Lufthansa: to Hedge or Not to Hedge
LUFTHANSA: TO HEDGE OR NOT TO HEDGE
1. If the DM/US$ exchange rate were 2.4DM/US$ in January 1986, what would be the all in cost of the aircraft purchase under each alternative? What would be the all in cost of the aircraft purchase under each alternative if the exchange rate were 3.4DM/US$? Consider both fully hedging the cost and hedging exactly one half of the cost (why may you only want to hedge part of the purchase price?).
1. Do nothing and wait and see what the exchange rate is like in January 1986.
500,000,000 USD x 2.4DM/USD = 1,200,000,000 DM
The cost of the aircraft purchase will be 1200 million DM.
2. Cover the purchase price using forward contracts.
If the company use forward contracts they have the obligation to perform, i.e. they have to buy the amount they have agreed upon in one year for the forward rate of 3.20 DM/USD.
If they fully hedging the cost the all in cost of the aircraft purchase will be:
500,000,000 USD x 3.2DM/USD = 1,600,000,000 DM
The cost of the aircraft purchase will be 1600 million DM.
If they choose to hedging exactly one half of the cost the all in cost of the aircraft purchase will be:
(250,000,000 USD x 2.4DM/USD) + (250,000,000 USD x 3.2DM/USD) = 1,400,000,000 DM
The cost of the aircraft purchase will be 1400 million DM.
3. Cover the cost using foreign currency put options
A put option gives Lufthansa the right to sell the DM at 3.20 DM/USD in one year. Even if they don’t exercise the option they have to pay the 6 % premium. The DM has appreciated in relation to the USD and the put option is therefore out-of-the money and Lufthansa will not use the option. But they will have to pay for the premium.
If they fully hedging the cost the all in cost of the aircraft purchase will be:
500,000,000 x 3.2DM/USD x 0.06 = 96,000,000 DM
500,000,000 USD x 2.4DM/USD + 96,000,000 DM = 1,496,000,000 DM
The cost of the aircraft purchase will be 1496 million DM.
If they choose to
1. If the DM/US$ exchange rate were 2.4DM/US$ in January 1986, what would be the all in cost of the aircraft purchase under each alternative? What would be the all in cost of the aircraft purchase under each alternative if the exchange rate were 3.4DM/US$? Consider both fully hedging the cost and hedging exactly one half of the cost (why may you only want to hedge part of the purchase price?).
1. Do nothing and wait and see what the exchange rate is like in January 1986.
500,000,000 USD x 2.4DM/USD = 1,200,000,000 DM
The cost of the aircraft purchase will be 1200 million DM.
2. Cover the purchase price using forward contracts.
If the company use forward contracts they have the obligation to perform, i.e. they have to buy the amount they have agreed upon in one year for the forward rate of 3.20 DM/USD.
If they fully hedging the cost the all in cost of the aircraft purchase will be:
500,000,000 USD x 3.2DM/USD = 1,600,000,000 DM
The cost of the aircraft purchase will be 1600 million DM.
If they choose to hedging exactly one half of the cost the all in cost of the aircraft purchase will be:
(250,000,000 USD x 2.4DM/USD) + (250,000,000 USD x 3.2DM/USD) = 1,400,000,000 DM
The cost of the aircraft purchase will be 1400 million DM.
3. Cover the cost using foreign currency put options
A put option gives Lufthansa the right to sell the DM at 3.20 DM/USD in one year. Even if they don’t exercise the option they have to pay the 6 % premium. The DM has appreciated in relation to the USD and the put option is therefore out-of-the money and Lufthansa will not use the option. But they will have to pay for the premium.
If they fully hedging the cost the all in cost of the aircraft purchase will be:
500,000,000 x 3.2DM/USD x 0.06 = 96,000,000 DM
500,000,000 USD x 2.4DM/USD + 96,000,000 DM = 1,496,000,000 DM
The cost of the aircraft purchase will be 1496 million DM.
If they choose to