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Lufthansa case
A) What aspects of Ruhnau’s decision can be called “speculation” and what aspects can be called “hedging”? Explain.
Simply put, an uncovered commercial transaction (receivable,payable) is “speculative” until it is covered. In the Lufthansa case, Ruhnau’s decision resulted in “speculating” with ½ of his exposure ($250m) with one year forward contracts of 3.2/$ which was representative of the current exchange rate of 3.2/$ in Jan of 1985. This approach left ½ of his exposure ‘covered.’ Because Ruhnau left the other ½ of his exposure uncovered – it was subject to fluctuation in the dm/$ exchange rate which ‘could’ either leave him saving money if the exchange rate of the DM increased relative to the dollar, or could cost Lufthansa if the $ strengthened against the DM.
B) Why were options contracts rejected as a hedging strategy? Should they have been rejected – why or why not?
The option premium in the case was 6% or DM96m of the total amount DM1.6m. This meant that the total price for the coverage provided by the option was DM 1,696m however, this was perceived to be a high price to pay given he was speculating on the dollar moving down. Downward movement of the dollar, if an option was used for the full amount, would mean that Ruhnau would let the option expire without providing value and cost him DM96m which would be added to the total cost of the purchase.
Had he optioned the full amount, the DM would have to move from 3.2 to 2.8 DM/$ to realize the approximate break even point given the nearly 100m expense of the option. Conversely had the dollar continued to appreciate and the ...