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Lufthansa: To Hedge or Not To Hedge

The following is an MBA problem for which I am seeking a detailed answer in understandable English. (Note: I have had a problem in the past with answers that were substantively good but were hard for me to understand/figure out due to improper use of English grammar.)

Case Synopsis: Heinz Ruhnau, Lufthansa's CEO, needed to determine how to deal with the foreign ex change risk resulting from the purchase of 20 new aircraft. Due to Lufthansa's recent growth, it needed new aircraft. Its official policy was to have half Boeing and half Airbus aircraft, so it needed to purchase some aircraft from Boeing to offset its pending purchase of aircraft from Airbus. Ruhnau needed to determine how to deal with the massive foreign ex change exposure caused by the US$500 million purchase price (Lufthansa was the flagship German airline with the majority of its revenues in deutsche marks). The exposure was the result of this money being due in one year - upon delivery of the aircraft. He was considering four alternatives to deal with this risk:

1) do nothing,
2) hedge using forward contracts,
3) hedge using options, or
4) use the money market to lock in current exchange rates.

Due to the restrictive covenants on Lufthansa's borrowing, the fourth option was not a viable alternative.

Based on the above synopsis and the full case attached, please answer the following questions:

1) If the DM/$ exchange rate were 2.4DM/$ in January 1986, what would be the all in cost of the aircraft purchase under each alternative? (Consider both fully hedging the cost and hedging exactly one half of the cost.)

2) If the DM/$ exchange rate were 3.4DM/$ in January 1986, what would be the all in cost of the aircraft purchase under each alternative? (Consider both fully hedging the cost and hedging exactly one half of the cost.)

3) Why may you only want to hedge part of the purchase price?

4) Which alternative would you choose and why?

Solution Preview

Case Synopsis: Heinz Ruhnau, Lufthansa's CEO, needed to determine how to deal with the foreign ex change risk resulting from the purchase of 20 new aircraft. Due to Lufthansa's recent growth, it needed new aircraft. Its official policy was to have half Boeing and half Airbus aircraft, so it needed to purchase some aircraft from Boeing to offset its pending purchase of aircraft from Airbus. Ruhnau needed to determine how to deal with the massive foreign ex change exposure caused by the US$500 million purchase price (Lufthansa was the flagship German airline with the majority of its revenues in deutsche marks). The exposure was the result of this money being due in one year - upon delivery of the aircraft. He was considering four alternatives to deal with this risk:

1) do nothing,
2) hedge using forward contracts,
3) hedge using options, or
4) use the money market to lock in current exchange rates.

Due to the restrictive covenants on Lufthansa's borrowing, the fourth option was not a viable alternative.

Based on the above synopsis and the full case attached, please answer the following questions:

1) If the DM/$ exchange rate were 2.4DM/$ in January 1986, what would be the all in cost of the aircraft purchase under each alternative? (Consider both fully hedging the cost and hedging exactly one half of the cost.)

For the first alternative, which is do nothing and wait to see what the exchange rate is like in January 1986, the all in cost of the aircraft purchase will be as follows: -

US$500 million x 2.4DM/$ = DM1,200 million

For the second alternative, which is hedge using forward contracts, if we choose to fully hedging the cost, the all in cost of the aircraft purchase will be as follows: -

By using forward contracts, the company has to comply with the contracts that they have agreed with the bank. The one year forward rate Lufthansa's bank was willing to offer for such a large transaction to buy U.S. dollars in January 1985was 3.20DM/USD.

US$500 million x 3.2DM/$ = DM1,600 million

For the second alternative, which is hedge using forward contracts, if we choose to hedging exactly one half of the cost, the all in cost of the aircraft purchase will be as follows: -

The one year forward rate Lufthansa's bank was willing to offer for such a large transaction to buy U.S. dollars in January 1985was 3.20DM/USD.

(US$250 million x 3.2DM/$) + (US$250 million x 2.4DM/$) = DM1,400 million

For the third alternative, which is hedge using options, if we choose to fully hedging the cost, the all in cost of the aircraft purchase will be as follows: -

US$500 million x 2.4DM/$ = DM1,200 million

However, we choose to cover some or all of the cost with foreign currency put options. A put option (the right to sell DM at 3.20 DM/USD in one year) was being sold for a premium of six per cent of the number of DM being sold if the option is exercised. The company can either choose or not choose to exercise the option.

As the dollar depreciates, the company can ...

Solution Summary

This solution is comprised of a detailed explanation to answer the request of the assignment of more than 2,000 words of text.

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