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Case Study: Lufthansa Corporation and Transaction Exposure

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Case Study: Lufthansa Corporation and Transaction Exposure
In January 1985, the German airline company, Lufthansa, signed a contract with the U.S. Corporation, Boeing, to purchase 20 Boeing 737 airplanes. Boeing agreed to deliver the airplanes to Lufthansa in one year later, in January 1986. Lufthansa agreed to make a single payment, of $500 million, when the planes were delivered. The spot exchange rate at the time the contract was signed was DM3.2/$, which corresponded to a deutschmark liability of 1.6 billion.
Since 1982, the U.S. dollar had been steadily appreciating against the German mark. In January 1982, the dollar was trading around 2.3 marks, and by January 1985, it had risen to 3.2. This represented an appreciation of the dollar of just under 40%.
Although many analysts had concluded that the U.S. dollar was overvalued during this period, it continued to show strength. Government intervention to weaken the dollar was not being discussed at this time. See chart which follows.
While many forecasters were predicting an eventual weakening in the U.S. dollar, for Lufthansa, the size of the contract, which was denominated in U.S. dollars, was seen as a too large of an uncovered transaction exposure.
What would you have recommended that Lufthansa do, and why?

Lufthansa’s Decision and Outcome
As noted the size of the contract, which was denominated in U.S. dollars, was seen as a too large of an uncovered transaction exposure for Lufthansa. On the other hand, most analysts were predicting a weakening of the U.S. dollar. If this were to occur, it could result in a smaller deutschmark denominated payment for Lufthansa. Recall, Lufthansa’s liability was denominated in U.S. dollars, thus a weakening dollar would have required fewer marks.
Lufthansa decided to hedge 50% of its exposure with a forward contract. This forward contract was set at DM3.2/$; thus Lufthansa would purchase $250 million in January 1985 for 800 million marks. The remaining 50% was left uncovered to take advantage of a possible weakening of the dollar.
During the 12 month period, the U.S. dollar did weaken against the mark. In January 1985, it was trading around 3.2 and by January 1986, it was trading around 2.45. This represented a decline of 23%. See chart below.

Cost of the 20 Airplanes
The cost of the 20 airplanes to Boeing was as follows:
50% covered with a forward contract, or

$250,000,000 x 3.2 = 800,000,000 marks

50% uncovered and purchased at spot, or

$250,000,000 x 2.45 = 612,500,000

Total mark liability in January 1985 = 1,412,500,000

Lufthansa had guessed correctly. The mark had strengthened and they were able to take advantage of that with an uncovered position. If they had covered 100% of their exposure, their cost would have been 1.6 billion marks, or 13% more.
On the other hand, if Lufthansa had not covered any of their liability, their cost in January 1986 would have been 1.225 billion, of 13% less.
Follow up
The Chairman of Lufthansa, Heinz Ruhnau, was criticized for his handling of the company’s exposure. The Minister of Transportation in Germany (who had ultimate authority over the airline), criticized Ruhnau for hedging 50% of the exposure which resulted in 187,500,000 marks more than if the company had not covered. As a result, Ruhnau was only offered a short term renewal contract as Chairman by the Minister of Transportation.

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