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If Karl Marx could see what the foreign exchange market is doing to the world’s captains of industry, he would surely be laughing. Not only do they put up with labor problems, competition, deregulation, and rapid changes in technology—no, that is not enough. Add currency volatility to that list in the last few years. And it’s so bad that a successful corporate executive of one of the world’s prestige airlines can put on a multimillion dollar currency speculation, and win—and still get lambasted by his critics. It’s enough to make a capitalist cry. - Intermarket, 1985

It was February 14, 1986, and Herr Heinz Ruhnau, Chairman of Lufthansa (Germany) was summoned to meet with Lufthansa’s board. The board’s task was to determine if Herr Ruhnau’s term of office should be terminated. Herr Ruhnau had already been summoned by Germany’s transportation minister to explain his supposed speculative management of Lufthansa’s exposure in the purchase of Boeing aircraft.

In January 1985 Lufthansa, under the chairmanship of Herr Heinz Ruhnau, purchased twenty 737 jets from Boeing (U.S.). The agreed upon price was $500,000,000, payable in U.S. dollars on delivery of the aircraft in one year, in January 1986. The U.S. dollar had been rising steadily and rapidly since 1980, and was approximately DM3.2/$ in January 1985. If the dollar were to continue to rise, the cost of the jet aircraft to Lufthansa would rise substantially by the time payment was due. Herr Ruhnau had his own view or expectations regarding the direction of the exchange rate. Like many others at the time, he believed the dollar had risen about as far as it was going to go, and would probably fall by the time January 1986 rolled around. But then again, it really wasn’t his money to gamble with. He compromised. He sold half the exposure ($250,000,000) at a rate of DM3.2/$, and left the remaining half ($250,000,000) uncovered.

Evaluation of the Hedging Alternatives
Lufthansa and Herr Ruhnau had the same basic hedging alternatives available to all firms: 1. Remain uncovered,
2. Cover the entire exposure with forward contracts,
3. Cover some proportion of the exposure, leaving the balance uncovered, 4. Cover the exposure with foreign currency options,
5. Obtain U.S. dollars now and hold them until payment is due. Although the final expense of each alternative could not be known beforehand, each alternative’s outcome could be simulated over a range of potential ending exchange rates. Exhibit 1 illustrates the final net cost of the first four alternatives over a range of potential end-of-period spot exchange rates. 2 A06-99-0028

Of course one of the common methods of covering a foreign currency exposure for firms, which involves no use of financial contracts like forwards or options, is the matching of currency cash flows. Lufthansa did have inflows of U.S. dollars on a regular basis as a result of airline ticket purchases in the United States. Although Herr Ruhnau thought briefly about matching these U.S. dollar-denominated cash inflows against the dollar outflows to Boeing, the magnitude of the mismatch was obvious. Lufthansa simply did not receive anything close to $500 million a year in dollar-earnings, or even over several years for that matter.

1. Remain Uncovered. Remaining uncovered is the maximum risk approach. It therefore represents the greatest potential benefits (if the dollar weakens versus the Deutschemark), and the greatest potential cost (if the dollar continues to strengthen versus the Deutschemark). If the exchange rate were to drop to DM2.2/$ by January 1986, the purchase of the Boeing 737s would be only DM1.1 billion. Of course if the dollar continued to appreciate, rising to perhaps DM4.0/$ by 1986, the total cost would be DM2.0 billion. The uncovered position’s risk is therefore shown as that value-line which has the steepest slope (covers the widest vertical distance) in Exhibit 1. This is obviously a sizeable level of risk for any firm to...
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