1. What is the Foreign Exchange Risk faced by the LUFTHANSA?
Ruhnau expected if the U.S. dollar continued to appreciate, it would reach 3.3DM/USD and at the same time he also personally believed that the DM/USD exchange rate would fall from 3.17DM/USD to between 2.45 and 2.40 DM/USD by January 1986. Unfortunately, he was not sure when this depreciation would start. If it did not start before January 1986, he felt the U.S. dollar could be as high as 3.40 DM/USD in January 1986.
2. What alternatives did Lufthansa’s CEO was considering and why?
1. Do nothing and wait to see what the exchange rate is like in January 1986. 2. Cover some or the entire purchase price with forward contracts. This strategy would lock in the DM price and remove any uncertainty. i. The one year forward rate Lufthansa’s bank was willing to offer for such a large transaction to buy U.S. dollars in January 1985 was 3.20 DM/USD. 3. Cover some or all of the cost with foreign currency put options. This strategy would lock in a maximum price for the aircraft but also allow Lufthansa to pay a lower price if the U.S. dollar depreciated as he expected. i. 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. 4. Borrow DM to buy U.S. dollars today and invest them for one year. This strategy would lock in the price at today’s spot exchange rate. The loan could be repaid using the funds to be made available for the purchase in one year. i. In January
1985 the spot exchange rate was 3.17 DM/USD, the Eurocurrency U.S. dollar one year interest rate was 9.5625 per cent and the Eurocurrency one year DM interest rate was 6.3125 per cent.
3. According to you how each individual alternative to hedge the possible foreign exchange risks may be beneficial or not beneficial to the company?
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