Generally, exchange rates tell us how much our currency is worth in a foreign currency. As simple as it may sound, foreign exchange traders make millions from this simple concept. They trade currencies 24 hours a day and seven days a week, and as of 2016, this market trades $5.1 trillion a day. Usually, a country’s foreign exchange rate is either determined by the floating exchange rate or fixed exchange rate concept. Where each has its mechanism to maintain the currency against the dollar or any other flexible currency like the pound or yen. These bring us to our case today, a deal in foreign currency which has its risks that is; the economic uncertainty, translation risk, and the transaction risk. In this paper I will discuss, the transaction risk Lufthansa may face both positive and negative and how the company will mitigate or prevent any loss.
Lufthansa is facing a transaction risk as the future behavior of the dollar is unknown; in one year a lot can change in the foreign exchange market. Either the dollar can get stronger or weaker. If the dollar gains against the local currency, the company will have to pay more than 1.6 billion. If the local currency gains against the dollar, the company will have a less burden as the cost will be less than 1.6 billion. So what is the company supposed to do? And why? Will it save their bank accounts from giving more than 1.6 billion?
There are several ways Lufthansa could have dealt with this situation. As an economist, my first advice would be the invoice. During the negotiations of the contract, Lufthansa managerial should have ensured the invoice was in Deutsche Mark (DM). In this case come rain come sunshine their liability would still be 1.6 billion.
Secondly, if Lufthansa usually had many purchases and sells in foreign currency then netting would have been possible. In this case, it owed the corporation $500 million, and maybe there was another U.S corporation that owed Lufthansa $480 million for example. Then by netting off group currency flows the net exposure would have been $20 million.
Matching would have been an excellent solution if only Lufthansa had other money transactions in the U.S. The company would have opened an account with a US bank. Deposit money in this account from their U.S clients and when the money is more than or $500million, pay off the corporation — mitigating any losses.
Lastly, I would have advised the company to use the forward exchange contract where they would have agreed to buy the dollar at an agreed amount at a specific period in future, in this case, one year. For example, they would have agreed to buy at 2.9-3.5DM/$. One year later the bank would sell them $500 at this rate irrespective of the spot rate at that particular time. Reducing risk.
From all of the above solutions, some would work and others would not. The invoice solution wouldn’t work if the contract had already been settled. Secondly, netting may or may not work considering the level of their transactions in the U.S. leaving us with Matching, putting in mind it is an airline company, so they always have flights from the U.S to Germany or other destinations. Hence all tickets bought from the U.S would be channeled to an account in one of the US banks. This would be much safer than the forward exchange contract.