EXHIBIT 1 Lufthansa's Net Cost by Hedging Alternative Uncovered Put option cover 50% forward Billions of DM 100% forward-cover 2.20 2.40 3.80 4.00 2.60 2.80 3.00 3.20 3.40 3.60 Ending DM/$ exchange rate (Jan 1986) 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: toimivi 1. Remain uncovered, 2. Cover the entire exposure with forward contracts, Cover some proportion of the exposure, leaving the balance uncovered, 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 notential end-of-neriod snot exchange rates 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 carry. Many firms believe the decision to leave a large exposure uncovered for a long period of time to be nothing other than currency speculation. 2. Full Forward Cover. If Lufthansa were very risk averse and wished to eliminate fully its currency exposure, it could buy forward contracts for the purchase of U.S. dollars for the entire amount. This would have locked-in an exchange rate of DM3.2/$, with a known final cost of DM1.6 billion. This alternative is represented by the horizontal value-line in Exhibit 1; the total cost of the Boeing 737s no longer has any risk or sensitivity to the ending spot exchange rate. Most firms believe they should accept or tolerate risk in their line of business, not in the process of payment. The 100% forward cover alterna- tive is often used by firms as their benchmark, their comparison measure for actual currency costs when all is said and done. 3. Partial Forward Cover. This alternative would cover only part of the total exposure leaving the remaining exposure uncovered. Herr Ruhnau's expectations were for the dollar to fall, so he expected Lufthansa would benefit from leaving more of the position uncovered (as in alternative #1 above). This strategy is somewhat arbitrary, however, in that there are few objective methods available for determin- ing the proper balance (20/80, 40/60, 50/50, etc.) between covered/uncovered should be. Exhibit 1 illustrates the total ending cost of this alternative for a partial cover of 50/50; $250 million purchased with forward contracts of DM3.2/$, and the $250 million remaining purchased at the end-of-period spot rate. Note that this value line's slope is simply half that of the 100% uncovered position. Any other partial cover strategy would similarly fall between the unhedged and 100% cover lines. Two principal points can be made regarding partial forward cover strategies such as this. First, Herr Ruhnau's total potential exposure is still unlimited. The possibility that the dollar would appreci- ate to astronomical levels still exists, and $250 million could translate into an infinite amount of Deut- schemarks. The second point is that the first point is highly unlikely to occur. Therefore, for the imme- diate ranges of potential exchange rates on either side of the current spot rate of DM3.2/$, Herr Ruhnau has reduced the risk (vertical distance in Exhibit 1) of the final Deutschemark outlay over a range of ending values and the benchmark value of DM3.2/$. EXHIBIT 2 What Herr Ruhnau Could See: The Rise Spot rate, DM/$ DM/S 20 L Jan 82 m mmmmmmmmmmllimmmmmm Jan 83 Jan 84 Jan 85 Jan 86 Jan 87