Lufthansa Case Study

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Lufthansa Case Study
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Synopsis

• Lufthansa, purchased twenty 737 Boeing aircraft
  in January of 1985 for 500 million.
• The payment was due in January of 1986 upon
  delivery of the aircraft from the U.S.
  manufacturer.
• At the time of the purchase, the U.S. dollar was
  at a record high versus the Deutschemark, and had
  been steadily appreciating against the
  Deutschemark for 5 years.
• The CEO of Lufthansa, Herr Heinz Ruhnau, was
  responsible for determining what hedging if any
  would be use.

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Focus of The Case

• The focal point of of this case is the managerial
  decision-making, the formation of expectations,
  and the value and leadership of senior
  management.
• Arguing over what Herr Heinz Ruhnau did in
  retrospect and what we may think he should have
  done is not the point.
• The more general lesson is whether the firms best
  interests are found in accepting open uncovered
  positions or not.

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Question 1

• T dollar was high at this point, and therefore
  the decision to purchase now seems to be a bit
  late.
• Yet, given the trend in the movement of the DM/
  rate over the previous years, it appears (using
  the graphic available to Herr Heinz Ruhnau in
  January 1985, Exhibit 2), that postponing the
  purchase would only result in a higher dollar and
  therefore a higher expense.

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Question 2

• Should Herr Ruhnau have gone whole hog?
• There are two views
• Since he is paid the big bucks to make the big
  decisions, and if he believed the dollar was
  about to fall he should have remained completely
  uncovered.
• Or, on the contrary, he is also paid the big
  bucks to pursue Lufthansas strategic future, and
  that does not include the gambling on exchange
  rate movements.
• Both views are valid, however, that the 50/50
  result is difficult to defend itself.
• (This is equivalent to covering one exposure and
  leaving an identical exposure completely
  uncovered a somewhat schizophrenic view on the
  direction of exchange rate movements.)

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Question 3

• The purchase of a put option would have indeed
  provided solid insurance. Yet, it is difficult to
  explain why one should spend millions on the
  purchase of protection which one hopes not to
  use.
• This is a flawed argument as it is obvious if we
  extend it to any insurance policy. However, it
  has real meaning in many boardrooms even today.
• As a matter of fact, few private firms were
  actually using currency options for risk
  management in 1985 when this situation arose.
• Herr Ruhnau could have purchased an
  out-of-the-money put option on Deutschemarks to
  reduce the premium paid.
• He could also have purchased a collar, i.e., sold
  a call to finance the purchase of the put option
  hedge on Deutschemarks to reduce the premium
  further.

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Question4

• 4. Why Boeing instead of Airbus?
• We have no information for a factual evaluation
  of this issue.
• But it is important to notice that the choice of
  purchase and the terms of a purchase give rise to
  the exposure itself.

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Other Points

• The initial decision is made with a highly
  overvalued dollar but a trend line which was hard
  to argue with. What do you expect, and which
  hedging alternative would you pick?
• With the 50/50 hedge position he cannot possibly
  win. One sides gains will always offset the
  losses on the other.
• Why did Ruhnau not change his position when it
  became clear that the dollar had indeed peaked
  and was on its way back down?
• This may be the most legitimate criticism of Herr
  Ruhnaus management the failure to re-position
  the hedge when new information is
  incontrovertible. Although this would not recoup
  previous exchange rate losses, it would allow
  Lufthansa to enjoy any further drop in the value
  of the dollar (or suffer any increases if the
  value of the dollar turned once again).