Cases in International Finance Hedging Foreign Exchange Exposure
Case #1: Lufthansa “If Karl Marx could see what the foreign exchange market is doing to captains of industry…a successful corporate executive of one of the world’s prestige airlines can put on a multimillion dollar currency speculation – and win – and still get lambasted by the critics. Its enough to make a capitalist cry!” Intermarket, 1985
Some interesting Facts… 1926: Lufthansa was born through the merger of Deutsche Aero Lloyd and Junkers Luftverkehr – it inherits its crane logo from DAL 1934: Lufthansa offers its first transatlantic flight 1990: Lufthansa resumes flights to Berlin following German unification 1990: Lufthansa joins the star alliance with Air Canada, SAS, Thai Airlines and United Airways – the first multinational airline grouping
Lufthansa Today Lufthansa is the national carrier of Germany – headed by Wolfgang Mayrhuber (since 2003) • Revenue (2004): E 17B • Net Income (2004): E 383M • Passengers (2004): 50.9M • Load Factor (2004): 74% Lufthansa has 253 aircraft with an average age of 10.5 years. Boeing: 40% Airbus: 60%
In January 1985, under the Chairmanship of Heinz Ruhnau, Lufthansa purchased twenty 737 jets from Boeing for $25,000,000 apiece ($500M Total) Length: 100 Feet Wingspan: 86 Feet Cruising Speed: 470 MPH Max Altitude: 35,000 Feet Range: 1000 Miles Seats: 123 At the time, the exchange rate was DM 3.20 per dollar. At this rate, the planes would cost Lufthansa DM1.6B
Over the previous year, the dollar had been appreciating against the Deutschmark..
Lufthansa’s Options Option #1: Remain Uncovered The riskiest option with the greatest potential gain (if the dollar weakens against the Deutschmark) and the greatest potential cost (if the dollar strengthens). Option #2: Full Forward Hedge The safest of the options. If Lufthansa bought dollars forward at the current rate of 3.2, they could lock in a cost of DM1.6B Option #3: Option Hedge If Lufthansa purchased put option on DM at 3.20 DM/$ (or call options on dollars), they could take advantage of the potential gain from a dollar depreciation, but still hedge the possible appreciation risk
Lufthansa’s Options Option #4: Money Market Hedge Lufthansa could obtain dollars now, by borrowing Deutschmarks, converting them to dollars at DM 3.20 and then depositing them in either a US bank or a Eurodollar account until needed. In principle, this should have the same effect as the forward hedge Option #5: Partial Hedge Lufthansa could purchase $250 M dollars forward at DM 3.20 at allow the remaining balance to be un-hedged. Option #6: Cash Flow Matching Lufthansa could try and generate $500M in ticket sales in the US – very unlikely!
Lufthansa’s Options Uncovered Full Forward Option Hedge Partial Hedge
Ruhnau was convinced that the dollar was going to fall and opted for the partial hedge. He was proved right as the dollar plummeted in the mid eighties.
Did Ruhnau make the right decision? While Ruhnau was correct on the direction of the dollar, he could have saved some money using options rather than a partial hedge!
Case #1: Porsche “Porsche makes most of its cars in Germany, so its costs are mainly in Euro. Yet a large chunk of its revenues come from sales in America. “ The Economist, June 5, 2003
Some interesting Facts… Porsche was founded in 1931 by Ferdinand Porsche, a former Daimler Benz director. One of the first Porsche models…look familiar?
Some interesting Facts… The first real Porsche – designed in 1948 September 30, 1955: James Dean is killed driving his Porsche 550 Spyder
Porsche Today Porsche is led by President and CEO Dr. Wendelin Wiedeking (since 1993) • Net Sales (2003): E 5.582B • Net Income (2003): E 565M • EPS(2003): E 32.29 • EPS Growth (2003): 22% Porsche is essentially a privately held company. All 8.75M voting shares are held by the Porsche family. The remaining 8.75M non-voting shares are primarily held by institutional investors
The Jewel in the Porsche Crown has always been the 911 Series. (14 different 911 models currently) Engine: 3.6l 6 Cylinder Engine Power: 325 Hp @ 6,800 RPM Acceleration: 0-60 in 4.8 Sec. Top Speed: 177 Mph Porsche 911 Carrera Units Sold (2003): 27,789 Average Price: E 92,000 Cost: E 78,000 Profit Margin: 16% The 911 commands almost exclusive ownership of its market segment (high end sports cars). While sales are cyclical, price elasticity is very low.
The Boxster was introduced in 1996 to compete with the lowers end sport scars already on the market. Engine: 2.7l 6 Cylinder Engine Power: 240 Hp @ 6,400 RPM Acceleration: 0-60 in 5.9 Sec. Top Speed: 160 Mph Porsche Boxster Units Sold (2003): 18,411 Average Price: E 44,000 Cost: E 41,000 Profit Margin: 8% The Boxster is less cyclical than the 911, but much more price sensitive – particularly since introduction of the BMW Z4 in 2003
Porsche recently gained entry into the lucrative SUV market. Fuelled by SUV crazy Americans, the launch of the Cayenne in 2002 has been hailed as one of the most successful produce launches in history Engine: 3.2l 6 Cylinder Engine Power: 247 Hp @ 6,000 RPM Acceleration: 0-60 in 8.5 Sec. Top Speed: 133 Mph Porsche Cayenne Units Sold (2003): 20,603 Average Price: E 68,000 Cost: E 61,000 Profit Margin: 10% The Cayenne is clearly at the high end for SUVs – Porsche is quickly moving to develop a lower powered, lower cost version.
Porsche’s Competitive Position “We learned the hard way that banks are never there when you need them…” : Porsche’s anti-debt philosophy
Porsche’s Foreign Exchange Exposure Porsche has the heaviest US exposure (and this is increasing), yet it has the lowest rate of natural hedging in the sector…” (Citigroup)
Pricing Pressures Porsche’s Newest Model, the 911 Carrera 4s Cabriolet (2003)was priced in continental Europe at E 85,000 (a 15% markup over cost of $72,000). Simultaneously, the new Cabriolet was introduced in the US for $93,000 $ 93,000 Implied Exchange Rate = = 1.09 $/E (.91 E/$) E 85,000
As the Dollar falls, so do profit margin! At the current $1.29 per Euro exchange rate… $ 93,000 A profit margin of essentially zero over the cost of E 72,000!! = E 72,093 1.29 $/E Alternatively, Porsche could price to 911 in the US at a lower profit margin (say, that of the Boxster -8%) E 72,000(1.08) = E 77,800(1.29) = $100,310 Price elasticity of the 911 is the lowest of the various Porsche platforms, but could the US market withstand a price increase of this magnitude? (7.8%)
Porsche’s Problem Defined: Porsche has three model lines with different market characteristics – 45% of Porsche’s sales are in the US ($1.836B per year) With the exception of an assembly plant in Finland (also a Euro country), all Porsche’s are manufactured in Germany As the dollar continues to decline, what options does Porsche have to cover its currency exposure?
What did Porsche Actually Do? Porsche chose an aggressive strategy of put options on dollars (i.e. contracts to sell dollars at a fixed price). Porsche maintains a 3 year rolling portfolio of put options with strike prices based on currency forecasts. - Sales revenues through model year 2006 are completely hedged. • Currency Exposure Covered by Derivative Instruments • BMW: 35% • Mercedes: 30% • Porsche: 100% • Volkswagen: 30% Is this the best strategy?