Case Study: Managing Transaction Exposure, Lufthansa

Corporation, 1985
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.
Background
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.
Issue
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.
Recommendation
What would you have recommended that Lufthansa do, and why?

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Transaction Exposure Issue for Lufthansa

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, Lufthansas liability was denominated in U.S. dollars, thus a
weakening dollar would have required fewer marks.
Lufthansas Decision
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.
Outcome
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.

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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
Analysis
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
companys 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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