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Ming Yu ChanSunil K. DixitAlex GaliuKevin HanBaban Pal Singh
FIN 570- International Financial Management
Summer 2008
California State University, Fullerton
Company History
• 1926: Formed from a merger between Deutsche Aero Lloyd (DAL) and Junkers Luftverkehr
• 1934-1938: Opens first trans-oceanic
• 1939-1945: (War-time) All flights discontinued in 1945
• 1951-1955: Post war air transport resumes
• 1960: Enters the jet age
• 2005: Celebrates the 50th anniversary of its postwar re-entry
Company Background
Corporate headquarters - in Cologne
Main base and primary traffic hub - Frankfurt International Airport in Frankfurt am Main
Second hub - Munich International Airport
Largest airline in Europe
World’s sixth largest airline
Company Background
Five business segments – Passenger Transportation, Logistic, MRO Business, Catering and IT Service
Core Business - Passenger Transportation
Founding member of Star Alliance, the world's largest airline alliance
Services to 209 destinations in 81 countries
Herr Heinz Ruhnau
Lufthansa Chairman on July 1, 1982 – Sept 1, 1991 - No private enterprise experience
Undersecretary in the Transport Ministry of West Germany
Strong affiliations with the West German Social Democratic Party
Immediate task - improve Lufthansa's thin profit margin
Herr Heinz Ruhnau - Contd
Chairman – Supervisor Board - Mitteldeutsche Flughafen AG (1996-2003)
Now a honorary Professor - Technical University Dresden - Institute of Economics and Logistics
Frequent speaker – on Transport and Eastern European Economies
Case Overview
January 1985 - purchased twenty Boeing 737
Trading price: US$500 million due in
January 1986 Exchange rate: DM3.2/$ - January 1985
Exchange Rate Fluctuation
Upward USD since 1980
If USD continued to rise, the total cost to Lufthansa would also
rise
Spot rate, DM 2.8/$2
2.2
2.4
2.6
2.8
3
3.2
Jan-82 Jan-83 Jan-84 Jan-85 Jan-86 Jan-87
DM/$
Economic Environment USA
GDP Growth Rate – 1984: 6.8%– 1985: 2.4%*
Inflation– 1984: 4.3%– 1985: 3.55%
Banks Prime Lending Rate. – 1985: 10.61%
Sources: 1984 – OECD; 1985 – Private Bank Forecasts
(WSJ)
Germany
GDP Growth Rate– 1984: 2.6%– 1985: 3.%*
Inflation– 1984: 2.4%– 1985: 2.5%*
Banks Prime Lending Rate– 1985: 9.53%
* Forecast
Economic Environment - Contd
Predictions Based on key economic Data– US Dollar - expected to Depreciate against
German DM in 1986
– German DM - expected to Appreciate against US Dollar in 1986
Decision Outcome
50% forward contract @ DM3.2/$ The remaining 50% uncovered The spot rate in January 1986 = DM 2.3/$
Total DM Cost
Forward Contract (DM3.2/$) 800 million
Uncovered (DM2.3/$) 575 million
Total 1,375 million
Decision Outcome
Herr Ruhnau was summoned to meet with Lufthansa’s board
Was accused of recklessly speculating with Lufthansa’s money
DM Rate ForecastInternational Fisher Effect
US prime rate in Jan 1985: 10.61% German banks’ prime lending rate in Jan 1985: 9.53% Spot rate in Jan 1985: DM3.2/$ Projected spot rate in Jan 1986:
= DM 3.168/$
DM Rate ForecastPurchasing Power Parity
US inflation in 1985: 3.55% German inflation in 1985: 2.5% Spot rate in Jan 1985: DM3.2/$ Projected spot rate in Jan 1986:
= DM 3.168/$ 0
1
1
t
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f
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January 1986 - DM Spot Rate Projections
Purchasing power parity: DM3.168/$
International fisher effect: DM3.168/$
Forward rate (Given in the case): DM3.2/$
Lufthansa’s Issues - Basic
Importance
Urgency
Low High
Low
ILevel of FX Transaction
Risk/Management Competency
IIEconomic
Environment(You cannot
control)
High
IIIRisk Aversion/ company’s FX
policy
IVHedging Solution
and Forecast
Lufthansa’s Issues - Immediate
Importance
Urgency
Low High
Low
ITiming of Purchase(1 Year to Delivery)
IIAdequacy of
Funds/Capital
High
IIIDelivery of Airplanes
IVCost of Hedging
Cause/Effect Analysis Basic Issues
FX Rate Forecast
Economic
Environment
Adequacy of Funds
Hedging Decision
Purchase Contract
FX Risk Aversion
Cost of Hedging
Cause/Effect AnalysisImmediate Issues
Hedging Method
Cost of Hedging
Contract Date
Covenants Restrictions
Delivery Date
FX Transaction Risk
FX Exposure
- Acquisition of assets
- Proceeds payable in foreign currency (US $)
- May result in higher costs – if DM depreciates against US $
- Reduce/manage FX Risk
Decision Criteria
Sound hedging policy - desirable for FX transaction risks
Our Forecast - US $ was to depreciate Lufthansa’s covenants – restrictions on debt
amounts & currencies of denomination Assumption - jets would be delivered on time US Operations – US $ cash inflows insufficient Not enough facts - Boeing vs. Airbus issue or timing
or purchase – Assumed Sound Business Decisions
Hedging Alternatives
Uncovered Forward contract cover Partial forward uncovered Foreign currency option Buy dollar now
Alternative Analysis#1 Uncovered
Option
USD (Million
)Rate Type DM/$
Total DM cost
(Million)Risk
Uncovered 500
Spot - Actual
Jan 1986
2.3 1,150 High
Uncovered 500
Spot Forecast Jan 1986 (PPP)
3.168 1,584 High
Uncovered 500
Spot Forecast
Jan 1986 (IFE)
3.168 1,584 High
Maximum Risk – Speculative Gain/Loss Possible
Alternative Analysis #2 Full Forward Cover
Option
USD (Million
)Rate Type DM/$
Total DM cost (Million) Risk
Full Forward Cover
500 Forward 3.2 1,600 Low
Minimum Risk – Costs higher
Alternative Analysis#3 Partial Forward Cover
OptionUSD
(Million) Rate Type DM/$Total DM cost
(Million) Risk
250 Forward 3.2 800
Medium
PartialForward
Cover 50:50 250Spot - Actual
Jan 1986 2.3 575
Medium
250Spot Forecast Jan 1986 (PPP) 3.168 792
Medium
250 Spot Forecast Jan 1986 (IFE)
3.168 792 Medium
Medium Risk – Partial Hedge
Alternative Analysis#4 DM Put Options
OptionUSD
(Million) Rate Type DM/$Total DM cost
(Million) Risk
DM PutOptions 500 Strike Price 3.2 1,600 Low
Premium 6%96
If Not Exercised (6%)
96
Spot - Actual Jan 1986
2.3 1,150
Total 1,246 Low
Low Risk – Freedom to Walk Away – Sunk Cost (Premium)
Alternative Analysis#5 Buy Dollar Now
Option
USD
(Million) Rate Type DM/$
Total DM cost
(Million) Risk
Buy DollarNow & Invest
DM(Full Contract) 500 Spot 3.2 1,600 Low
DM Interest@ 6.3125% p.a. 101
Total 1,701USD Interest @ 9.5625%
(US$47.8125 Million) 2.3 110
Total 1,591 LowNo Risk – Availability of cash? – Covenants’ Restrictions on debt
Alternatives Summary
Alternative Scenario Cost (DM) -Million Total Costs Risk
Uncovered $ 500 x 2.3 1,150 1,150 High
$ 500 x 3.168 1,584 1,584
Full Fwd $ 500x3.2 1,600 1,600 Low
Partial FWD $ 250x3.2 800
(50:50) $ 250x2.3 575 1,375 Medium
$ 250x3.2 800
$ 250x3.168 792 1,592 High
DM Put Options $ 500x3.2 plus 6% prem 1,696 1,696 Low
$ 500x2.3 plus 6% prem 1,246 1,246 Low
$ 500 x 3.168 plus 6% prem 1,680 1,680 Low
Recommendation
Uncovered position - not desirable Corporate FX hedging policy Implement 6 steps to hedge against FX
exposure Corporate decision-making Experience does matter Forward not the right tool in this case Exit if US$ depreciates
Recommendation (Contd)
Buy DM Put Options If US $ appreciates = USD 500 x 3.2 + 6% = DM
1.696 Billion If dollar declined to DM 2.3/$ = USD 500 x 2.3 +
DM 96 Mil = DM 1.246 Billion Downside = costs DM 96 million more than
uncovered position Benefit = 100% hedging
Foreign Exchange Risk Management Steps
Forecasting
Risk Estimation
Benchmarking
Hedging
Reporting & Review
Contingency Steps
Lufthansa’s Hedging Policy 2007
“Lufthansa Finance Cockpit”
Capital expenditure on aircraft: 50% hedging
Review every 6 months Hedging level revised
upto 90%