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

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f

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i

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%