Lufthansa Analysis Ruehner

Lufthansa Case Analysis

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1 Executive Summary By using a partial forward cover, Herr Heinz acted to mitigate risk from further DM depreciation while also taking advantage of DM appreciation should it occur as he expected. The DM did appreciate from 3.2DM/$ to 2.3DM/$. The total cost to Lufthansa dropped from DM1.6 billion to DM1.375M, a savings of DM225 million, by using the partial forward cover. However given the significant volatility in DM/$ rate, the put option method would have saved an additional DM129 million for a total savings of DM354 million. Had DM appreciated less than 12%, the partial forward cover would have saved Lufthansa more money than put option.

2 Detailed Analysis

2.1 Timing of Boeing Purchase 2.2 Partial Forward Coverage 2.3 Use of Put Options Since 1980, the DM had depreciated significantly in regards to the US dollar. Herr Heinz believed that DM/$ exchange would fall between when the contract was signed in January 1985 and payment due at aircraft delivery in January 1986. Herr Heinz did not want to lock in the DM/ $ at the current spot rate as he anticipated significant cost savings as the DM appreciated. However, he was not certain about this prediction as forward exchange rates are notoriously difficult to predict. Thus, Herr Heinz sought to mitigate risk and limit potential cost increases if he was wrong and the DM continued to depreciate. Lufthansa primary business is as an airline, and Herr Heinz wanted to limit his exposure in the currency market as currency speculation was not a Lufthansa core competency. Herr Heinz’s two main alternatives to take advantage of the expected DM appreciation while limiting risk should DM actually depreciate were: partial forward cover and put options. As shown in Exhibit 2 of the case, the choice of the partial cover or the put option depends on how much volatility Herr Heinz expected in the DM/$ rate. The partial forward cover was a better choice if the DM/$ rate stayed between 2.816 and 3.584, or +/- 12%. Within range, the partial

Lufthansa Case Analysis

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forward had a lower total cost to Lufthansa than the put option due the additional expense from the 6% premium (or DM96 million) required to purchase the option. Even if the DM/$ had only fluctuated by +/- 20% (2.56 to 3.84) of original 3.2 DM/$, the partial forward cover would have been 5% more expensive result than the put option at DM64 million as shown in Table X. Aircraft Cost with DM/$ Fluctuations (Millions of DM)

2.3 Partial Forward Cover Cost Put Option Cost

1375 1246

January 1986 DM/$ Spot Rate 2.56 2.816 3.2 3.584 1440 1376

1504 1504

1600 1696

1696 1696

3.84 1760 1696

However during the one year span between ordering and delivery of aircraft, the DM appreciated by 28% from 3.2 DM/$ to 2.3DM/$. This significant currency revaluation caused the partial forward coverage to be 10% more expensive than put option cost at DM129 million. By leveraging a partial forward cover rather than a put option, Lufthansa still saved money compared to the original DM$1.6 billion expected cost, but they only saved DM225 million instead of DM354 million.

2.4 Buying Boeing Instead of Airbus