Case Study Transaction Exposure: Lufthansa's Purchase of Boeing 737s In January 1985 Lufthansa, the national airline of Germany,

under the chairmanship of Heinz Ruhnau, signed a contract with Boeing (U.S.) for the purchase of 20 Boeing 737 jets. Boeing agreed to deliver the 20 aircraft to Lufthansa's specifications in one year, in January 1986. Lufthansa would have a single payment due on that date of $500 million. Given a spot exchange rate of DM3.2000/$ in January 1985, this was an expected purchase of DM1.6 billion. The Problem Heinz Ruhnau was quite concerned over the exchange rate exposure that Lufthansa was bearing in this transaction. The U.S. dollar had been steadily appreciating in value against the Deutsche Mark (DM) for several years. Although many currency advisors and analysts had repeatedly stated they believed the dollar to be overvalued, it had continued to climb. Herr Ruhnau agreed with the majority of the currency advisors who believed the dollar would fall soon. Ruhnau also knew, however, that the size of the transaction represented too large a risk to Lufthansa if left unhedged. The current 360-day forward rate was the same as the spot rate, DM3.2000/$, as a result of Eurodollar and EuroDeutschemark interest rates being the same. But Ruhnau was torn between taking the most conservative strategy of locking in a forward contract for the entire amount and following his instincts that the dollar would fall in the coming year. If the dollar did fall, as he expected, he could potentially save Lufthansa millions of Deutschemarks in the completion of the sale. Although Ruhnau did not typically involve himself in currency management issues, the sheer size and significance of this transaction required him to make the final decision. The Decision Herr Ruhnau decided to compromise. He would cover one-half of the total exposure, $250 million, with a forward contract at DM3.2000/$, and he would leave the other half uncovered. This would allow him to reduce his total exchange rate risk significantly, but still allow him to benefit if the dollar did indeed weaken versus the Deutschemark in the coming year as he expected. The Outcome In the end, Ruhnau's expectations proved correct. The dollar did indeed fall in the coming year to DM2.3000/$ by January 1986. (Although most currency analysts had predicted the dollar would fall, most were surprised by the speed and magnitude of this change.) The total cost to Lufthansa for settlement of its payment to Boeing totaled DM 1.375 billion: Half covered with forward contract: $250,000,000 X DM3.2000/$ = DM800,000,000 Half left uncovered : $250,000,000 X DM2.3000/$ = DM575,000,000 Total : = DM1,375,000,000 The problem with the outcome (Exhibit A) was that the half of the exposure that he had covered with the forward contract had resulted in a cost of DM225,000,000 higher than that left uncovered. As a result, Ruhnau was heavily criticized for his handling of Lufthansa's currency exposure. Ruhnau was accused of recklessly speculating with Lufthansa's money, but the forward contract was seen as speculation, not the amount of the dollar exposure left uncovered. Herr Rulumau was called before the Minister of Transportation in Germany (the government authority over the national airline) to explain his actions. Discussions of his employment contract, which was due to be renewed, were postponed and eventually he was given only a short renewal. Clearly the concept of speculation takes on a completely different meaning when performance is evaluated with 20/20 hindsight!

Questions for discussion 1. Herr Ruhnau was accused of making the following mistakes (alongwith a few other errors): a. Purchasing the Boeing aircraft at the wrong time. The U.S. dollar was at an all-time high at the time of the purchase in January 1985. b. Purchasing Boeing aircraft at all. Germany, as well as the other major European Economic Community countries, had a vested interest in the joint venture Airbus. Airbus's chief rival was Boeing in the manufacture of large long-distance civil aircraft. Are these accusations, in your opinion, right? Justify your answer. 2. From the perspective gained from answering Question 1, would you consider this

hedging incident to be one of Managing Transaction or Translation or Economic Exposure? Justify.

3. Is it fair to judge transaction exposure management effectiveness with 20/20 hindsight? 4. Review briefly the characteristics of forward contracts?. How do forward contracts enable Lufthansa to hedge their transaction exposure in the Boeing 737 imports? How would the foreign exchange market have to move for the forward contract hedge to be fully in Ruhaus favor? 5. Do you think Heinz Ruhnau's hedging strategy made sense? What is the resulting position and cost for Ruhnau if instead the dollar increases to DM4.1000/$? 6. To what degree did he limit the upside and downside exposure of the transaction by hedging one-half of it? Were there any other alternatives that were there, besides forward contracts, to hedge Lufthansas transaction exposure without the upside or downside exposure? 7. Do you agree with Ruhnau's critics that he was "speculating"? Why? 8. Do you agree that a little bit of speculation in forex markets would not hurt corporates bottom lines? Why or why not? (Source : Page 231, Multinational Business Finance by Eiteman, et al. _________________________________________________________________________________