Case Study Analysis: Lufthansa: to Hedge or Not to Hedge… Essay

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Case Study Analysis: Lufthansa: To Hedge or Not to Hedge…
By Mathew Stubbs and Michael Homewood
In January 1985, Lufthansa, a German airline company procured twenty new 737 airplanes from Boeing. Under the chairmanship of Heinz Ruhnau, a price of US$500 million was negotiated. The agreed price was payable in United States Dollars (USD) upon delivery of the aircraft in one years time, on January 1986. Since Lufthansa’s operating revenues were primarily in Deutsche Marks (DM), Ruhnau needed to determine an appropriate solution to minimize the resulting foreign exchange risk.

In the year preceding the expansion purchase, Lufthansa was experiencing periods of extensive growth. In 1984, the company experienced an overall increase in
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Furthermore, it allows them to determine their required cash flow. As a result, they are able to plan appropriately to meet repayment demands.

In order to minimise exchange rate risk the objective for Lufthansa should be the to ensure that the exchange rate does not appreciate any further in order to cap the total cost of purchasing a new fleet by using different hedging strategies.

Evaluation of Hedging Alternatives
Ruhnau identified five possible strategies to mitigate the potential foreign exchange risk that Lufthansa was facing. The five alternatives were as follows: 1. Remain uncovered and see where the exchange is like in January 1986. 2. Cover a proportion of the exposure with a forward contract, leaving the remaining balance uncovered. 3. Cover the entire exposure with forward contracts. 4. Cover the entire exposure with foreign currency put options. 5. Obtain US dollars and invest them for one year until payment is due.
The final cumulative expense of each hedging tool could not have been known beforehand. However, each possible outcome could be calculated using simulated exchange rates. Exhibit 3 exemplifies the final net costs of the possible alternatives that Ruhnau had available, which is further highlighted in the table below.

Alternative | Relevant Rates | Total Deutsche Mark Cost | Uncovered | Min: DM2.4/$ Max: DM3.4/$ | 1,200,000,000 | 1,700,000,000 | Partial Forward Cover | Min: