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Managing Transaction Exposure, Lufthansa Corporation

Essay by   •  April 10, 2019  •  Case Study  •  938 Words (4 Pages)  •  27 Views

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Bryan Lara Mares

Ryan Miller


Case 3

Transaction exposure can be a critical financial risk for a multinational corporation. The uncertainty of future exchange rates could in turn cause substantial changes to the real value of a transaction agreed upon to be paid in the future. For these reasons, many MNCs decide to hedge their financial risk through the use of futures and options contracts.

In the case of Lufthansa’s future hedge of their 1985, Boeing aircraft purchase, the hedge ended up being less profitable for the company compared with taking a stance of indifference. However, hedging against transaction exposure was the correct decision order to minimize the risk to the company, although we may have encouraged hedging by buying a call option instead of a partial hedge via a forward contract.

        We should begin by acknowledging that the economists’ theories of an expected weakening of the dollar makes sense based on historical data. The strength of a currency, when left to freely float, will go through periods of strengthening and weakening due to economic factors--specifically, changes in quantities of imports and exports. As the US dollar strengthens, consumers are economically encouraged to import more goods as the dollar is capable of buying more of a foreign currency (in this case, the deutsche mark), thereby making the goods less expensive. The opposite effect occurs for exports, as Germans will have to give up more deutsche marks to purchase the dollar. Both phenomena should then result in a plateau and eventual decline in the exchange rate of the dollar against the mark.

        It was odd that the US dollar continued to strengthen despite these expectations, but eventually the trend would have to change, as it ultimately did in the year between when Lufthansa contracted Boeing for aircraft and when it had to make payments. In any case, it makes sense for Lufthansa to hedge. However, a forwards contract ultimately resulted in a more expensive purchase for the company than they would have had if they did not hedge their obligation at all.

        What would have been the better hedging strategy? One option would have been to utilize a money market hedge for the full $500 million purchase. Bankrate indicates that the average interest rate yield for a 1-year certificate of deposit in January 1985 was 9.36%. Due to the lack of information on lending rates for the deutsche mark in the same time period, we will assume that they would utilize free cash flow to invest in an American CD so as to cover the amount--although we should acknowledge that such a large amount is not a realistic expectation of Lufthansa.

        Nonetheless, in such a hypothetical scenario, Lufthansa would have invested whatever US $ amount which would have a future value of the contract obligation, which would be $500 Million/1.0936, or $457,205,559.62. This US amount would be the equivalent of 1,463,057,790.78 marks as the initial spot rate of 3.2DM/$ in January 1985. This amount would have exceeded the amount that Lufthansa ultimately paid (DM1,412,500,500), without considering any potential interest that would have been incurred by borrowing the marks in Germany needed to cover the obligation.



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