Introduction
The problem of fluctuating currencies in global trade is an issue that most companies face when executing cross border transactions. In this case, the problem experienced by Lufthansa primarily boils down to one key aspect – the manner in which the company should handle a large foreign currency transaction by facing a minimal loss at an optimum cost with the least risk. In such cases, most often the least risky approach is also the most expensive one as would be evident in this case.
On the other hand, the seemingly risky approach also holds very little or no immediate cost but could hold a future cost. The solution to this problem lies in taking a path that involves the least immediate cost but without a future significant cost. A commensurate hedging strategy should therefore be applied. This paper presents a brief analysis of the four possible alternatives that the company can exercise in this transaction and would also present a recommendation on the best possibilities out of the resultant solution.
In January 1985, Lufthansa procured twenty new 737 Boeing airplanes. A price of US$500 million was negotiated by the Chairman of the Board of the company named Ruhnau. The agreed price was payable in US Dollars within one year of the delivery of the aircraft (January 1986). Since Lufthansa’s operating revenues were largely accounted for and received in Deutsche Marks (DM), Chairman Ruhnau had to arrive at a suitable solution to reduce the risk resulting from the large foreign exchange exposure. While he firmly believed that the US$ would strongly depreciate by January 1986 against the DM, he was nervous when applying his gut feeling to this scenario since the situation involved millions of dollars. In addition, any adverse moves in the currency would leave the company in a very bad situation. Given the scenario at the time, he devised four different options in order to hedge the large exposure and protect the company against such adverse currency movements. This paper will now analyze each option.
Analysis
1. Do Nothing: This option is probably the riskiest of the available options, but it also the option that carries the highest potential benefits for the airline. The prevailing scenario at the time (in January 1985) clearly indicates a market uptrend in the DM/$ spot rate and falling interest rates in the US compared to those in Germany. Such a trend clearly indicates a scenario of a strengthened dollar against the DM in the near term but a possibility of dollar depreciation in the long term (over a year). In such a scenario, a strategy of not taking a suitable cover for this transaction and relying on market forces would be a typical risk reward approach to this scenario. One can refer to the table in the Appendix to understand the effect of this strategy. The best case scenario would be that the exchange rate remains around the region of 2.4 DM/$, the company would end up footing a bill of DM 1.2 billion. On the other hand, if the exchange rate were to move upward to 3.4 DM/$, the bill for this acquisition would be DM 1.7 billion or higher. One can clearly see from this instance that the company bears a considerable amount of risk by adopting this strategy since it is almost impossible to correctly predict currency movements for such an extended period. One could construe such a strategy as being speculative. This would not only jeopardize the finances of the airline, but also make them answerable to their investors and shareholders.
2. Partial Forward Cover: As per the assumption of this paper, this strategy would cover a certain percentage of the exposure with a forward contract that has been pre-negotiated with a bank. The company would allow the remaining exposure to be uncovered. One should note that a forward contract is an agreement between two establishments to buy or sell a particular asset at an indicated time at a price agreed upon on the present day. In this case, Ruhnau would adopt this strategy on the anticipation that the dollar would fall. In such a case, Lufthansa would stand partly benefitted by leaving a fixed percentage of the currency exposure uncovered.
However, the risk in this scenario stems from the possible escalation of the partly exposed exposure to exorbitant levels. As observed, the cost of acquisition could range from DM 1.4 to 1.65 billion, depending on the exposure taken and the currency price fluctuation. It is, therefore, apparent that such a scenario, the company would still end up paying a somewhat significant number of DM’s to buy the dollars at an enhanced price. While the macroeconomic factors pointed to the improbability of dollar price escalation, Ruhnau would have significantly reduced the foreign exchange risk of the final DM over a large range of final values. Furthermore, while the percentage of exposure can vary considerably, but in this case the paper assumed an optimal ratio of 50/50 for calculations since it closely resembles the decision that Ruhnau pursued in 1985.
Full Forward Cover: This strategy is an almost zero risk approach and a plan that Lufthansa should adopt to fully eliminate its currency exposure through the purchase of forward contracts for the entire US dollar amount of the purchase. As shown in the table in the Appendix, this policy would ensure that a price of DM3.2/$ is locked-in for the purpose of this transaction that amounts to about DM1.6 billion. While this strategy could have proven extremely beneficial for Lufthansa, in the short term, as it reduces all currency risks with relation to the ending spot exchange rate. However, is apparent that in January 1986 the final exchange rate ended well below the forward contract price. Such an event would have been highly detrimental to Lufthansa since it would have been a notional loss that would have translated to a higher cost of payment as opposed to the lower market price. It would be prudent for the company to consider the 100% forward cover policy as a comparative measure of actual currency costs when all formalities are completed.
3. Foreign Currency Put Options. In 1985, this method of hedging was a particularly exceptional one. This policy was unique given its “kinked shape” value line and its ability to meet both conditions of the company – low cost of hedging and adequate cover both ways. Consider, for instance, that Ruhnau purchased a put option at the value of DM3.2/$. At this time, if the dollar continued its uptrend, the total cost of obtaining US$500 million would be locked in at DM1.6 billion plus the cost of the premium. Such an approach would protect the company from paying the excess amount that resulted from the currency appreciation. However, as anticipated, if the dollar depreciated Lufthansa would let the option expire. The resultant profit premium collected could be used by the company to purchase the dollars at the spot rate and at a much lower cost. However, the only negative aspect of this policy would be in the scenario where the dollar did not depreciate below the original DM3.2/$ rate. In such a scenario, Lufthansa would stand to lose the premium for the DM96 million for a hedging instrument that the company did not use.
4. Buy Dollars Today and Invest: This final strategy employs a tactic of using a money market hedge for an account payable. In this case, Lufthansa would purchase the US$500 million and invest the entire funds in a high interest bearing instrument until the final payment was due. While this option eliminates all unnecessary currency exposures it also requires an extremely high capital investment almost immediately. For such a purpose, Lufthansa would have to generate an extremely large amount of money in a very short period of time. Such a thing would have been extremely unlikely and unreasonable for Lufthansa given that it was planning to pay this amount through its accrued revenues. In addition, Lufthansa had certain rules that placed restrictions on the types, amounts and currencies of denomination that it could carry on its balance sheet as was the prevailing custom in Germany in 1985. Therefore, while this approach would have been the least riskiest and arguably somewhat marginally profitable it was an option that would have been extremely difficult for the airline to implement.
Recommendation: Based on the analysis, one can understand that there are two possible options for the airline. These recommendations would make Lufthansa’s hedging strategy more appropriate and, at the same time, limit Lufthansa’s extent of exchange rate risk.
The purchase of the aircraft from Boeing could have been scheduled at a better time. Lufthansa should have continued with Ruhnau’s original expectation and waited until the value of the dollar decreased. Since the US dollar was at a record high level at the time of purchase, which consequently increased the value of the Deutsche Mark required for payment in January 1986. If Lufthansa waited further the company would have made significant savings.
Alternatively, Lufthansa should purchase the Put options. The purchase of Put options would have protected Lufthansa against adverse exchange rate movements, while, at the same time, maintaining the ability to expire the put option if the dollar decreased. This approach would have allowed the airline to exchange the DM at the spot rate, if preferred. This option would also have been much better than the Forward Rate option since a Put option is cheaper and more efficient than a Forward Contract.
Therefore, it is recommended that given the risks noted in the various strategies Lufthansa adopt one of the two recommendations mentioned above in order to protect its finances against the risk of currency rate volatility.
Appendix
Scenarios Listed
