Lufthansa Harvard Case Solution & Analysis

Background & Issues Involved

            A contract was signed by the national airline of Germany in order to purchase around 20 Boeing 737 jets in the January of 1985. This contract had been signed under the championship of Heinz Ruhnau for the Lufthansa airline. A time period of one year had been agreed by Boeing and they had promised to deliver all the 20 Jets by the January of 1986. A single payment of about $ 500 million was due and at the current spot exchange rate of DM 3.2 per $, the company would have to pay around DM 1.6 billion.

                        The exchange rate exposure for the management of Lufthansa was increasing as the value of the Dollar was appreciating against the DM. Most of the industry analysts and the advisors had stated that the dollar exchange rate was overprices and it would fall but the exchange rate continued to climb and as a result, Herr became concerned about the risk in the transaction however, he decided to compromise and instead of the full amount.

            He hedged the half of the price of about $ 250 million with a forward contract at a rate of DM 3.2 per $ and in the end at the time of the outcome, the expectations of Herr proved to be correct and the dollar fell, however, the total amount that the company had to pay under the 50% hedged forward contract was DM 800 million which was DM 225 million higher than the cost of the 50% un-hedged amount.

 Therefore, he was heavily criticized for speculating over the major transaction of the company. As a result the renewal of his employment contract was postponed and questions on firing him started to emerge. A range of strategies will have to be evaluated and a decision will be made that whether Herr should be fired or not.

Analysis

            There were a number of reasons or mistakes due to which, Herr Ruhnau was accused of such as he was accused of speculating the position of the company on a major transaction, purchasing the aircrafts of Boeing at the wrong time, only hedging half of the exposure of the company at a time when he expected the dollar would fall which actually happened.

            However, it could be said that Ruhnau was actually speculating because as he had left the 50% of the total transaction amount as un-hedged and he had predicted that the dollar would depreciate against the mark and as a result had had a chance to make maximum profit and even maximum loss. In the end, his predictions turned out to be correct however he was blamed for speculating with the forward contracts and because of that the management of the company had to pay additional DMs.

            The predictions of Heinz were correct but they were not based upon any hard evidence and he should not have entered into the forward contract agreement and should have waited till the time the exchange rate had fallen and then he could have taken the advantage of benefiting the company by paying less DM for the purchase of the jet planes. Also, instead of going for the forward contracts he should have gone for the put options so that he could have saved the company from any higher losses in the future as a result of the unpredictable exchange rate movements. Herr would have to pay the millions of the cost of the premium of put options however, the put options would have provided the company with an insurance cover. Furthermore, in order to reduce the total cost of the premium paid, he could have purchased the out of the money put options.

            A range of hedging alternatives has been discussed below with their respective total costs under each of the hedging strategies of the company.

Lufthansa Case Solution

Hedging Alternatives

Remain Uncovered:The first alternative available to the management of the company is to remain 100% un-hedged on this transaction. In this case the management would have to pay the total cost of $ 500 million at the current prevailing spot rate in 1986. Different spot rates on the basis of the best, worse and expected scenarios have been assumed and the total contract price has been calculated. The total contract price is expected to be around DM 1.6 billion. Therefore, this shows that the level of risk is very high under this alternative and it would remain high until the dollar depreciates..................

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