The case is about the Lufthansa Airline which is going to buy 20 new 737 Boeing airplanes for $500 million. The plane is ordered in January 1985, and the payment is to be made on January 1986. The need for this deal was because of its increasing passenger volume as well the revenue of Lufthansa was increasing at a rate sufficient to afford the deal. However, the main issue in the case was the problem caused due to the appreciating value of dollars as compared to Deutsche marks.
Heinz Ruhnau, the chairperson of the board of Lufthansa, was worried because of this appreciating dollar, as this would cost Lufthansa to pay a hefty amount for each Boeing airplanes. The fact that the booming US economy was as clear as a mirror to predict that the appreciation of the dollar was most likely to continue even in 1986. However, the fluctuation of the exchange rate was difficult to predict. The pattern of fluctuation that might occur in the future could not be predicted hence making the mode of payment by Lufthansa, confusing and complicated. This led Lufthansa exposed to exchange rate risk due to high volatility as both Deutsche Mark and US dollar floated in the market, and both countries chose to keep inflation steady. It was agreed that US dollar was overvalued, so G7 countries including the United States Congress wanted to curb the growing dollar for the benefit of US economy.
The concern of the chairman regarding the payment for the new 20 Boeings was due to the dollar appreciation. As a result of this, Heinz Ruhnau identified four different alternatives to cover the risk that might arise in the future.
The alternatives identified by Heinz has their own cost and benefit. To find out the best alternative, it is very important to evaluate each alternative based on their cost and the benefits. Different alternatives identified by the chairman are:
Do nothing and wait to see what the exchange rate is like in January 1986.
Cover some or the entire purchase price with forward contracts.
Cover some or all of the cost with foreign currency put options.
Obtain dollars by borrowing DM and invest them for one year.
For the first alternative, the relevant rate could be 2.4 DM/$ for minimum and could rise up to 3.5 DM/$ for maximum. The DM cost for the former would be 1,200,000,000 whereas for the maximum case would be 1,700,000,000.
Similarly, for the second alternative, the minimum relevant rate would be 0.5(2.4 DM/$) + 2 (3.2 DM/$) = 7.6 DM/$ and for max would be 0.5(3.4) + 2(3.2) = 8.1 DM/$. The cost for each would be 1,400,000,000 and 1,650,000,000 respectively deutsche mark.
For full forward cover, the relevant rate would be 3.2 DM/$ with cost 1,600,000,000
For a final put option, the relevant rate would be 3.2 DM/$ per strike with the cost of 1,296,000,000 Deutsche mark.
Before taking the decision, we need to analyze each of the alternatives.
This is the riskiest alternative available. While it is the riskiest alternative, it can generate the highest return if the situation turns out to be favorable. This is the riskiest because when the exchange rate becomes maximum, then the company will have to bear the highest cost. In case if the exchange rate falls, then the company can buy the planes for a lower price without incurring another cost.
Partial/Full Forward Cover:
The forward contract means the agreements between firms to make a transaction at today’s exchange rate. When a partial forward cover strategy is implemented then when the dollar depreciates, in such case Lufthansa will get chance to reap the benefit. However, the disadvantage of this partial cover is that the company will have the unlimited exposure. The company can have to bear the loss if the dollar value rises. To keep the balance between the risk of loss and return, 50 percent of the transaction can be covered by the contract while 50 percent remains uncovered.
Alternately, Lufthansa can implement the full forward cover strategy. This strategy will protect the company from bearing the unlimited risk of loss due to the appreciation of the dollar. When the entire transaction is covered by the forward contract, then the company can lock the price of the dollar amount at a rate determined today. So, the company is prevented from paying a hefty price if the dollar appreciated in 1986. If the transaction is covered at 3.2 DM/$, then it will make up to 1.6 billion Deutsche mark i.e. company do not have to pay more than 1.6 billion Deutsche mark in 1986 no matter what exchange rate will prevail in the market. But, the company will have to incur the loss if the exchange rate fall below 3.2 DM/$ because the company must pay 1.6 billion Deutsche mark to close the deal with Boeing.
Foreign Currency Put Option:
This is a unique type of alternative available to Ruhnau due to the existence of the kinked shaped value line. Ruhnau can implement this strategy to protect the risk that might arise in future due to dollar appreciation. Ruhnau could purchase the foreign currency put option to lock the price at 3.2 DM/$. This strategy will cost 1.6 billion DM to the company and the premium to be paid for put option. If the dollar keeps on rising beyond 3.2 DM/$, then the company can exercise the option and close the deal with Boeing at 3.2 DM/dollar. On the other side, if the dollar depreciates below 3.2 DM/$, then there is no compulsion of exercising the option and the company can make the deal at the exchange rate prevailing at the time of closing deal. In this case, the company will have to pay 96 million DM as the premium for option even if it is not exercised.
Buy Dollars and Invest:
In this strategy, Lufthansa will buy dollars today at a prevailing rate and invest the dollars in the high return generating investment alternatives for a short period. The company can take back its investment in 1986 and then pay for to the Boeing. In such case, there will not be any risk to the company because the company will have sufficient dollars already to pay for the new planes. However, the company will have to commit its 500 million dollars today for the investment of short term. It will be difficult to find the safer investment alternative for such a big amount and even if it is found, then converting that investment to cash in such a short period is next to impossible. In case, the investment alternative turn out to be negative return generating type, then it will add more problem to the company.
However, as the deal is already made, now it’s the time to select the alternative. From my analysis, I would recommend Lufthansa to cover its exposure by purchasing the put option to protect the company from the losses that might arise because of fluctuations in exchange rate. As there is no compulsion to exercise the option, the company can leave the option to expire at a minimum cost and close the deal at the prevailing rate. Therefore, I would suggest Lufthansa to go for the third option.