Cases in international finance

Case #1: Lufthansa “If Karl Marx could see what the foreign exchange market is doing to captains of industry…a successful corporate executive of one of the world’s prestige airlines can

Cases in International Finance

Hedging Foreign Exchange Exposure

Case #1: Lufthansa

“If Karl Marx could see what the foreign exchange market is doing to captains of industry…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 the critics Its enough to make a capitalist cry!”

Intermarket, 1985

Some interesting Facts…

1926: Lufthansa was born through the merger of Deutsche Aero Lloyd and Junkers Luftverkehr – it inherits its crane logo from DAL

1934: Lufthansa offers its first transatlantic flight

1990: Lufthansa resumes flights to Berlin following German unification

1990: Lufthansa joins the star alliance with Air Canada, SAS, Thai Airlines and United Airways – the first multinational airline grouping

Lufthansa Today

Lufthansa is the national carrier of Germany –

headed by Wolfgang Mayrhuber (since 2003)

In January 1985, under the Chairmanship of Heinz Ruhnau,

Lufthansa purchased twenty 737 jets from Boeing for $25,000,000 apiece ($500M Total)

Length: 100 Feet Wingspan: 86 Feet Cruising Speed: 470 MPH Max Altitude: 35,000 Feet Range: 1000 Miles

Seats: 123

At the time, the exchange rate was DM 3.20 per dollar At this

rate, the planes would cost Lufthansa DM1.6B

Over the previous year, the dollar had been appreciating against the Deutschmark

Lufthansa’s Options

Option #1: Remain Uncovered

The riskiest option with the greatest potential gain (if the dollar weakens against the Deutschmark) and the greatest potential cost (if the dollar strengthens)

Option #2: Full Forward Hedge

The safest of the options If Lufthansa bought dollars forward at the current rate of 3.2, they could lock in a cost of DM1.6B

Option #3: Option Hedge

If Lufthansa purchased put option on DM at 3.20 DM/$ (or call options on dollars), they could take advantage of the potential gain from

a dollar depreciation, but still hedge the possible appreciation risk

Lufthansa’s Options

Option #4: Money Market Hedge

Lufthansa could obtain dollars now, by borrowing Deutschmarks, converting them to dollars at DM 3.20 and then depositing them in either a

US bank or a Eurodollar account until needed In principle, this should have the same effect as the forward hedge

Option #5: Partial Hedge

Lufthansa could purchase $250 M dollars forward at DM 3.20 at allow the remaining balance to be un-hedged.

Option #6: Cash Flow Matching

Lufthansa could try and generate $500M in ticket sales in the US – very unlikely!

Lufthansa’s Options

Uncovered Full Forward

Partial Hedge

Option Hedge

Ruhnau was convinced that the dollar was going to fall and opted for the partial hedge He was proved right as the dollar plummeted in the mid eighties.

Did Ruhnau make the right decision?

Case #1: Porsche

“Porsche makes most of its cars in Germany,

so its costs are mainly in Euro Yet a large chunk of its revenues come from sales in America “

The Economist, June 5, 2003

Some interesting Facts…

Porsche was founded in 1931 by Ferdinand Porsche, a former Daimler Benz director

One of the first Porsche models…look familiar?

Some interesting Facts…

The first real Porsche – designed

in 1948

September 30, 1955: James Dean is killed driving his Porsche 550 Spyder

Porsche Today

Porsche is led by President and CEO Dr

Wendelin Wiedeking (since 1993)

The Jewel in the Porsche Crown has always been the 911 Series

(14 different 911 models currently)

Porsche 911 Carrera

Engine: 3.6l 6 Cylinder Engine Power: 325 Hp @ 6,800 RPM Acceleration: 0-60 in 4.8 Sec Top Speed: 177 Mph

The Boxster was introduced in 1996 to compete with the lowers end sport scars already on the market.

Porsche Boxster

Engine: 2.7l 6 Cylinder Engine Power: 240 Hp @ 6,400 RPM Acceleration: 0-60 in 5.9 Sec Top Speed: 160 Mph

Porsche recently gained entry into the lucrative SUV market Fuelled by SUV crazy Americans, the launch of the Cayenne in 2002 has been

hailed as one of the most successful produce launches in history

Porsche Cayenne

Engine: 3.2l 6 Cylinder Engine Power: 247 Hp @ 6,000 RPM Acceleration: 0-60 in 8.5 Sec Top Speed: 133 Mph

Porsche’s Growing Sales

Porsche’s Foreign Exchange

Porsche has the heaviest US exposure (and this is increasing), yet it

has the lowest rate of natural hedging in the sector…” (Citigroup)

EUR/USD

As the Dollar falls, so do profit margin!

At the current $1.29 per Euro exchange rate…

$ 93,000 1.29 $/E = E 72,093

A profit margin of essentially zero over the cost of E 72,000!!

Alternatively, Porsche could price to 911 in the US at a lower profit margin (say, that of the Boxster -8%)

E 72,000(1.08) = E 77,800(1.29) = $100,310

Price elasticity of the 911 is the lowest of the various Porsche

platforms, but could the US market withstand a price increase of this magnitude? (7.8%)

Porsche’s Problem Defined:

Porsche has three model lines with different market

characteristics – 45% of Porsche’s sales are in the US ($1.836B per year)

With the exception of an assembly plant in Finland (also a Euro country), all Porsche’s are manufactured in Germany

As the dollar continues to decline, what options does Porsche have to cover its currency exposure?

What did Porsche Actually Do?Porsche chose an aggressive strategy of put options on dollars (i.e contracts to sell dollars at a fixed price) Porsche maintains a

3 year rolling portfolio of put options with strike prices based on currency forecasts - Sales revenues through model year 2006 are completely hedged.

Currency Exposure Covered by Derivative Instruments