Case synopsisCase synopsis
In January 1985, Lufthansa, under the chairmanship of Heinz 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.
Case synopsisCase synopsis
The US$ had been rising steadily and rapidly since 1980, and was approximately DM3.2/$ in January 1985.
Worst case scenario: US$ continues to appreciate.
Herr Ruhnau’s expectationsHerr Ruhnau’s expectations
“Like others at that time, he believed that the US$ had risen about as far as it was going to go, and would probably begin to fall by the time January 1986 rolled around.”
Hedging alternativesHedging alternatives
Remain uncovered
Full forward cover
Option hedging
Money market hedge
Some combination of the above alternatives
Remain uncoveredRemain uncovered
It is the maximum risk approach.
If e = DM 2.2/$ by January 1986, the purchase of the jets would be only DM 1.1 billion.
If e = DM 4/$ the total cost would be DM 2 billion.
Many firms believe that:
uncovered position = currency speculation.
Full forward coverFull forward cover
This approach would have locked in an exchange rate of DM 3.2/$, with a known final cost of DM 1.6 billion.
Foreign currency optionsForeign currency options
A put option on the DM at DM 3.2/$, could locked in DM 1.6 billion plus the cost of the option premium (DM 96 million).
The total cost of the purchase in the event the put was exercised would be DM 1.696 billion.
Money market hedgeMoney market hedge
Obtain the $500 million now and hold those funds in an interest-bearing account or asset until payment was due.
What ultimately eliminated this alternative for consideration was that Lufthansa had several covenants that limited the types, amounts, and currencies of denomination of the debt it could carry on its balance sheet.
Heinz Ruhnau's decisionHeinz Ruhnau's decision
Ruhnau covered forward half of the exposure ($250 million) at DM 3.2/$, and left the remaining half uncovered.
Expected cost as of January 1985Expected cost as of January 1985 Alternative Benchmark
rateDollar up No change
in spotDollar down
Uncovered DM 3.2/$ Cannot tell DM 1.6 b Cannot tell
Full forwardcover
DM 3.2/$ DM 1.6 b DM 1.6 b DM 1.6 b
Partialforwardcover, 50/50
DM 3.2/$ Cannot tell + DM 0.8 b
DM 1.6 b Cannot tell + DM 0.8 b
Put options DM 3.2/$ DM 1.696 b DM 1.696 b Cannot tell + DM 69 m
Expected cost as of January 1985Expected cost as of January 1985 Alternative Benchmark
rateDollar up No change
in spotDollar down
Uncovered DM 3.2/$ Cannot tell DM 1.6 b Cannot tell
Full forwardcover
DM 3.2/$ DM 1.6 b DM 1.6 b DM 1.6 b
Partialforwardcover, 50/50
DM 3.2/$ Cannot tell + DM 0.8 b
DM 1.6 b Cannot tell + DM 0.8 b
Put options DM 3.2/$ DM 1.696 b DM 1.696 b Cannot tell + DM 69 m
Expected cost as of January 1985Expected cost as of January 1985 Alternative Benchmark
rateDollar up No change
in spotDollar down
Uncovered DM 3.2/$ Cannot tell DM 1.6 b Cannot tell
Full forwardcover
DM 3.2/$ DM 1.6 b DM 1.6 b DM 1.6 b
Partialforwardcover, 50/50
DM 3.2/$ Cannot tell + DM 0.8 b
DM 1.6 b Cannot tell + DM 0.8 b
Put options DM 3.2/$ DM 1.696 b DM 1.696 b Cannot tell + DM 69 m
Expected cost as of January 1985Expected cost as of January 1985 Alternative Benchmark
rateDollar up No change
in spotDollar down
Uncovered DM 3.2/$ Cannot tell DM 1.6 b Cannot tell
Full forwardcover
DM 3.2/$ DM 1.6 b DM 1.6 b DM 1.6 b
Partialforwardcover,50/50
DM 3.2/$ Cannot tell + DM 0.8 b
DM 1.6 b Cannot tell + DM 0.8 b
Put options DM 3.2/$ DM 1.696 b DM 1.696 b Cannot tell + DM 69 m
Expected cost as of January 1985Expected cost as of January 1985 Alternative Benchmark
rateDollar up No change
in spotDollar down
Uncovered DM 3.2/$ Cannot tell
DM 1.6 b Cannot tell
Full forwardcover
DM 3.2/$ DM 1.6 b DM 1.6 b DM 1.6 b
Partialforwardcover, 50/50
DM 3.2/$ Cannot tell + DM 0.8
b
DM 1.6 b Cannot tell + DM 0.8 b
Put options DM 3.2/$ DM 1.696 b DM 1.696 b Cannot tell + DM 69 m
Outcome: Perfect hindsightOutcome: Perfect hindsight
Alternative Benchmark rate Total DM cost
Uncovered DM 2.3/$ $1.15 billion
Full forward cover DM 3.2/$ $1.6 billion
Partial forward cover,50/50
DM 2.75/$ 1.375 billion
Put options DM 3.2/$ (strike) 1.246 billion
Outcome: Perfect hindsightOutcome: Perfect hindsight
Alternative Benchmark rate Total DM cost
Uncovered DM 2.3/$ $1.15 billion
Full forward cover DM 3.2/$ $1.6 billion
Partial forward cover,50/50
DM 2.75/$ 1.375 billion
Put options DM 3.2/$ (strike) 1.246 billion
Outcome: Perfect hindsightOutcome: Perfect hindsight
Alternative Benchmark rate Total DM cost
Uncovered DM 2.3/$ $1.15 billion
Full forward cover DM 3.2/$ $1.6 billion
Partial forward cover,50/50
DM 2.75/$ 1.375 billion
Put options DM 3.2/$ (strike) 1.246 billion
Outcome: Perfect hindsightOutcome: Perfect hindsight
Alternative
Benchmark rate
Total DM cost
Uncovered
DM 2.3/$
DM1.15 billion
Full forward cover
DM 3.2/$
DM1.6 billion
Partial forward cover, 50/50
DM 2.75/$
DM1.375 billion
Put options
DM 3.2/$ (strike)
DM1.246 billion
The AftermathThe Aftermath
“On February 14, 1986, Heinz Ruhnau was summoned to meet with Lufthansa's board and with Germany's transportation minister to explain his supposed speculative management of Lufthansa's exposure in the purchase of Boeing jets.
Herr Ruhnau was accused of recklessy speculating with Lufthansa's money, but the speculation was seen as the forward contract, not the amount of the exposure left uncovered for the full year.”
Herr Ruhnau was accused of making the following Herr Ruhnau was accused of making the following mistakes:mistakes:
Purchasing the Boeing aircraft at the wrong time.
Choosing to hedge half of the exposure when he expected the dollar to fall.
Choosing forward hedging over options
Purchasing Boeing jets at all
What went wrong?What went wrong?
Lufthansa’s board should have chosen DM1.6 b as a benchmark (DM3.2/$)
Herr Ruhnau expected the dollar to fall; hence, he should have used option hedging
Concept check #1Concept check #1
If you believe there is a 80% probability that your house will be destroyed by floods, would you buy insurance or move to another location?
Concept check #2Concept check #2
You want your exams to be assessed based on:
a. a pre-determined, objective exam key
b. instructor’s inspiration at the time of grading