In January 1985, a German company that uses Deutschmarks made a large purchase from a U.S. company that uses U.S. dollars, and needed to evaluate the best hedging alternatives to secure the least possible cost. The Chairman of Lufthansa, Herr Heinz Ruhnau, purchased twenty 737 jets from Boeing. The total purchase price was $500,000,000, which was payable in U.S. dollars on delivery of the aircrafts in one year.
Chairman Ruhnau chose a partial cover by hedging 50% of the exposure with forward contracts, which was $250 million at the one year forward rate of DM3.
2/$. He left the remaining 50% ($250 million) uncovered.
Due to this decision, Lufthansa paid DM225,000,000 more than if Ruhnau would have chosen to not hedge at all or DM196,000,000 if he chose the put option. The Board of Directors is going to determine whether Ruhnau should be kept on as Chairman or be terminated.
Purchasing the Boeing aircraft at the wrong time. The U.S. dollar was at an all-time high at the time of the purchase, in January of 1985.
In January 1985, the Board of Directors believed Ruhnau purchased the aircrafts at the wrong time since the U.S. dollar was at an all-time high, which was DM3.2/$. Ruhnau and many others at the time believed the U.S. dollar had reached its max and would start its decline. The U.S. dollar dropped to DM2.3/$ when payment was due one year later.
The Board understands the difficulty to determine future currency exchange rates, even when using different forecasting techniques there is no guarantee to predict accurate future exchange rates.
However, Ruhnau and many others believed the U.S. dollar would depreciate.
The Board also questions Ruhnau about the necessity of these aircrafts, the timing of purchase, and the purchase price agreed upon.
The U.S. dollar had been rising for the past three years and was at an all-time high at the time of purchase, in January 1985. Herr made the decision to purchase the Boeing Aircraft at this time.
The Board is looking in hindsight and focused on the U.S. dollar being at an all-time high of DM3.2/$ at the time of purchase and then falling to DM2.3/$ when payment was due.
There are three main possible scenarios Ruhnau could have considered when evaluating his decision:
The U.S. dollar had been steadily rising against the DM for the past three years. The U.S. dollar was at an all-time high and it could have steadily continued to rise. One month later, the U.S. dollar did rise to DM3.4/$.
If the U.S. dollar did continue to rise to DM4.0/$, then Ruhnau made the right decision to purchase the Boeing Aircraft. If he would have waited and the U.S. dollar continued to rise, then he would have had to a total cost of DM2.0 billion, which would have been an additional DM625,000,000 cost in comparison to the partial forward cover. Ruhnau would have been blamed for this substantial loss.
The most accurate predictor of the future U.S. dollar rate is today’s rate because today’s rate already includes all the information about the economy, social issues, politics, and all other pertinent details affecting the exchange rate.
The U.S. dollar was increasing about DM0.20/$ per year from 1982 to1983, and from 1983 to 1984. Then the U.S. dollar jumped DM0.40/$ from 1984 to 1985. This steady rise showed the U.S. dollar was strong and would steadily increase or fluctuate around at a similar number.
Even though Ruhnau and many others expected the U.S. dollar to decrease, there was no way of knowing with absolute certainty that would come to fruition and how much it would actually fall. Ruhnau needed to make a decision with the information he had.
There are various forecasting techniques, which include the Efficient Markets Approach, the Fundamental Approach, and the Technical Approach. Even if Ruhnau researched and followed these methods, they would still not predict with certainty the future U.S. dollar rate. They would either confirm or counter his expectations and he would need to make a decision without being able to accurately predict the future exchange rate. There are also other factors that could dramatically affect the U.S. dollar or German Deutschmark, such as unexpected events which could make significant impacts in appreciation or depreciation.
In the 1980’s, Lufthansa increased the number of non-stop connections and more dense route networks (History). The aircraft purchase could have been necessary at this time because the aircrafts could be used for expansion or growth. Potential sales from expansion opportunities of adding new flight routes, additional flight time options, or other additional uses would be a substantial gain to Lufthansa, which could be hundreds of millions of dollars in additional yearly sales. The difference between total DM cost of the partial forward cover and the uncovered or put option would seem minimal in the long-run.
The aircrafts could have been a necessary purchase to replace aging planes which may not have been able to keep up with their current flight offerings. If the planes were not purchased, then there could be impacts in current flight options for Lufthansa’s customers and lead to substantial losses.
The deal Boeing offered could have been an extremely discounted price that Ruhnau spent negotiating over a long period of time, that would counteract potential exchange rate what the board deems as ‘losses.’ Ruhnau may have had a short window of opportunity to sign the contract. Ruhnau may have also agreed on 20 aircrafts because Boeing would give them a better rate on each aircraft when purchasing a large amount.
The airline industry had been growing substantially and was competing for customers globally, even creating a crowded airspace that resulted in more time spent flying in holding patterns. Aircrafts became a much more popular and common mean of mass transportation. Through this change in the airline industry, Lufthansa was increasingly becoming more a competitive airline (History).
The airline industry may have been planning to increase costs or going through changes in material costs due to the higher demand, which would drive up prices. Boeing may have wanted to create a new type of aircraft and were discounting these aircrafts so they could decrease their inventory. If the U.S. dollar appreciated substantially, then they may have increased their prices to make up for the difference. This situations would have not been in Lufthansa’s favor.
Choosing to hedge half the exposure when he expected the dollar to fall. If he had gone through with his instincts or expectations, he would have left
the whole amount unhedged (which some critics have termed “whole hog”).
The Board did not understand why Ruhnau chose to take the $500 million purchase price and hedge half, while he left the other half uncovered. The U.S. dollar was rising for the past three years and Ruhnau believed it was going to start its decline, many others believed the same also. If Ruhnau did pan to hedge, then why did he not hedge during the negotiation process?
The Board believed the best choice would have been to remain uncovered because they could have saved DM225,000,000. The Board would like Ruhnau to explain the thinking behind his course of action.
Ruhnau did expect the U.S. dollar to fall but he chose to compromise and hedge half the exposure and kept the other half uncovered. The partial cover of 50/50 includes $250 million purchased with forward contracts of DM3.2/$, and the remaining $250 million purchased at the end-of-period spot rate. The value of the line slopes halfway between the 100% uncovered and 100% covered lines in Exhibit 1.
Ruhnau’s instincts were to leave the whole amount unhedged, however, it is not Ruhnau’s money to make that type of decision and “gamble” with Lufthansa’s money. Ruhnau had an obligation to the stakeholders and needs to take into consideration the various possible outcomes that would affect stakeholders. Hedging mitigates potential losses and can be viewed as an insurance premium helping firms avoid steep currency losses. He chose a partial forward cover rather than a full forward cover, while using the full
as a benchmark.
This alternative does yield the greatest benefit in hindsight, however, it has the most risk. For every change of DM0.1/$, there is a change of DM50,000,000 in total cost, which is a substantial risk for slight changes in the exchange rate.
Since the U.S. dollar depreciated significantly, then they would have gained the greatest potential benefit, which could have been an additional DM225,000,000 than what was received from the partial forward cover.
Another possibility is that Ruhnau would have not hedged, and the U.S. dollar could have experienced a drastic appreciation or the DM could have experienced a drastic deprecation that could have been impacted by other factors. If the U.S. dollar would have appreciated to 4.0 DM/$, then Ruhnau would have faced substantial losses; the total DM cost would have been DM2.0 billion, which would have cost an additional DM400,000,000.
If Ruhnau would have not hedged, he would watch the U.S. dollar dramatically increase to almost 3.4 DM/$ in another month. He may have then felt pressure to make a decision about hedging. That would have contributed significantly to the amount of losses, adding DM50,000,000 to total DM cost to the partial forward cover.
If Ruhnau would have not hedged, even as he saw the U.S. dollar increase, he would have seen the U.S. dollar then begin to fall in March. He may have made the decision to use the rate of 2.8 DM/$ because he may have thought that’s as low as it would probably go. That would have also been a good rate to stay at considering the U.S. dollar could go back up again.
Few argued for leaving the entire amount uncovered. If anyone had recommended letting $500,000,000 remain uncovered for an entire year, no one would have listened to them or taken that advice. That is an extreme gamble that is leaving them completely open to any volatility in the market.
Most firms choose to hedge at the billing exposure. If Ruhnau would have hedged prior to finalizing the contract, he wouldn’t know what the total amount to hedge would have been. Also, he would have more time to watch the pattern of the exchange rate. Additionally, if the deal with Boeing did not go through, then he would be left with a hedge involving U.S. dollars that he may not ever need.
Additionally, Germans tend to be risk averse. In Hofstede’s theory of cultural dimensions, German’s score higher on uncertainty avoidance, which means that Germans prefer to make choices with less uncertainty and would rather rely on expertise (What about Germany?).
Ruhnau supports hedging because there are several benefits, which include:
Ruhnau still left himself open to potential unlimited exposure, since the U.S. dollar could appreciate to excessively high levels but was very unlikely. However, Ruhnau still reduced the risk.
Choosing to use forward contracts as his hedging tool instead of options. The purchase of put options would have allowed Herr Ruhnau to protect himself against adverse exchange rate movements while preserving the flexibility of exchanging Deutschemarks for dollars spot if preferred.
The Board believed there were better choices that Ruhnau could have made, that would have been more cost effective for Lufthansa. The Board knows the put option was the best course of action Ruhnau could have taken. The use of put options would have protected Lufthansa if the U.S. dollar continued to appreciate and started its decline like Ruhnau felt it was going to do, they could have just let the options expire without using them.
If the dollar continued to appreciate they would have exercised the options and if the dollar started to decline we could have let them expire and used the spot rate instead. Yes there is a cost to the options but it is less than the cost associated with hedging, which is why they felt it was the better option. Buying a put option would have saved DM129,000,000.
The Board would like Ruhnau to explain the thinking behind choosing to hedge instead of using put options.
Ruhnau chose a partial forward cover instead of purchasing a put option for several reasons. At the time, foreign currency options were a relatively new tool for exposure management by many firms and had a substantial up-front premium requirement of DM96,000,000. The lack of familiarity and large cost seemed unnecessary, especially when he could use a partial forward cover to reduce the risk and still benefit.
Ruhnau felt strongly about the U.S. dollar depreciating, and that is why he did choose the partial forward cover. This decision was still risky and he did follow his instincts. They gained DM225,000,000 by making that choice rather than selecting the full forward cover.
When evaluating the partial forward cover and the put option, Ruhnau would have discovered Lufthansa would not benefit unless the exchange rate dropped to DM2.8/$. Ruhnau and many others may have believed that the U.S. dollar would depreciate, but no one would have predicted it would decrease to DM2.3/$ within one year, when it took three years to build from that same rate.
Paying the DM96,000,000 premium would be similar to buying insurance. The put option would have only been exercised if the U.S. dollar did not do what many already predicted. Ruhnau did not feel it was necessary to spend such a large amount of money to secure something they did not expect to happen. Lufthansa already had several relatively strict covenants limiting types, amounts, and currencies of debt it could carry on its balance sheet. Adding a seemingly unnecessary DM96,000,000 did not fit with the way they currently operate.
Ruhnau chose the partial forward cover is actually a gain when comparing it to the full forward cover. Lufthansa gained DM225,000,000.
Ruhnau is the Chairman, but he shouldn’t have been the main person in charge of this decision. The Chief Financial Officer (CFO), other financial analysts within the company, and/or third-parties could have contributed. In Hofstede’s theory of cultural dimensions, Germany scores low on Power Distance, which is means they have a direct and participative communication style that is common. Leadership is also challenged, and the acceptance of decisions relies on expertise (What about Germany?). Therefore, in order to make this decision, all members with input most likely agreed on the decision before-hand.
To blame the Chairman solely when many have contributed their analysis to make this decision is unreasonable. The recommendations may have instructed him to take a full forward cover because of the strong and steady rise of the U.S. dollar. However, Ruhnau could have went against those recommendations and chose the partial forward cover. There would have not been anyone recommending taking the whole amount uncovered, nor would the Board have considered that option at the time of purchase.
Purchasing Boeing aircraft at all. Germany, as well as the other major European Economic Community countries, has a vested interest in the conglomerate Airbus. Airbus’s chief rival was Boeing in the manufacture of large long-distance civil aircraft.
Negotiating and signing a deal for that large of an amount without taking the right precaution could have left the company in a very bad position. Why wasn’t the Board notified? Why couldn’t Ruhnau have waited to where appropriate risk measures were put in place? Why would this deal be negotiated in times where the U.S. dollar was on a three-year appreciation momentum?
Lufthansa as well as other European based airlines support Airbus. Airbus is also supported by a number of European countries. Making a decision to purchase Boeing aircrafts just does the exact opposite of that. Why? What are the benefits of going with Boeing versus Airbus?
Time could have been of importance, and Boeing may have offered a great deal that had to be agreed upon quickly. Based on personal speculation of the U.S. dollar value, Ruhnau had reason to believe the U.S. dollar would depreciate in value against the Deutschmark. If the deal was negotiated in a period where the dollar was already weak, Boeing would have accounted for the decrease in dollar value and Lufthansa wouldn’t have benefited.
Even though Lufthansa made most aircraft purchases mostly to Airbus, which is a European-based company, Lufthansa would benefit from this as it increases competition. Maintaining a diversified fleet of aircrafts is essential, not only because it allowed Lufthansa to negotiate purchase deals across manufacturers, but it also serves as a differentiation of products as comfort and style were apparent to clients.
(Assumption) Delivery dates could have been essential to the growth of the company back then. Airbus might have not been able to accommodate that.
The Board of Lufthansa should retain Chairman Herr Heinz Ruhnau as Chairman.
Ruhnau evaluated the decision based on the information he had at the time. That information included that the U.S. dollar had been rising for the past three years and was at an all-time high. Ruhnau used this information as well as opinions, including his own, that the U.S. dollar would depreciate to make the choice of a partial forward cover.
Ruhnau was focused on the growth and expansion of Lufthansa, resulting from more popularity among customers using airlines for mass transportation. He felt this purchase was a necessity, being purchase at the right time and price.
Ruhnau was wise and knowledgeable enough to know to not go with his instincts because this money belonged to Lufthansa and the stakeholders. Rather than fully going with his instincts and understanding the market is not predictable, he chose the safer option of a partial forward cover rather than 100% uncovered.
In hindsight, the Board noted that the put option would have been the best alternative to select. However, when this was a new tool and would cost DM96,000,000. Additionally, it would only be beneficial if the DM/$ went below DM2.8/$. Ruhnau and many others may have expected a depreciation, but on one would have expected the dollar to fall to DM2.3/$.
Ruhnau could have chosen Boeing over Airbus for several reasons, including timing of delivery, purchase price, type of planes offered, and to increase future competition to use as leverage in future negotiations.
Overall, when evaluating Ruhnau’s choices from his perspective in 1985, all of his choices make sense and are reasonable. No one can predict the future exchange rate and should not be penalized for not knowing which direction and how far in that direction the exchange rate will go.
History. (n.d.). Retrieved April 2, 2012, from http://www.lufthansa.com: http://konzern.lufthansa.com/en/history/eighties.html
What about Germany? (n.d.). Retrieved April 9, 2012, from http://geert-hofstede.com: http://geert-hofstede.com/germany.html
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