Lufthansa – Hedging Alternatives
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Executive Summary
Lufthansa CEO Herr Ruhnau was under-fired for his hedging decision on the purchase of 20 Boeing aircrafts which cost Lufthansa an additional DM 225M back in Jan. 1985. Some criticisms are valid to a certain degree given the strict covenants and guidelines Ruhnau had to work against however others are base-less such as forcing Ruhnau to step down as CEO. This case analysis will discuss the hedging alternatives Ruhnau considered, the decision that was made, an analysis of the criticisms made against Ruhnau and justifications for why Ruhnau should continue his chairmanship of Lufthansa.
Background
In January 1985, German-based airline Lufthansa, under the direction of chairman Herr Heinz Ruhnau, purchased twenty Boeing 737 jets at a hefty price of $25,000,000 per for a total transaction of $500,000,000. The term of the purchase is for Lufthansa to pay the entire amount in U.S. dollars upon delivery one year later in January 1986.
As of Jan. 1985, the conversion rate stood at DM 3.2/$ and with the U.S. dollar on a rise against the German DM since 1980, Ruhnau had several financial hedging options to undertake in order to minimize Lufthansa’s foreign exchange exposure risk for the next 12 months. These financial instruments include the basic hedging alternatives such as remaining uncovered, use of forward contracts with either partial or full coverage, matching of currency with cash inflows of U.S. dollars, foreign currency options or buy and invest in U.S. dollars now.
Given the various hedging alternatives, Lufthansa could ideally choose any of these options, however due to strict company guidelines already set in place with regards to the type of financial hedging that could affect the company balance sheet, Ruhnau’s option were further limited.
Since the U.S. dollar had been on a steady rise since 1980, Ruhnau believed that the dollar would weaken, however he was not certain by how much and whether or not it would weaken enough by Jan. 1986 when payments are due to Boeing. Based on this uncertainty and other risk factors, Ruhnau decided to minimize Lufthansa’s foreign currency exposure by undertaking a 50% forward cover, which has the smallest delta either side of the current spot rate, protecting against either a decrease or increase in the DM/$ conversion rate.
Analysis
Ruhnau’s expectation that the U.S. dollar was over-valued was actually correct because within months, the dollar depreciated over 30% within the next 12 months and continued to further decline for the next several years. However, since looking into the future is never certain, Ruhnau took what he believed to be the best course of action at the time and is now being heavily criticized for his actions after the fact. Ruhnau’s rivals accused him of “recklessly speculating with Lufthansa’s money” and that he made four major mistakes with regards to the Boeing purchase hedging decision.
Since the dollar was at an all-time high in Jan. 1985, Ruhnau was accused of purchasing the Boeing aircrafts at the wrong time. With 20/20 hindsight, maybe purchasing the aircraft when Ruhnau did may have not been at the most opportune time, however if it was purchased when the dollar was weakening, who’s to say that the value of the aircraft would not have increased to offset the decline in the dollar? Foreign currency will always fluctuate based on the host country’s economic and political policy, therefore timing a purchase based on the rise and fall of a foreign currency is speculative at best which is why hedging should be required to minimize the foreign currency exposure.
A second accusation was the percentage of covered forward contract used. Ruhnau was accused that if he was so sure that the dollar would weaken, why did he not leave the entire amount uncovered rather than covering 50% of the exposure. However, remaining uncovered is considered to be the maximum risk approach, which is not something that a firm would do, especially on a large transaction such as this one. The believe with remaining uncovered for such a large exposure is considered by many as pure speculation.