk should DM actually depreciate were: partial forward cover and put options. As
shown in Exhibit 2 of the case, the choice of the partial cover or the put option depends on how
much volatility Herr Heinz expected in the DM/$ rate. The partial forward cover was a better
choice if the DM/$ rate stayed between 2.816 and 3.584, or +/- 12%. Within range, the partial
Lufthansa Case Analysis 2

forward had a lower total cost to Lufthansa than the put option due the additional expense from
the 6% premium (or DM96 million) required to purchase the option.

Even if the DM/$ had only fluctuated by +/- 20% (2.56 to 3.84) of original 3.2 DM/$, the partial
forward cover would have been 5% more expensive result than the put option at DM64 million
as shown in Table X.

Aircraft Cost with DM/$ Fluctuations

(Millions of DM)
January 1986 DM/$ Spot Rate
2.3 2.56 2.816 3.2 3.584 3.84
Partial Forward Cover Cost 1375 1440 1504 1600 1696 1760
Put Option Cost 1246 1376 1504 1696 1696 1696

However during the one year span between ordering and delivery of aircraft, the DM appreciated
by 28% from 3.2 DM/$ to 2.3DM/$. This significant currency revaluation caused the partial
forward coverage to be 10% more expensive than put option cost at DM129 million. By
leveraging a partial forward cover rather than a put option, Lufthansa still saved money
compared to the original DM$1.6 billion expected cost, but they only saved DM225 million
instead of DM354 million.

2.4 Buying Boeing Instead of Airbus