The Lufthansa Group, officially headquartered in Cologne, Germany, is the largest airline in Europe, both in terms of passengers carried and fleet size. The airline operates services to 18 domestic destinations and 197 international destinations in 78 countries across Africa, Americas, Asia and Europe, using a fleet of more than 280 aircrafts. Lufthansa Group is divided into five business segments, which cover the areas of passenger transportation, airfreight and airline services: Passenger Airline Group, Logistics, MRO1, Catering and IT Services. All of the business segments occupy a leading position in their sectors and in some cases are the global market leaders. International ticket sales and the purchase of fuel, aircraft and spare parts give rise to foreign currency risks for the Lufthansa Group. All subsidiaries report their currency exposure to the central financial planning department over a timeframe of at least 24 months. The Group has a foreign exchange department that is specialized in trading foreign currencies and is responsible for the financial hedges of the Group. Of the 80 currencies relevant for the Lufthansa Group, 20 are hedged. The main currencies are the U.S. dollar, Japanese yen and Chinese renmimbi. Currencies highly correlated with the US dollar are also set off against operating USD exposure. It is Group policy to hedge 100% of the foreign exchange rate exposure towards the main currencies by systematic financial management (using financial derivatives) and by creating natural hedges. For U.S. dollars, Lufthansa is mainly in a net payer position, as fuel payments are dollar denominated. For other currencies there is always a net surplus. The main risks in this respect stem from the pound sterling, the Swiss franc, the Japanese yen, the Chinese renmimbi and the Indian rupee. On January 1, 2011, the Lufthansa Group appointed Dr. Christoph Franz as Chief Executive Officer. In his role, Mr Franz is responsible for the segments Passengers Airline Group, Logistics, MRO, Catering and IT Services, comprising over 120,000 employees worldwide. When Dr. Franz was hired, his challenge was to boost profits, which decreased significantly due to the recent global financial crisis and rising oil prices. Declining profits were reflected in a negative trend in Lufthansas share price; a trend that the Board of Directors would like to see reversed. In January 2012, Lufthansa bought ten 737 jets from Boeing. The agreed upon price was USD 500,000,000; payable in U.S. dollars on delivery of the aircraft in one year, in January 2013. The value of the dollar against the euro had been fluctuating significantly over the past two years. At the end of 2009, the dollar traded only at EUR/USD 0.6870. The U.S. currency regained value during the first part of 2010, but by June 2011 the value of the dollar dropped to an all-time low of 0.6810 euro. By the end of 2011, the dollar was rising again, and in January 2012, it traded at EUR/USD 0.7704.

Mr. Franz had his own view on expectations regarding the directions of the exchange rate. Like many others, he believed that the dollar would decline again over the coming year. The panic on the financial markets due to the European debt crisis, which caused the euro to plummet, was coming an end. Also, the inflation differential pointed towards a weakening dollar: analysts forecasted a 3% inflation rate for the U.S., while inflation in Europe would be only 2%. Thus, Mr. Franz believed, the euro would regain power at the expense of the dollar. You just have been hired at the foreign exchange trading desk of Lufthansa and are asked to help the CEO Office with the management of their foreign exchange rate risks. Your first task is to advice Mr. Franz on how to hedge the $500 million exposure resulting from the order at Boeing. You contact market makers at Deutsche Bank and UBS and receive the following quotes:

Spot rate (EUR/USD) 0.7704 0.7704 0.7704 0.7704 1 year Forward rate (EUR/USD) 0.7650 0.7652 0.7651 0.7653 You call a trader at the Chicago Mercantile Exchange (CME) and learn that following options are available: - Call options on USD, size $100,000, strike price EUR/USD 0.7650, maturity January 2013, premium 0.005 EUR/USD. - Put options on USD, size $100,000, strike price EUR/USD 0.7650, maturity January 2013, premium 0.003 EUR/USD. Market interest rates are 2% per year in the United States and 1% per year in Europe. 1. Calculate the cash flows resulting from a forward market hedging strategy. Argument on which market maker you would choose as your counterparty.

2. Calculate the cash flows resulting from hedging with options. Explain whether you would use call or put options (and why!).