Free Case Study About Hedging At Lufthansa: A Case Study

Published: 2021-07-10 20:15:05
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Category: Investment, Company, Money, Aviation, Airline, Lufthansa, Exchange, Purchase

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1. History
Deutsche Lufthansa AG is one of the leading airlines worldwide and the largest in Germany. It resulted from the merger of Deutscher Aero Lloyd and Junkers Luftverkehr on 6 January 1926 (“1920s” n. p.). By 1931, it served Paris, Barcelona, Rome, and Oslo, accounting for a third of all passenger travel in Europe. Its operations stopped in the Second World War, near the war’s end, and formally dissolved in 1951. It resumed in 1954 as a new entity called Aktiengesellschaft fur Luftverkehrsbedarf or Luftag. In April 1955, it started its transatlantic flights to New York City as well as Paris, London, Madrid, and Lisbon (The Editors n. p.). Being headquartered in Cologne, its transport hubs are located at the Frankfurt International Airport and Munich International Airport. Its fleet of airplanes includes Airbus A319, A320, A321, A300 and Boeing 737 (“Lufthansa” n. p.).
2. Company Background
The Lufthansa Group operates globally. Its group fleet consists of 615 airplanes, the majority of which are manufactured by Airbus and Boeing (“The Fleet” n. p.). Short and medium routes are served by aircrafts from Bombardier, Embraer, Fokker, and BAE Systems.
Lufthansa consists of five business segments: passenger transportation (Passenger Airline Group), airfreight (Logistics), and downstream services (Catering and IT Services) (“Company Portrait” n. p.). The Executive Board manages the Company; while the Supervisory Board appoints, advises, and supervises the Executive Board. As of 2014, it has a workforce of 119,000 employees. It aims to become the “first choice” for customers, employees, shareholders, and partners. Its three strategic pillars are: (a) “Increase company value”; (b) Grow profitably and actively shape the aviation industry; and (c) Continual increase in “customer satisfaction”.
3. The Case
Lufthansa experienced a significant increase in demand and profitability in the most recent years prior to 1985 (Sapp 1). Its revenue increased to US$4.5 billion in 1984 from US$4.2 billion in 1983. The net profits more than doubled to US$54 million from US$23 million. With the increase in passenger volume, which requires new aircraft, and the increase in revenue to afford new aircraft, it was undertaking a forceful expansion program. Consistent with its standing fleet policy, Chairman Heinz Ruhnau ordered 20 new Boeing 737 airplanes in January 1985 at a cost of US$ 500 million and was negotiating with Airbus Industries for at least 20 new aircraft. However, Lufthansa still currently owes Boeing US$500 million payable in US dollars (2); the US currency at its peak of DM3.17 with indications (e.g. current US-Germany interest rate differential) that it would continue to rise (2-3); its revenues mainly in DM and its USD revenues already allocated to cover other USD-denominated expenditures (1-2); and the payable needed to be paid off upon delivery in January 1986 (1).
At the recent exchange rate, the Boeing airplanes would cost DM1.585 billion, which could increase to DMI1.650 billion should the rate hit 3.3DM/USD in January 1986 (Sapp 2). Due to the apparent overvaluation of the USD, Ruhnau strongly believed that the dollar would have increased by then, perhaps between DM2.45 and DM2.40; but could not be sure about it or when the decline would begin. Furthermore, if the exchange rate fails to decline before January 1986, the USD rate could reach up to DM3.40 in January 1986.
4. Hedging Alternatives
4.1 Remain Uncovered: Ruhnau could wait for January 1986 to arrive and see what that exchange rate would be (Sapp 2);
4.2 Full Forward Cover: Ruhnau could purchase forward contracts for US$500 million in order to lock USD at DM3.17 for a currency exchange premium of DM0.03/USD [DM3.20-DM3.17] (DM15 million) or 0.9463 percent [DM0.03/DM3.17] (2);
4.3 Partial Forward Cover: Ruhnau could purchase forward contracts for any part of the entire cost to allow some flexibility both on upside and downside exchange rate directions (3);
4.4 Foreign Currency Put Options: Ruhnau could purchase USD put options to partially or fully cover the maximum price of the US$500 million cost of the new aircraft at the exchange rate premium of DM0.03/USD [DM3.20-DM3.17] (or DM15 million) and a premium of 6.0 percent of the number DM sold (DM96 million or US$30 million if at 3.20 DM/USD) [(US$500 million x DM3.20 x 0.06] upon exercise. This right-to-sell contract will simultaneously allow Lufthansa to get the aircraft cheaper should the USD depreciate (3);
4.5 Buy Dollars: Lastly, Ruhnau could borrow DM at an interest rate of 6.3125 percent to purchase USD at DM3.17 (3). The USD interest rate of 9.5625 percent could virtually pay for the DM interest and the principal owed could be paid off from the revenue of the new airplanes and a gross interest income of 3.25 percent.
5. A Possible Alternative
Barring extreme interest rate fluctuations until January 1986 that can adversely result to loan rate adjustments in the direction of either upward for the DM loan or downward for the USD interest rate, taking a loan for DM1.585 billion to purchase US$500 million at a spot exchange rate of 3.17 DM/USD constitutes the best alternative among the five abovementioned to minimize cost of purchasing the Boeing aircraft. It has three advantages: (1) there would be no need to pay a currency exchange premium of DM15 million in buying forward contracts; (2) no need to pay the 6.0 percent premium on the number of DM sold when exercising the put option; and (3) a reasonably possible gross interest income of 3.25 percent if the interest rate on loans and deposits or money market accounts remained essentially as they were within the one-year period. One inevitable disadvantage though will be its inability to profit from possible weakening of USD against DM. However, the likelihood is not strong. Moreover, viewed from the primary objective of avoiding a more costly purchase of the Boeing aircraft, gaining from currency strength of DM against USD will be irrelevant provided the current DM/USD spot exchange rate is considered by Lufthansa as acceptable for the transaction to proceed.
6. Conclusion
Of the five alternative options presented in the case study, remaining uncovered shall be the last option to adopt. So much uncertainty accompanies this alternative. The use of forward contracts can lock in the currency exchange rate of 3.17 DM/USD for January 1986 take out. However, it will cost Lufthansa DM15 million; something that can be easily avoided by a simple purchase of USD at the same exchange rate using a short-term DM loan. Furthermore, foreign currency put option id doubly costly due to its currency exchange premium similar to forward contracts plus an additional 6.0 percent on the number of DM when exercised. The purchase of USD at the 3.17 DM/USD exchange rate is straightforward and simple with added potential interest profit on the difference between the DM loan interest rate and the USD deposit or money market interest when the loan proceeds are placed in such account to be withdrawn in January 1986 to close the deal. That is, barring extraordinary events that will push banking regulators to drastically cut on the interest rates either in the DM or the USD side.
Works Cited
“1920s: A Pioneering Era.” Web. 14 July 2015.

“Company Portrait.” Web. 14 July 2015.
“Lufthansa.” Web. 14 July 2015.

“The Fleet.” Web. 14 July 2015.
Sapp, Stephen. “Lufthansa: To Hedge or Not to Hedge.” Ivy 08 Sep. 2005, 9B00N022:1-4.
PDF file.
The Editors. “Lufthansa: German Airline.” 31 Mar. 2014. Web. 14 July 2015.

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