CHOOSING TO USE FORWARD CONTRACTS AS HIS HEDGING TOOL INSTEAD OF OPTIONS

In reference to the Lfthansa Case Herr Ruhnau was accused of making the following four errors:

1). Purchasing the Boeing aricraft at the wrong time. The U.S. dollar was at an all time high at the time of the purchase in January 1985.

2). Choosing to hedge half the exposure when he expected the dollar to fall. If he had gone through with his instincts or expectations, he would have left the whole amount unhedged (which some crtics have termed “whole hog”).

3). Choosing to use forward contracts as his hedging tool instead of options. The purchase of put options would have allowed Herr Ruhnau to protect himself against adverse exchange rate movements while preserving the flexibility of exchaning DM for U.S. dollars spot if the market moved moved in his favor.

4). Purchasing Boeing aircraft at all. Germany, as well as the other major European Economic Community countries, has a vested interest in the manufacture of large long-distance civil aircraft.

Given these criticisms, should the board of Lufthansa retain Herr Heinz Ruhnau as chairperson? How should Ruhnau justify his actions and so justify his further employment?
1. Herr Ruhnau was accused of making the following mistakes (alongwith a few other errors):

Purchasing the Boeing aircraft at the wrong time. The U.S. dollar was at an all-time high at the time of the purchase in January 1985.

Purchasing Boeing aircraft at all. Germany, as well as the other major European Economic Community countries, had a vested interest in the joint venture Airbus. Airbus’s chief rival was Boeing in the manufacture of large long-distance civil aircraft.

Are these accusations, in your opinion, right? Justify your answer.

2. From the perspective gained from answering Question 1, would you consider this ‘hedging’ incident to be one of Managing Transaction or Translation or Economic Exposure? Justify.
3. Is it fair to judge transaction exposure management effectiveness with 20/20 hindsight?
4. Review briefly the characteristics of forward contracts?. How do forward contracts enable Lufthansa to hedge their transaction exposure in the Boeing 737 imports? How would the foreign exchange market have to move for the forward contract hedge to be fully in Ruhau’s favor?
5. Do you think Heinz Ruhnau’s hedging strategy made sense? What is the resulting position and cost for Ruhnau if instead the dollar increases to DM4.1000/$?
6. To what degree did he limit the upside and downside exposure of the transaction by hedging one-half of it? Were there any other alternatives that were there, besides forward contracts, to hedge Lufthansa’s transaction exposure without the upside or downside exposure?
7. Do you agree with Ruhnau’s critics that he was “speculating”? Why?
8. Do you agree that “a little bit of speculation in forex markets would not hurt corporates’ bottom lines”? Why or why not?

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